The curse of commission salesmen

The spate of finance company collapses has clearly dentedinvestors’ confidence. That’s obvious from the fact that many investors have beenclamouring to get their deposits out of finance companies and into banks. Ironically,that panic has probably been the cause of several finance company closures andwill most likely threaten more over the coming months.

For those that have lost their precious savings the crisisis very real. The total potential (not actual) losses from finance companyfailures to date are estimated to be around $1bn. But let’s get that sum inperspective – last year household net financial wealth (mainly share portfolios,managed funds, etc) increased a cool $5bn and the net capital gain on housingwas a mammoth $50bn. These gains might not be as tangible as finance companydeposits but they make the shock to household wealth from the finance company meltdownlook pretty small, so far.

The damage may not be large in a macro sense, but there areplenty of mum and dad savers who have been burnt; and some badly. Thegovernment has been under pressure to do something and to be fair a newregulatory regime for the finance sector is in the pipeline. The currentproblems have now forced the pace on introducing new regulations to increasedisclosure by finance companies.

One proposal is to make credit ratings mandatory for most financecompanies – some already pay to have their businesses rated by agencies. Theproblem with credit ratings, however, is that they are not always easy tointerpret, different agencies have different rating statements, and ratings areno guarantee that finance companies are sound. Furthermore, credit ratings can havethe perverse effect of accelerating problems. Take for example Geneva Finance,which is rated by Standard & Poors. The latter has warned that Geneva faces"increasing pressure on its liquidity and funding". Nothing like stating theobvious and encourage the very behaviour that will justify the warning! While mandatorycredit ratings may seem a logical step to protect investors we should be waryof placing too much faith in them keeping investors’ money safe.    

Another area the government is looking to tighten up on isthe provision of financial advice. One of the more unsavoury aspects of KO’d financecompanies is the way some mum and dad savers were folded into the likes ofBridgecorp by salesmen on handsome commissions posing as financial advisers.

Most finance companies offer commissions to those who getinvestors to sign over their savings. In some cases these commissions arepunishing (up to 3% of the amount invested). Over a one to three year termthat’s a substantial increase in the premium a finance company may be payingfor its funds. The trouble is that the poor old investor does not always see, orknow about, this additional premium – too often it’s a secret between thesalesman and the finance company. The key is that the investor is seduced bythe free advice offered by the salesman who is then rewarded by thefinance company whose product he promotes.

David Hutton, chief executive of the Institute of FinancialAdvisors, in trying to fend off recent criticism that financial advisors are atleast partly to blame for the losses being suffered by investors, has said that"investors had to balance the risk against the reward and do their ownresearch, and not rely solely on financial advice".

Mr Hutton has a point – financial advice that’s free maybe worthless.

The worry for the government is that these dubious practicesare not confined to finance companies. The insurance and savings industry has longused commissioned salesmen to persuade people to make life-time commitments toproducts that are so complicated that salesmen must become advisers. The same practicehas now invaded the government’s flagship KiwiSaver regime.

There are salesmen masquerading as advisors out therepushing KiwiSaver schemes in return for a commission. The quality andsuitability of the scheme for an individual is likely to take a back seat to theexistence and size of commissions.

The government should require finance companies, fundmanagers and KiwiSaver providers – rather than their salesmen – to stateclearly whether they offer commissions and if so how much. That way, savers shouldbe aware of any potential bias in the advice they receive. Furthermore, in thecase of finance companies it would be clearer to investors just how much thecompany was having to pay to attract funds.

Accurate information about the cost of finance is essentialif people are going to properly appreciate the risks they are taking whenplacing their savings with finance companies.

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