The curse of commission salesmen
Fri 14 Sep 2007 by Infometrics Ltd.

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

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

The damage may not be large in a macro sense, but there are plenty of mum and dad savers who have been burnt; and some badly. The government has been under pressure to do something and to be fair a new regulatory regime for the finance sector is in the pipeline. The current problems have now forced the pace on introducing new regulations to increase disclosure by finance companies.

One proposal is to make credit ratings mandatory for most finance companies — some already pay to have their businesses rated by agencies. The problem with credit ratings, however, is that they are not always easy to interpret, different agencies have different rating statements, and ratings are no guarantee that finance companies are sound. Furthermore, credit ratings can have the 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 the obvious and encourage the very behaviour that will justify the warning! While mandatory credit ratings may seem a logical step to protect investors we should be wary of placing too much faith in them keeping investors’ money safe.

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

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

David Hutton, chief executive of the Institute of Financial Advisors, in trying to fend off recent criticism that financial advisors are at least 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 own research, 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 practices are not confined to finance companies. The insurance and savings industry has long used commissioned salesmen to persuade people to make life-time commitments to products that are so complicated that salesmen must become advisers. The same practice has now invaded the government’s flagship KiwiSaver regime.

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

The government should require finance companies, fund managers and KiwiSaver providers — rather than their salesmen — to state clearly whether they offer commissions and if so how much. That way, savers should be aware of any potential bias in the advice they receive. Furthermore, in the case of finance companies it would be clearer to investors just how much the company was having to pay to attract funds.

Accurate information about the cost of finance is essential if people are going to properly appreciate the risks they are taking when placing their savings with finance companies.

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