Secrets Of Success: Sense of duty is a long term asset

Sir Callum McCarthy's outburst at the weekend about the shortcomings of the financial-services industry struck a chord in this corner. His predecessor at the Financial Services Authority, Sir Howard Davies, once told me that if he had known how time-consuming the fallout from life companies' failings would be, he would have thought twice about the job. Maybe Sir Callum is thinking the same thing.

The point Sir Callum made in his speech was that the sales-driven business model that dominates how most financial products are distributed in the UK is flawed. It doesn't even favour those in the business you would have thought it would most benefit.

The biggest independent financial advisers, noted Sir Callum, lose money in aggregate. In the pensions business, many providers spend a lot of time vying to encourage their rivals' customers to switch their business from one company to another. It's a mindless merry-go-round and a zero-sum game that incurs costs, to the consumer's detriment, and racks up profitless turnover.

What the providers lose most is the trust and confidence of their client base - their real long-term asset. Most firms pay lip service to qualities that customers most value, such as reliability, integrity and competence. In practice, the way the business works often militates against this, with results that are plain to see.

The gap between rhetoric and reality is something the industry acknowledges - at least if you trust the findings of a survey of the asset-management industry published this week by Professor Amin Rajan and his colleagues at the consultancy Create. Having talked to a range of pension-plan sponsors and asset-management firms, Rajah's conclusion is blunt: both know they are failing those they are meant to be serving.

"Many asset managers and pension-plan sponsors have suffered a huge erosion of trust from stakeholders as a result of the size of losses in the bear market," the report says. "New rules on duty of care will be adding to their fiduciary burdens."

Ironically, everyone seems to agree on what they should be trying to achieve (strong, reliable investment performance with effective control of risks). But they disagree on the best way to get there.

Sir Callum rightlyfocuses on the central role that incentives play in distorting the way that the industry operates. When short-term competitive dynamics drown out long-term priorities, the relentless drive for sales produces disturbing results, such as the churning of investors' portfolios and the sale of inappropriate products.

The example of Vanguard in the US has demonstrated that a business with different incentives will produce a radically different way of operating. Vanguard's success stems from its ownership structure, which is a form of mutuality based on the idea that the investors in its funds also own the management company.

This creates a powerful incentive for the management to control costs, invest in customer education, and measure success in terms of the benefits for investors, rather than sales or management remuneration. The less spent on sales and marketing, the more left for investors.

Vanguard pays no commission to intermediaries, spends only a fraction of its annual sales each year on advertising, invests heavily in investor education and state-of-the-art technology, and specialises in providing low-turnover index funds at the lowest possible cost. It recognises that this is the most cost-effective solution for the majority of its investors, especially those in defined-contribution pension schemes.

Mutuality of a different kind has been tried in the UK, not least in the life industry, where the model has failed to align the interests of management and investors.

The real problem for many life companies has been complacency, bureaucracy and weak management - a function of their long histories. The problem is compounded by the fact that investors are ill-qualified to know what is best for them, and few advisers have an incentive to tell them.

So Sir Callum was right to say what he did. Can the problems be resolved by the industry putting its house in order? The evidence from the Create survey does not fill me with confidence. Identifying the things that investors want is one thing. Having the energy and determination to start doing business in a new way is another, especially if it involves taking a financial hit.

Most asset managers seem to think that the answer lies in new products. Many pension-plan sponsors, having been burnt once already, are understandably more cautious. They think a few simple things done well would better serve their needs. Professor Rajan rightly points out that, in retrospect, many of the things that pension-plan trustees did in the later stages of the 1990s bull market defied common sense.

The fundamental problem may be that what investors really want is a service, provided by an organisation that sees itself driven by a sense of fiduciary duty, rather than short-term sales and profit maximisation. What they get, under our business model, is often a set of products that are heavily marketed, regardless of suitability, and that meet customer interests by luck and coincidence rather than by design.

jd@independent-investor.com