Should much of our financial advice be outlawed?

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Recently, a person named David Blake implied that almost all financial advice given today should be outlawed.

You often hear outlandish claims from people less than fully informed on financial advice, but David Blake does not belong in this category. His views should be respected and his claims taken seriously by advisers, directors and executives of advice firms, and investors in considering how they are advised.

Who is David Blake?

David Blake’s career straddles both academia and industry, and he’s been highly successful in both. Completing his PhD in 1986, Blake is Professor of Pension Economics at Cass Business School, City University London, Director of the Pensions Institute (which he founded in 1996), and Chairman of Square Mile Consultants, a training and research consultancy. He is also: the co-founder with JPMorgan and Towers Watson of the LifeMetrics Indices; Senior Research Associate, Financial Markets Group, London School of Economics; Senior Consultant, UBS Pensions Research Centre, London School of Economics; and Research Associate, Centre for Risk & Insurance Studies, University of Nottingham Business School.

To say that he is well qualified to voice a strong opinion on this topic is an understatement.

What did he say?

Blake led the production of a report by the Independent Review of Retirement Income (IRRI) in the UK, released in March 2016. The report was far reaching, but his recommendations regarding financial advice were especially relevant:

“The use of deterministic projections of the returns on products should be banned.”

(‘Deterministic’ effectively assumes the average outcome will be achieved and it is only this outcome that is communicated).

“They should be replaced with stochastic projections that take into account important real-world issues, such as sequence-of-returns risk, inflation, and transactions costs in dynamic investment strategies.”

In short (on reading the full document), there are two important elements of this recommendation. The first is that advice needs to consider all of the key risks, most of which fall into two main groups: investment and mortality risk. The second is that the analysis of outcomes needs to be stochastic rather than deterministic. This simply means that the range and associated likelihood of outcomes are presented, something that can be quite hard to model in practice.

By suggesting that any advice that doesn’t meet these standards should be outlawed, Blake means that offering a deterministic prognosis represents dangerously misleading information.

How does this apply to the Australian advice industry?

This recommendation is produced in a UK environment and policy setting. However, Blake has shared his views at conferences in Australia and they appear to be universal.

Does the financial advice provided in Australia meet the standards recommended by Blake? The broad answer, unfortunately, is no. Most of it has similar failings to the advice provided in the UK: namely it doesn’t account for the major risks to financial outcomes, particularly mortality risk, and it tends to assume an average outcome such as 7% per annum over a defined period.

This is largely a failing of the advice industry rather than the advisers themselves (though they should push hard for the tools they need to deliver quality advice), and most of the major financial planning software fails to address the issues raised by Blake.

Additionally, the majority of roboadvice offerings appear to fail to meet the standards set by Blake. While many provide stochastic reporting it is largely based on one or two investment risk factors (which are relatively easy to model) while ignoring mortality risk. In this respect, roboadvice appears to be at a crossroads – will it represent high-quality online advice that takes full advantage of systems designed in a clean-sheet-of-paper environment, or will it simply consist of smart graphics wrapped around basic advice tools?

Regulators are not likely to rush to implement Blake’s recommendations in the near term. However, the advice industry has been called out by a universal claim from a highly respected thought leader. It remains to be seen if there’s sufficient motivation out there to significantly raise the bar regarding the standard of financial advice. It’s also unclear if leaders with appropriate skillsets can move the industry in the right direction going forward.

There is no denying that developing tools, and using, interpreting and communicating the output are challenging areas. In my view the primary management challenge is twofold: overseeing the technical issues while successfully communicating complex issues to clients.

Facing the challenge

I’ve been to industry conferences where I sometimes lose confidence that this challenge can be met. One such conference left me aghast, the spirit of the day evolving as follows: ‘Modelling needs to consider all risks and be stochastic’ and ‘It is challenging to communicate more complex modelling to people who are not financially trained’ to ‘This is too complex and we should stop talking about all this stochastic stuff’.

Many other industries develop complex products which are explained effectively to consumers; consider for example the technology in cars and medical treatments. Too hard to explain cannot be an excuse for not innovating.

If you consider the following alternative lines for inclusion in a statement of advice, the motivation for change becomes clearer:

1. In developing your financial plan we assume that you will die with 100% certainty at the age of X and that markets will perform exactly Y% each year.

Or

2. In developing your financial plan we have considered the possibility and likelihood of you dying at different ages and have considered a large range of possible scenarios for investment markets, which we all know are difficult to forecast.

It is obvious to me which approach represents superior advice. Dismiss this article if you like, because regulatory-led changes are unlikely, but you do so at your own risk. The poor quality of advice provided to individuals all around the world, including Australia, is a fundamental challenge to an important service industry. At some point it will become a strategic issue. Some people will see the opportunity to improve an important service currently being delivered at sub-standard quality. Others will see the opportunity to profit by innovating. Whatever the motivation, I look forward to seeing our advice industry meet David Blake’s standards.

 

David Bell is Chief Investment Officer at Mine Wealth + Wellbeing. He is working towards a PhD at University of New South Wales.

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18 Responses to Should much of our financial advice be outlawed?

  1. John August 16, 2016 at 12:41 PM #

    Interesting article and you make important points but I can’t see the point of what sounds like a complicated structure – people in finance like being blinded by what they think is science, but isn’t. Look at poor old John Maudlin for only one of many examples -he’ll be right one day, of course and then, like astrologers and psychics say, ‘look I told you so, it was in the charts!’ Keep it simple by projecting pessimistically seems wise to me (not that you should be over conservative in how you choose to invest). We have no way of knowing so we pluck a figure out of the air that is low historically. Like a lot of retirees my projections are always based on 3%+ inflation. If I make less return over the next 20 years it will not be good but I think it’s pessimistic enough to allow me some peace of mind. It also allows me to think that even 4 or 5% is great. Project glass half empty to enjoy glass half full.

  2. Gen Y August 11, 2016 at 10:09 PM #

    The article and many of the comments assume that the value of financial advice is portfolio construction. Of course, those in the industry doing it well know that portfolio construction is a tiny piece of the puzzle and most of the value is navigating the complexities of the Australian environment, as well as drawing out people’s goals, objectives and tolerance to risk (investment and insurable).

    Finally, the author obviously has not seen any of the customer research showing that stochastic modelling is confusing the clients, and most would prefer a deterministic model. What % confidence do I need of hitting my retirement goals? Most clients do not understand the statistics that underpin it, and a deterministic approach meets the objective allowing a good adviser to focus on the things that matter.

    • BB August 12, 2016 at 10:54 PM #

      Sorry Gen Y,

      The article and most of the comments do not suggest that at all. The comments are focused on risk assessment & risk management (not portfolio construction) of which the ‘risk profile’ as you call it, is (should be?) but a small piece.

      The risk assessment and management processes in question are actually highly focused on client goals and objectives, which often have a significant impact on potential risk (with impacts from investment choices and management often ranking well behind other factors for some clients). Risk assessment that allows for uncertainty in these variables brings those decisions and tradeoffs alive, something the existing risk profiling process almost entirely ignores.

      Stochastic methods are perfectly valid for everyday clients if utilised and communicated correctly. You don’t need to be an actuary nor do clients need to make complex decisions on probability levels or confidence intervals for the information to be useful, for them to be better informed and for you to demonstrate professional rigor and informed client consent.

      ‘Research’ suggests clients don’t understand stochastic models but that they somehow ‘understand’ and ‘prefer’ deterministic ones? If the client doesn’t understand it, the problem lies with their adviser, not them. Honestly, what client understands the difference between the approaches without understanding what the former is? And then what client with that understanding actively bases decisions on the later not the former? Total hogwash, As I commented earlier, a doctor can’t simply rule out current research and treatment because it’s easier for him/her to explain the 1980 Journal of medicine approach instead. That is your duty, not the clients, speaking of which….

      To suggest that one can somehow better meet a fiduciary or best interest duty by ignoring best practice is frankly concerning, although unfortunately, all too common a default position for some advisers. Even more disturbing is that your defense for this is based on the fact that clients (the lay person in a fiduciary relationship) are in a position to judge the validity or quality of a complex professional process. They pay a professional adviser for that, in confidence that their professional training allows them to make those complex judgements on their behalf, and to use their skills and training to communicate those complex issues in the simplest way possible. Does ones lawyer dismiss a complex legal defense on the basis that the client wouldn’t understand the legislative references???

      Frankly, such an uninformed and dismissive take on an important development area of retail advice in favor of a ‘value of my advice’ elevator speech might not be uncommon from a previous adviser generation, but the fact it has come from a fellow Gen Y’er isn’t just concerning, it’s downright disappointing.

  3. Stephen Romic August 5, 2016 at 12:55 PM #

    Nicely done, David

    Any tools that give us a better understanding of the inherent uncertainties should indeed be the industry path. It’s a big job to build such usable tools; even bigger to break down the prevailing barriers

    • BB August 5, 2016 at 5:58 PM #

      “there is a much better chance the client, our clients will get close to what they need”

      That Bob is a statement of probability, this article is addressing the need for more adequate tools and resources so that advisers can actually support that statement with something other than anecdotes, platitudes and generic assumptions.

      The article doesn’t state behavioral issues are not important, it is clearly addressing a different set of issues.

      Finametirca as a system is largely concerned with the psychometric aspects of risk, the concepts and tools mentioned here address other aspects of the risk equation. I believe Mr. Resnik himself has penned many an article calling out the serious shortfalls in current industry process in these areas.

      Suggesting that all or even most advisers are acutely aware of these issues and thus work outside of the broader industry, licensee frameworks and available resources to address them independently, or that the issues can be addressed with ‘coaching’ is total nonsense. It’s the equivalent of a physician suggesting they don’t need improved diagnosis techniques because their bedside manner will cover it?

      The concepts suggested here remain very much a niche area within the broader FP industry (the extremely basic iterations within coin and xplan coupled with their non-existent usage data more than attest to that).

      This is not ‘adviser bashing’ it’s a simple industry critique and an important one on the journey of increased advice quality, better client outcomes, better adviser protection and recognition as a profession.

  4. Bob Daws CFP SSA August 5, 2016 at 9:37 AM #

    And of course we leave out of this article the behaviour of clients which can at times completely wreck any chance they had of achievement with or without an adviser, at least with an adviser there is a much better chance the client, our clients will get close to what they need.

    I find it very interesting that such a reputable academic who has never sat down with a client and looked at all the clients issues can make such a sweeping statement, it not just about the numbers its about human beings and their behaviour that has the largest bearing on the outcomes. I can model 15 different scenarios based upon FinaMetrica’s world leading risk profiling tools yet if the clients behaviour twists and turns it’s all for nothing. So please stop bashing the advisers, we are conscious of this issue and try very hard to coach clients, moderate their expectations. Suggest you have a talk to Warren Buffet.

  5. Peter Vann August 4, 2016 at 5:50 PM #

    Hi David

    I’m glad to hear your clarion call on this topic.

    1) An early paper on part of this topic by Bengen (1994) provides a simple case illustrating why one can’t use average returns (reference below) in the section “The Averages”.

    I recommend that readers understand “why it is so”.

    2) Yes Kevin, we can not predict the future path of investment returns and longevity. Hence stochastic analysis does provide a useful method to understand these uncertainties and provide a better base for retirement planning.

    3) Dollar weighted returns and the like are difficult to translate into retirement outcomes. Sure they are part of the path to retirement outcomes, but efforts may be better focused by looking at the impact of decisions on the end outcome, namely the estimated (distribution of) retirement outcomes (i.e. you retirement paycheque). Then one will have available information that the majority of Australians should understand and become engaged with.

    BTW, last weekend I delivered a new MAFC course “Life Cycle Investing” that addresses many of these points aiming to upskill full and part time students in these issues for the benefit of the industry. Hence I’m very pleased to see these issues again being raised in Cuffelinks (Andrew Gale also wrote a good article calling for stochastic analysis a little while ago).

    Thanks
    Peter

    Bengen, W. (1994). “Determining withdrawal rates using historical data”. Journal of Financial Planning, vol. 14, no 12, pp 171 – 180.
    http://www.retailinvestor.org/pdf/Bengen1.pdf

  6. Joe August 4, 2016 at 3:40 PM #

    Nice article. Interesting thoughts.

    Kevin, FYI there’s a lot more to financial advice than dollar cost averaging and diversification. You should check it out before adviser bashing.

    2008 must have been a great year for you with all those bank stocks. I wonder how you’ll fare following recent and, I assume, future regulatory changes. Not to mention those inevitable crashes you speak of.

    I find it interesting that you understand humans can’t predict the future, however you believe there will definitely be crashes in the future and that diversification won’t save anybody from them. Sounds like a prediction if I’ve ever heard one!

    • kevin August 6, 2016 at 2:18 PM #

      Yes Joe,you are correct,there are the taxation aspects.The general advice is always $$ cost average and diversify.

      You say the crashes are inevitable,I agree with you ,it isn’t a future prediction,it is simply learning the lessons that history teaches us.

      What would you say future crashes will be,only the 6 bank stocks that I own,or as history teaches the market goes down.The only one to surpass those highs is CBA as of prices now,with WBC being much the same as pre crash.

      They have crashed now from the highs of approx. 15 months ago,it may be quite a while until they go back to those highs,I don’t know.

      I can take a hit of a 60% drop with no problem,at todays prices.Should that happen then I will re assess,and probably buy more.

      The crash in 2008-9 took 60% of my capital base,there was no huge drop in income.The crash in bank stocks from last year’s high has cost me nothing in income.if income stays the same for the next 5 to 10 yrs I will still be very comfortable.As Ben Graham teaches,leave a good margin for safety.

      Did diversification save anyone in 2008-9,or did they all lose slightly less than the 60% that disappeared for me,but quickly came back.A drop of 6800 to approx. 3100 is still a drop.The facts will always be indisputable.

      I also find it strange that people choose the information that backs up what they want to see.The crash in 2003 for banks lost me capital (gross worth),CBA went from approx. $34 down to $23,I bought more.I bought more in the capital raising at approx. $26 in 2008-9.I also bought in the recent capital raising at $71.50.The facts aren’t going to change.

      After decades in the game I expect history to repeat,the roller coaster ride to repeat.I do not expect a roller coaster ride in my dividends.

      On a longer term basis Nab went from Around $1.80 in 1981 to the present price and has never missed paying a divi.Would you be prepared to take that chance in the future,that over the coming 35 yrs of ups and downs it may create wealth for you.NAB will not be the best performing stock over the next 35 yrs.Are you going to follow the advice of the experts that claim they can predict the next RHC or CSL ( I own neither of those),some of them will be right,but which of their predictions will be the right one.

      After centuries of having these banks it amazes me why the direct share ownership of any of them is less than1% of the population that own 1000 shares in any of them.WBC 200 yrs next year,ANZ and NAB approx. 180 yrs CBA approx. 104 yrs

      • SMSF Trustee August 8, 2016 at 9:59 AM #

        I am frightened that someone is allowed to get away with such a concentrated portfolio in a tax-advantaged environment. By all means people have the freedom to put their money at risk like this if they are paying full tax on it, but when a low tax rate is applied there should be a law compelling people to diversify.

        There is no way the banks will outperform the market in the next 30 years the way they have in the last 30. The environment post-deregulation could not have been more favourable for the big 4 in Australia, but changes to global banking regulations, forcing them to hold more unprofitable capital, will prevent them being anywhere near as successful. Besides, it will be horrifying to think of an Australia where the banks are even more dominant as part of the economy than they already are.

        Take your profits now, Kevin, and get into a portfolio that will withstand this new world.

  7. Kevin August 4, 2016 at 1:59 PM #

    I cannot understand why people think that the human race has an ability to predict the future,they can’t.I have never understood why people seek out the advice of the financial industry when it is always the same $$ cost average and diversify.

    My portfolio is 91% concentrated on financial stocks,they provide a very good income. I understand it can go against me,i understand the divi is not 100% guaranteed.I understand that there will be crashes in the future.When these crashes occur diversification will not save anyone.

    From the start of the SGC in approx. 1992 to date nobody has become wealthy by following the mantra.

    Choosing the worst bank over that period of coming up to 25 yrs (NAB) has produced a better outcome.Around $7500 bought 1000 shares in NAB,using the DRP people are now approaching 4000 shares in NAB,worth approx. $105,000.

    Using super they have contributed approx 1.88 yrs wages to have not much more than $105K.The $7500 was approx 3 months average wages back in 1992.Why do we pay the financial industry to tell us not to do that.Why do we pay them to tell us not to think.

    Outlawing the advice is probably correct,something needs to be done.

    When we all think alike nobody is thinking. Is the financial industry basically giving everybody the same advice?

    • Phil Brady August 8, 2016 at 3:06 PM #

      I agree BB the tools are not ideal. In fact I have to use 2 or 3 different sources to present the picture – one for range of outcomes, one for sequence risk, and one for longevity and annuity planning if appropriate – yes, there is a long way to go, I just keep telling myself its all part of the journey.

  8. Phil Brady August 4, 2016 at 1:32 PM #

    Hi David, if you look at XPLAN, the main industry used modelling software, it provides stochastic or ranges of outcomes on projections modelling. It is already used by financial planners. There are also excellent information sites and tools on longevity planning, what ages to use, based on some individual fact information input. As to modelling for sequencing risk, it is available and used, but when do you place in the negative years? Correct – that’s guesswork, just like the traditional form of deterministic modelling you are mostly correctly disparaging ( or Blake is). At any rate all models are useless unless accompanied by a regular review and an educated opinion on asset class valuations, a risk management overlay, individual to the client, and a detailed knowledge of their goals. i.e. if they want that, and most sensible people do once its explained- they will nearly always need advice of some sort. How does your own fund project its members super balances? If the time horizon is long enough and the assumptions reasonable enough then don’t deterministic modelling have a part – at least its making an attempt to get super fund investors to engage. Engagement is the major problem according to studies – do yo really think trying to educate them on stochastic modelling, without advice or support, is going to attract them? All very well for the multiple PHD academics, who make a great living consulting on these issues, and love their black boxes built in dark rooms – but to what end – more costs for the investor?

    • Peter Lang August 5, 2016 at 5:47 PM #

      Phil Brady,

      I strongly support what this article is advocating. I just wish my investment advisers had the competence to understand what is required, but they don’t.

      I have use of a stochastic model, called PensionModel, developed over a period of a decade (since 2004) by an RAAF Systems Engineer (almost too Defence quality standards). It is excellent and I’ve learnt an enormous amount and gained an enormous amount of confidence and peace of mind in my by using it. It’s taken me a decade, but I now feel much more confident with a fairly high proportion of growth assets in my retirement portfolio. I would not have the comfort I have now if not for PensionModel. It takes into account sequence-of-returns risk, inflation, transactions costs, MER for different asset classes, fees, age, pension entitlements if we meet the criteria, and more.

      • Phil Brady August 8, 2016 at 9:15 AM #

        That’s great Peter, all I’m saying is the tools exist for most advisers – whether they use them or not is another issue. But my interpretation of the article is that they are suggesting the tools don’t exist, or aren’t used – they are. As to the development of the model you refer to I can’t comment – other than to say great, but also to say IRESS has been around for a long time as well developing these tools, as have others.

      • BB August 8, 2016 at 11:03 AM #

        Phil, great to hear that you personally are utlising these tools but the facts simply don’t support your claims. Practical, quality versions of these tools are far and few between for advisers, IRESS’s model is the only broadly available option and even that is extremely simplisitic and way down the development priority list for them.

        Coin also had a simulator, once again, extremely basic and almost never reviewed. Infact (many years ago now) I enquired as to some of the technical details on the coin model, I was informed by their inhouse actuary that I was the first person he could ever remember asking any questions about it since the day it was built!

        The overwhelming majority of advisers and the retail wealth industry at large do not use these tools. Outside of availability, what education is provided on these? Think about it, you can go through diploma, advanced diploma, bachelor, masters and CFP level financial planning education and still never receive more than a passing, FYI glance on the use of such tools.

        As such, no major bank, outside AMP to some degree utlise these tools (the multiple majors I have worked with don’t even know what they are!). Smaller dealers are mostly carbon copies of the larger insto’s and outside some notable exceptions, they are no where near utlising these as standard process, the cost for them to build there own is also prohibitive. Not even the regulator has gotten their head around large scale use and disclosure for them.

        You Phil are the exception not the rule.

  9. Hilda August 4, 2016 at 1:11 PM #

    Considering all the possible scenarios that may evolve is surely part of the on going process of reviewing and planning – as opposed to just doing a financial plan and moving on. Generating options, scenarios and modelling should not be a one-off event.

  10. David Reed August 4, 2016 at 1:06 PM #

    Excellent article on a topic that needs much more attention.

    The impact of volatility and its significant effect on dollar weighted returns are brushed over when averages are used as the sole benchmark.

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