A fiduciary is one who has to always act in the client’s best interest and is expected to uphold this standard at all points in time. The fiduciary standard brings with it a lot of compliance costs, and if the rules are not complied with, there are heavy penalties in store for those who provide financial advice. Compliance also means a radical change to the business model for the majority of them.
The arguments for and against the fiduciary standard are also a part of the US presidential campaign. President Barack Obama remarked that he would use his veto power to implement the Department of Labour fiduciary standard, whereas a Donald Trump adviser promises to repeal the very same thing (http://bit.ly/2el36ec).
Public comments on the proposed modifications to the 2013 investment advisers regulation (http://bit.ly/2dExDby) put out by the Securities and Exchange Board of India (Sebi) would be in the process of being reviewed. If the proposals are implemented without many changes, it is expected that a lot of intermediaries in India would have to embrace the fiduciary standard.
Everyone is pushing for a fiduciary standard due to the global financial crisis, during which customers bought financial instruments not knowing the attached risks and ended up with next to zero value on a whole lot of bonds.
How can this standard be upheld? By removing any conflict of interest, which can arise from among many contributors. The one that has been most deliberated upon is remuneration of the agent from indirect sources.
The assumption is that any agency has to be meaningfully remunerative to service its principal (you). A fiduciary has a legal obligation to take her compensation only from her principal—you have to pay her yourself for the services. What you have been used to as a consumer of medical, legal or interior designing services, you will have to apply similar principles in dealing with financial services going forward. You would have to define the services you are looking for. Is it tax planning, insurance planning, overall financial planning, or assistance with specific matters such as writing a Will? You would have to agree to pay fees to the service provider. Natural questions that come up are: am I not paying more for something that was free all these years? Why should I pay?
That brings me to the cost of agency. There has been research done on this, pioneered by Michael Jensen (currently a faculty member at Harvard Business School; see more here: http://hbs.me/2fndCkP) along with William Meckling and further amplified by Nobel laureate Eugene F. Fama. While such studies are aimed at corporations, shareholders and management, I am making a humble attempt to simplify them and link them to customers like you (akin to shareholders); and to agents that you engage for financial matters (akin to management).
Agency costs = monitoring costs + bonding costs + residual loss.
Monitoring costs are associated with you having to spend time and money to monitor whether your agent is doing what is right for you. Bonding costs are incurred by your agent trying to understand you better, diagnose your financial situation and make appropriate recommendations. Residual loss is the potential loss that you would incur if the expected outcome is not achieved.
Imagine a situation where you are the owner of a company, have invested money in that business and you have hired good management to run its day-to-day affairs so that it can generate good profits for you. But what you failed to ensure was sufficient remuneration for the management to drive this outcome. Then, you would have more things to worry about in the future. It could mean that your capital doesn’t generate reasonable returns, or worse, you lose your money purely because the management wasn’t aligned to your objectives as a shareholder. Regulations put in place strict norms for the management to not do something wrong. However, what if there is inaction? What if in the fear of doing something wrong, and the lack of any reward to take on that risk, the management decides to do nothing? These situations also highlight that as a principal (investor, akin to a shareholder), you should be mindful of agreeing with your agent on a reasonable remuneration and reward for aligning with your objectives.
Whether a financial product has certain embedded costs, so that the reward to the agent is recovered from such costs charged to you and then paid to her, or you have to pay her directly, the cost of agency is bound to exist. Either ways, remember, you have to pay. Fiduciaries cannot work on indirect payments; and non-fiduciaries cannot claim to give you free service.
The alternative of not incurring an agency cost is always an open choice—isn’t it? We can do self-medication and not meet a doctor, and we can read books of law to defend our cases without having to hire an advocate. If you think you have all the time and discipline to take care of your financial matters, without using any agent, then that is a choice too. Choose wisely.
Rajesh Krishnamoorthy is managing director, iFast Financial India Pvt. Ltd.