Regulators have reviewed the ways financial advisors are paid, and are concerned by a number of industry practices. They say compensation methods are "heavily weighted towards sales activity and revenue generation".
The Canadian Securities Administrators (CSA) published Staff Notice 33-318 yesterday, which reviews the sort of compensation and incentives that firms pay to motivate advisors. The regulators say they have uncovered a number of potential conflicts of interest that could arise if some of these practices are not properly controlled.
Promoting proprietary products
One area of concern are monetary and non-monetary incentives that favour proprietary products. The CSA notes that some firms pay their representatives a higher grid payout rate for all their proprietary mutual funds or for a subset of their funds, while others base a part of representatives’ annual bonus on the performance of their business unit, which included both distribution and asset management.
“These practices create a serious conflict of interest,” reads the review. “These practices create an incentive for representatives and the firm to drive sales of proprietary products in order to maximize the firm’s profits, which can result in inappropriate advice and inferior client outcomes."
Referrals and “first past the post” incentives
Referral arrangements are also under scrutiny. The CSA says that offering advisors one-time or ongoing referral fees for things such as mortgages, investment loans, and insurance could be problematic.
"This practice may encourage representatives to search through their existing books of business to find those clients that could be sold the targeted product or service whether they need it or not. In the case of related party referral arrangements, it may encourage representatives to send their clients to another arm of their firm, even when third party product and/or service options may be more suitable," says the CSA. "It may also encourage representatives to shift clients to more profitable business lines within the firm with little or no benefit to the client."
First past the post incentives which reward advisors with bonuses or recognition through trips or club memberships according to their revenue or sales rank within the firm are another sore spot. "This practice may encourage representatives to increase sales and generate revenue as quickly as possible to secure the benefit. This introduces or increases the conflict between clients’ long term needs and firms’ short term revenue and profitability targets," says the CSA. "Also, when the benefit confers a title to the representative (e.g., President’s Club member), it could be misconstrued by the client as a measure of skill level, experience or quality, rather than a measure of sales activity, which may inappropriately increase client trust in the representative."
Compensation tied to amount invested and cross-selling
As for incentives that are tied to the amount the client invests at a particular point in time, the CSA believes these could result in a conflict of interest because advisors might recommend that the client invest or save more whether they need to or not, to concentrate their investment into a single product, or to adjust the timing of their investment to increase the size of the trade.
The CSA also looks down on cross-selling, as they think the practice may encourage (or in some cases even require) advisors to push products and services that a client may not need or that are not suitable. "Representatives are typically only compensated for cross-selling products offered by related entities," say the regulators. "Even when the need may be valid, the client may be better served by utilizing unrelated products and services."
These are just a few highlights from the review. The complete document (PDF) is available from the Ontario Securities Commission web site.