Financial advice: (potential) market failure edition

The issue of what financial advisers are paid for comes up often, mostly when there is a question about whether they have fulfilled their fiduciary duty in giving advice. There are a variety of different models for how advisers get paid, and all have at least the appearance of some problem with them. There are two main issues:

  1. Agency: Are the advisers incentives aligned with yours – will they be a trustworthy agent? To my knowledge, no firm charges fees which are perfectly incentive aligned. Clients would have to agree to pay based upon how much value advisers have added compared to what the client would have done on their own – a hard counter-factual to assess.
  2. Quality: How do you know you the advice you are getting is worth paying for?

In the UK, the Retail Distribution Review is changing how financial advisers can charge for their advice, and many advisers will be moved to an up-front fee basis, or having to give “on-going” advice, i.e. initiating interactions with the client depending (usually) on what the market does.

To focus on the second issue, many advisers are quite rightly scared that this might hurt their business significantly, but mostly for a psychological reason – people have a real problem paying for up-front financial advice. They aren’t sure of the quality of it (the adviser often knows better than them), and they will not know if the advice was of high quality until a point far in the future.

This opens up a possibility of market failure to (among other things) asymmetric information. A client cannot directly assess an advisers’ quality ahead of time, and thus will discount the value of advice to incorporate the risk it is low quality. Advisers who give high quality advice will know it, and not want to accept low-quality prices for their high-quality advice. As a result, fewer people will pay (up-front) for financial services, because it seems too expensive relative to what they expect from it.

Recently my parents went to a financial adviser to help them plan their transition into retirement. They were a bit shocked by the $800 price tag for about 2 hours of time with the financial adviser – yet this is incredibly cheap by many standards. Wealth management and financial advisers often charge in the region of 0.60% up to 2.5% of assets under management per year, and clients have historically accepted those charges. My parents charge would have amounted to less than 0.005%, yet they were still floored by it.

Independent Financial Advisers already are a well-established market, but it will be interesting to see how people react if they have to pay up front.


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