Performance Pay Not As Good As It Sounds

The idea comes from a reader. “In the ultimate form, there would be no fees, and the agent would be rewarded by a percentage of the clients' profit (and perhaps even loss?),” he writes. “The agent shares some of or all of the clients' risk. There would be a lot more conservative investing. The idea parallels the American lawyers' ‘No win/no fee’ arrangement.”

Not quite. Presumably the US lawyers take on only the cases they are pretty confident of winning. Even if they lost a case every now and then, I’m sure they would win others during the same year. I expect their income ranges from not bad some years to really high other years.

On the other hand, in a year like the one ending March 31 2009, most of the clients of a typical financial adviser would have suffered losses. The adviser would end up with no income.

What’s more, if the adviser had to pay out a percentage of losses, as the reader suggests, they could be dipping quite deeply into their savings. I doubt we would attract top people to a job with a reward structure like that. It’s one thing for clients to see their savings balance falling; it’s quite another for an adviser to receive negative income. No wonder the reader ended his letter with, “I have not put this to my adviser.”.

I suspect if we somehow forced advisers to accept a pay-by-performance structure, they would respond in one of two ways:

• Invest clients’ money really conservatively, as the reader suggests – probably mainly in high-quality bonds.

• Aim to cash in on the fact that higher-risk investments bring in higher average returns over the long term, by putting all clients’ money in risky investments. To do this, the adviser would need considerable savings, in case they hit a market slump before they gained from a boom period.

Neither of these strategies is good for clients. While it sounds as if our reader would welcome more conservative investing, many New Zealanders already invest too heavily in bank term deposits and safe bonds, missing out on higher returns. Just because conservative investment has paid off in recent times doesn’t mean it’s good for the long haul.

Every client has different investment needs – depending on when they plan to spend the money, what other savings they have, their tolerance for volatility and so on. Advisers focussing on how they themselves will fare if they are paid by performance aren’t likely to give their clients’ needs top priority.

That’s not to say that the current way many advisers are paid – via commissions and other rewards from companies that provide financial products – works well either. Clients can end up in unsuitable and sometimes downright dreadful products that pay the most to the adviser.

The best system is for clients to pay advisers by the hour, in the same way accountants and lawyers are paid. This wouldn’t necessarily cost clients more. Currently they effectively pay the advisers’ commissions because that money comes out of their investment returns. It’s just less obvious.

Under a fee system, the advisers who served their clients well – by getting good long-term returns for the appropriate level of risk and by explaining what’s happening – would be rewarded by happy clients recommending them to others.

In Australia, the UK and the US, financial advisers are increasingly working for fees, and some New Zealand advisers operate this way. I suggest readers seek them out.