When you seek care from your doctor, the idea that he or she may have a conflict of interest does not cross your mind. For example, we know that when he prescribes a drug, it is in our best interest; he does not receive a sales commission from pharmaceutical companies.
Unfortunately, you don't have the same guarantee when dealing with a financial advisor. Most financial advisors are compensated, in part or in whole, based on their sales of financial products. While they are required to offer you a product that "fits" your situation and goals, not all advisors are obligated to offer you the product that is in your best interest. For example, an advisor may offer you a mutual fund with a 2.3% fee rather than an exchange-traded fund with a 0.05% fee. Both products "fit" your profile and goals, except that your advisor will be better - often much better - compensated if he or she sells you a mutual fund.
To get an idea of the impact of conflicts of interest - and therefore fees - on your capital and retirement income, see our article: How to increase your retirement income by 50%.
5 "concerns" of the AMF
The organizations that regulate the financial sector in Canada (including the Autorité des marchés financiers in Quebec) have identified 5 main concerns in the client-advisor relationship (1) :
- Clients are not getting the value or returns they could reasonably expect from investing. High fees are the main cause.
- Mismatch between expectations and obligations: Most investors mistakenly assume that advisors must always provide advice in their best interests.
- Conflicts of interest. The AMF notes that "the implementation of current conflict of interest provisions is, in many cases, less effective than expected."
- Information asymmetry. Essentially, since your advisor knows much more about financial matters than you do, he or she should have an obligation to act in your best interests, which is not necessarily the case today.
- Clients are not getting the results the regulations are designed to give them.
Many conflicts of interest
In a notice issued in December 2016, the AMF notes numerous conflicts identified in a recent survey of Canadian financial advisors (2). Among the most egregious are:
- Referral agreements. Under these agreements, your advisor is encouraged to refer you to a colleague who will sell you a product or service, whether you need it or not.
- Professional titles related to sales targets. Your advisor has the title "Vice President". You think he earned that title because of his management skills? Think again, the title is simply tied to the volume of business they generate: the more they sell, the more prestigious the title.
- Incentive to sell you in-house products, more profitable for the institution but often more expensive for you. You are offered mutual funds at 2.3% fees or "investment solutions" at 1.75% rather than exchange-traded funds at 0.15% fees.
- Managers paid on sales volume. The manager to whom your consultant reports is more concerned with sales volume than with the quality of the advice: that's what determines his or her salary!
The document lists 18 conflicts of interest that have been identified in Canadian firms and that ultimately diminish your performance and the quality of the advice you receive.
How can you eliminate conflicts of interest?
As you can see, the majority of conflicts of interest are related to your advisor's compensation or other monetary benefits. You need to make sure you understand how your advisor is compensated, as this affects the advice he or she gives you, the fees you pay, and ultimately your performance and the achievement of your financial goals. Here are the questions you should ask your advisor:
- How is he compensated? If his compensation is even partially tied to the sale of financial products or if he is compensated for referring you to a colleague, he has a conflict of interest.
- Can they offer all products? If they cannot offer all investment products (including stocks and exchange-traded funds) or if they are restricted to their financial institution's "in-house" products or solutions, they cannot act in your best interest at all times. In fact, the AMF is considering removing the title of advisor from those who only offer in-house products and forcing them to call themselves "salespeople", which they are!
- Do they get paid on "cross-selling"? If they get paid on the sale of other products offered by their financial institution (insurance, trust services, etc.), they will tend to recommend these products to you.
You should deal with a truly independent financial advisor, whose compensation is based on the size of your portfolio, who receives no third-party compensation or cross-selling, and who is free to use the best investment vehicles available - including exchange traded funds.