Royal Commission report nails adviser conflicts of interest

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The Financial Services Royal Commission asked Professor Sunita Sah for a report on how to mitigate the negative effects of conflicts of interests that influence financial advisers. Professor Sah focusses her research on how professionals who give advice alter their behaviour due to conflicts of interest. Cornell University, where she is a professor of management, describes her interests as including institutional corruption, ethical decision-making, bias, and transparency.

The outcomes of conflicts of interest on advisers

Academic literature on the effects of conflicts of interest on advisers suggests:

1. Conflicts of interest lead to biased advice. Often, advisers are unaware of the bias, and the effects are consistently large.

2. Self-regulatory mechanisms that govern moral standards do not operate unless they are activated. The advisers may not view the conflict of interest as a moral dilemma: “many psychological processes can be used to selectively disengage from moral self-sanctions. Collectively, these processes are known as moral disengagement.”

3. Moral disengagement is not sudden. It creeps up on the person and gradually erodes self-imposed sanctions.

4. When the biased advice causes harm, advisers absolve themselves by attributing the activities as ‘ordered by others’. This is more prominent if the practice is widespread, and advisers thereby observe other advisers doing the same thing.

5. Moral disengagement can also happen at an institutional level.

6. If the most corrupted are rewarded, moral disengagement accelerates.

7. Over time, private opinion alters as well. Advisers giving biased advice begin to believe their own advice (as being in the best interests of the client).

8. Advisers routinely deny an influence of incentives to a bias even after its demonstration. The bias shifts to the subconscious. Subsequently, ethical issues (in relation to the advice) are pushed aside by the conscious mind.

9. Such psychological processes, including rationalisations at a conscious level, are well established in academia. If there are incentives to not act in the best interests of the client, biased behaviour will not be limited to ‘bad apples’ but will include many who genuinely consider themselves to be upstanding people and good moral agents. As the report says, humans “are fantastically adept at rationalising and believing what we want to believe.”

Thus, “it is relatively easy for advisers to, for example, persuade themselves that the products that they receive commissions for really are the best and the clients they recommend investments for really will benefit from those investments.”

10. A sense of invulnerability to misaligned incentives increases the likelihood of accepting such incentives, and paradoxically, succumbing to them subconsciously.

Is disclosure the remedy?

Reliance on professionalism is grossly insufficient. Sah’s report reminds us that CEOs and managing partners of the large accounting firms, including Arthur Anderson and PwC, testified before the US SEC that their ‘professionalism’ would protect them from being influenced by conflicts of interest.

Sah says that “the most frequently recommended and implemented policy across industries and professions is disclosure,” but warns us that disclosure can have unintended consequences. The psychological principle in play here is that people think it is less morally reprehensible to give biased advice intentionally once a conflict of interest has been disclosed. Advisers may even increase the bias in their advice to counteract anticipated discounting of their advice by their audience.

On the positive side, Sah says that her research indicates that “mandatory and voluntary conflict of interest disclosure can deter advisers from accepting conflicts of interest so that they have nothing to disclose except the absence of conflicts.”

In other words, the ability to disclose an absence of conflict is a marketing plus point. We do see that exploited in the marketplace. Corporations become incentivised to remove conflicts of interest. Perhaps regulators could use this source of competitive advantage by making disclosure mandatory.

Secondly, says Sah, if conflicts are unavoidable, as long as industry norms to place the clients first are actually in place (as against just a lip service to such a norm), disclosure will cause more norm-abiding behaviour. Further, real experts with long periods of training in their profession tend to decrease bias with disclosure.

The paradox of disclosure from the client side

As advisers feel more empowered to give biased advice with disclosure, clients may also suffer subconscious biases that unwittingly lead them toward the biased advice. Firstly, clients may feel they are insinuating distrust by not accepting advice where a conflict has been disclosed, and the relationship is good. Indeed, clients may even want to favour their advisers who disclose they receive a higher fee if the client chooses X rather than Y. The client’s trust in their adviser increases with disclosure. Advisers will also likely to emphasise situations where they are recommending a product which has a lesser incentive for them.

Such effects are mitigated if clients need not communicate their choices to their advisers. But this is difficult in financial planning as execution of strategy is often part of the service.

Disclosure works better if it’s up-front, temporally prior to the advice, or at least at the top of the page (or at the start of the conversation) that sets the advice out.

So disclosure isn’t enough. What else works? Or doesn’t?

Sah says that educating advisers about self-serving biases does not reduce their bias. It only makes them better at detecting other advisers’ biases. Human beings are terrific at pushing ethical concerns into the background when it serves them well. Sah asserts that “Enron’s 64-page Code of Ethics booklet did not prevent the ethical failures of many employees within that institution.”

Sanctions, Sah recognises, would be hard to implement when outcomes of investment decisions are known much after the fact, and culpability as to a deliberately unsound advice hard to determine.

Fines may encourage institutions to undertake a cost-benefit analysis. Thus, Sah contends that insufficient fines would not provide a significant enough disincentive.

However, I note that the report, despite having a US perspective, does not delve into the class-action litigious culture of the US, where impacts are much bigger and more public than regulatory fines. We may start seeing some of that in Australia with several class actions, using evidence uncovered by the Royal Commission, already announced.

Institutional norms are perceived in a variety of ways, including the actions of leaders, not just the Code of Ethics document. Sah asserts that norms strongly affect individuals. Those in authority should pay attention to the myriad ways in which norms, including of what other advisers actually do, are perceived.

Getting second opinions, cautions Sah, is mostly not feasible due to cost and time. Indeed, we know that a second financial planner may in fact have the same biased incentive.

Realigning incentives is superior to disclosure. Removing incentives that create conflicts is the best way, says Sah – “policies that restricted interactions between the pharmaceutical industry and physicians led physicians to prescribe less (expensive) branded drugs and more (cheaper) generic drugs.”

Sah also recommends that “advisees need to be personalised and the harm they have suffered publicised. This decreases the psychological distance between advisers and advisees.”

Well, that’s certainly happening with the Royal Commission.

Professor Sah’s research paper can be found here.

 

Vinay Kolhatkar is Assistant Editor at Cuffelinks.

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4 Responses to Royal Commission report nails adviser conflicts of interest

  1. Gary M November 22, 2018 at 11:45 AM #

    Not as dry a subject as expected. There’s a lot in here about what motivates people in many circumstances, including some surprises.

  2. Vinay Kolhatkar November 25, 2018 at 12:31 PM #

    Yes, indeed. Thank you for the comment. By the way, the books Freakonomics and Superfreakonomics were about economic and other motivations, but written in a lucid way with plenty of illustrations.

  3. Wayne Barber. CFP November 25, 2018 at 1:49 PM #

    “A conflict of interest exists even if no unethical or improper act results. ” taken from the legal definition of conflict of interest. How do you eliminate conflict of interest in a transactional society? Keeping in mind a commission in any way is now banned in Australia on financial advice. Regulations require an insight as to the best interest of the client. If you purchase a product or service, enquiries need to be made as to the reason, is it necessary, will it suit and will it be of benefit. Will it put you in a better position.
    When you purchase a coat at Myers, for example, are these same questions asked by the provider? Simple analogy I know but these are the considerations and steps followed in the advice process. How do you eliminate a conflict of interest altogether when a transaction takes place? Buyer matched to a provider.

    • Vinay Kolhatkar November 26, 2018 at 2:14 AM #

      I presume a flat fee charged for advice rendered (with no commissions on products recommended) would minimise, but not eliminate, conflict of interest. Any residual conflict should be disclosed.

      I believe first find ways to eliminate conflict and disclose what can’t be eliminated may be a good working rule.

      The salesperson at Myers or the Toyota dealer are not the potential customer’s advisers. The Toyota dealer will recommend a Toyota, not a Honda, and we all know this going in.

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