Archive for the ‘commission’ Tag

The end of free

It never was free, of course; we always paid. But in two years’ time, financial advisers will no longer be entitled to commission on the savings products they recommend to their clients.  Not before time, either. Most of the disasters in the personal financial sector have been caused, directly or indirectly, by the practice of paying commission on sales. By far the most high-profile  of these was the endowments mis-selling fiasco of the early 1990s;  and the only reason  defined-contribution pensions – in my view, just as egregiously mis-sold on commission – have not hit the headlines is that the alternative, defined-benefit schemes are just bust.

Commission indirectly resulted in the collapse of Equitable Life: because it, rightly, chose not to pay its sales staff commission, they were less motivated than the competition and it had to resort to offering guaranteed annuity rates that were unaffordable and which eventually bankrupted it.

Finally, though, as the last of the sickly foals has hobbled out of the stable, the FSA decides that it will close the door.

ponzi schemes

Continuing my ramblings about commission, I refer you, gentle reader, to my earlier posts about Bernard Madoff.

Madoff operated a classic Ponzi scheme, and in my earlier post I postulated that the market as a whole had done the same to its participants, largely as a result of commission.

A classic, or simple, Ponzi scheme, is an investment product producing above-average returns to early adopters by siphoning-off the deposits made by new investors. So long as the scheme continues to attract new depositors, investors get a good return; but it is as fraudulent as a chain letter. It is, of course, exactly the same thing, but less honest. At least with a chain letter you are told how it works, but the inexorable arithmetic is the same in both cases. Madoff made his scheme last for so long by providing only slightly above-average returns, which both made it seem more credible and extended the time-scale of the inexorable arithmetic.

I think that in addition to the simple Ponzi scheme used by Ponzi, Madoff and many others, it is possible to conceive of complex Ponzi schemes. A simple scheme is implemented in a self-contained financial instrument, whereas a complex scheme does the same thing using multiple instruments where the value flows between them; but from the outside, the effect is the same.  A complex scheme could then be either contrived or emergent. In a contrived complex Ponzi scheme, the operators of the various instruments deliberately set out to achieve the Ponzi effect and design them to do so. I think that some of the housing/buy-to-let/mortgage frauds may be contrived complex Ponzi schemes; estate agents, solicitors and mortgage brokers are typically implicated in a conspiracy to defraud.

Much more disturbing, however, is the case of the emergent complex Ponzi scheme. In this case, it is the interaction of various financial instruments, each of which is itself entirely legitimate, which leads to a Ponzi effect. One such instrument might be broker’s commission. Indeed, I suspect it is the main villain in my very strong hunch  that most of the financial services sector has been operating for much of the last quarter-century as a very large emergent complex Ponzi scheme. Not a deliberate, criminal enterprise, but one nevertheless where the operators have benefitted enormously as punters have lost.  I suspect that it is a property of commission-based sales in savings products that a complex emergent Ponzi scheme is inevitable.

Perhaps there is evidence for this, but I think that first I need an adequate algebra to make the case and then to derive relations which can be tested against available metrics.

Sales Commission and Market Failure

Time to give those “poor” MPs a rest, and consider another issue which might be germane.

Most insurance-based savings products, such as pensions and endowments, are sold on commission. There is a saying in the insurance industry that insurance is never bought, it is always sold.

In the recession of the early 1980s, and again in the early 1990s, commission-based sales jobs were always on offer. You could earn a lot of money selling life-insurance, but most people I knew were never so desperate as to sacrifice their integrity that far. The jobs were entitled “financial adviser”, but the only skill the “adviser” needed was rote-perfect knowledge of the policy sales pitch. The jobs were sales jobs, pure and simple: If you didn’t sell any policies, you didn’t make any money, and to the punter, commission was the hidden cost of “free” financial advice. “Advisers” were forbidden to disclose the level of their commission; so since solicitors were required by the Law Society fully to account to their clients for any commission they were paid on products bought on their behalf,  many life companies refused to sell through solicitors.

Some time before that, the cosy City club of life insurers had an agreement about the maximum levels of commission they would pay their sales people. Today, such an agreement would be unlawful; but back then, it was binding on its members. However, a small City merchant bank, Hambros, set up a life department and didn’t join the life insurer’s club. After all, Hambros were already a member of the Accepting Houses Committee (which had nothing to do with life insurance, but was another cosy City club). Hambros decided to ignore the maximum commission rule, and pay its sales team much higher commission than anyone else. This was a very successful strategy, and Hambro Life quickly became bigger than its parent.  Hambro Life eventually became Allied Dunbar. The interesting thing about this is that Hambro Life grew its market share only by paying its sales staff high commission. It had nothing to do with the benefits to policy holders.

All the major life offices paid commission to their sales staff. The main exception was the Equitable Life, whose sales staff were paid salaries.  Unfortunately, shorn of the incentive of commission, they were less succesful, so the Equitable resorted to sweetening its sales offering with a promise (a guaranteed annuity rate) that would eventually destroy the organisation.

The lack of transparency in commissions led to many abuses. Various systems of regulation were imposed over the years, with the life offices fiercely resisting commission disclosure for years. Now, however, commission must in most cases be disclosed. There is no such thing as free financial advice, and independent financial advisers started charging fees, offsetting them against the commission they received.

One of the biggest problems emerged with endowment mortgages. Endowment mortgages used to be quite a good idea, for tax reasons. There used to be a 50% tax credit for life insurance premiums, and there was also full tax relief on mortgage interest.  So if you took out an interest only loan, the interest is payable in full for the full period of the loan, and the tax relief would be continuing, whereas with a repayment mortgage the interest (and thus the tax relief) reduces over time.  Tie in an endowment policy, with its 50% tax relief, to deal with the principal of the loan, and you had a product that, in theory at least, could save the borrower some tax. However,  tax credit on life insurance premiums was abolished in the 1980s, and mortgage interest tax relief was curtailed (it, too, is now abolished).  This made endowment mortgages much less efficient; but they were entrenched. Estate agents were paid commission for arranging endowment mortgages; lenders regarded the additional security of a life policy as justification for increasing the loan-to-value ratio beyond the 85% with which they had been comfortable in the past, and everyone benefitted, except of course those who bought such policies. It quickly became apparent that they were never going to pay out the full value, and it was clear that most endowment mortgages sold after about 1988 were mis-sold.  Many of the brokers who mis-sold them were commission-only agents. My partner and I were one of many victims of this; we received no compensation because we had changed the mortgage to a repayment basis and weren’t going to suffer unduly. Apart from having a life policy that we had bought on the firm assurance (an express promise from the long-vanished broker) that on maturity it would pay out at least the full value of the mortgage, and is worth less than we have paid for it in total.  The endowment fiasco was certainly a prime example of commission-based sales causing market failure.

Endowments and pension products are basically the same thing. Commission disclosure seems to me to be a sine qua non for any commission-based sales, but I would say that wouldn’t I, and  it’s not really enough. After all, when I bought my duff endowment mortgage, I knew the broker was going to get most of my first year’s endowment contributions, even if I didn’t know exactly how much; I still bought the policy. The problem is that it inevitably distorts “best advice”.  There are rules about what financial advice advisers can give, which de-skills them and reduces a complex subject to a series of regulated tick-boxes. It’s going to be hard for a broker or adviser to advise against buying a savings product, even if objectively such advice is the best for the client concerned, when to do so means that he will not be paid. It demands an unrealistic expectation of the adviser’s integrity.

Commission creates a short-term/long-term mismatch, and this is really where it goes wrong. I’m talking here just about long-term regular savings contracts like endowments and money-purchase pensions, but we will see how the problem extends to all commission based sales, including vanilla stockbroking.  As a saver, my interests lie in the long-term performance of the product, whereas my adviser’s interests like in the attached commission.  Twenty-five years’ time matters for me, not for the broker. So a first step could be to require an alignment of interests. If my broker is to get commission, it should be paid in the form of units in the fund backing the policy he sells me. If he needs money now, he can borrow it at commercial rates against the security of those units, just as I have done for my mortgage.

The hidden pyramid…

Madoff’s scam, his fraudulent investment vehicle, was a classic pyramid scheme, an illegal chain letter on a massive scale. Chain letters at least are transparent: if you are dumb enough to send money to the person at the top of the list, you know it’s going straight into his pocket.

So, as commorancy says in the comment to my earlier post, how many more frauds are out there? How many more frauds have the regulators missed? I doubt that there are many that are quite so blatant as Madoff’s. His was conspicuously lacking in transparency; he didn’t use external brokers, and his auditors were a two-bit firm from out of town. What’s scandalous about Madoff is that so many well-paid investment managers put their clients’ money into it when all the signs were there that it was a bad one. Nicola Horlick has lost £10m of her clients’ money, and she’s blaming the SEC. It’s true that the SEC seem to have been particularly lax here, but regulators don’t have unlimited resources. Ms Horlick is supposed to be smart: it’s her job to check, and she shouldn’t have to rely on the regulator to do her job for her.  She and dozens of other similarly over-paid parasites working for Santander (which has lost £3 bn), HSBC (£1bn) and others  were woefully negligent ; and if I were one of her clients, I would be consulting m’learned friends.

But that doesn’t mean to say that there isn’t a bigger problem, to which I have alluded in my earlier post. Lots of people managing other people’s money – ultimately, most of it is our pensions and savings, don’t forget – have been paid a lot of money, because they have led us to believe that they are smart. They believed it themselves, and lots of them are indeed smart. They want to believe that they were smart enough to make above-average returns for us all by making smart decisions in the market, and for a long time they have done so. Here’s how.

Now, Madoff’s above-average returns were made by paying out new investors’ deposits as dividends to existing investors. This is an old, and pervasive trick in the market; and while Madoff’s scheme was fraudulent and illegal, a lot goes on that’s legal.  Go into a bank branch; you’ll queue for hours to cash a cheque, but in the lobby will be a couple of people with no queue. They can’t do anything useful for you, but they can sell you an investment product. The bank gets a fat commission from selling the savings plan or pension product. That commission comes out of the first year’s deposits you make towards your pension. It goes to the bank’s bottom line – it’s much more profitable selling investment products than cashing cheques. So profitable, in fact, that the bank can afford to cash cheques free. Now, the  fund manager whom you are paying to look after the money in your pension fund looks at the  banks’ financial statements and sees that they are profitable. So she decides to put your money into bank stocks. You get some of the returns, which are earned from the commission paid by new depositors.

Spot the basic difference between Madoff’s illegal scam and the legal one which has been the financial services sector since 1986?

No, me neither.