«Agency Theory and Financial Planning Practice Geoffrey Kingston* Haijie Weng Macquarie University This draft: 12 June 2013 * Department of Economics, ...»
Agency Theory and Financial Planning Practice
This draft: 12 June 2013
* Department of Economics, Faculty of Business and Economics, Macquarie University, North Ryde
NSW2109, email@example.com. The Australian Research Council kindly assisted us, via
DP120102239, as did the Centre for International Financial Regulation via E045. Benjamin Chan of
Morningstar was generous in responding to our requests for their research. Sessions hosted by the Australian Conference of Economists, the Centre for Pensions and Superannuation and The Centre for Financial Risk gave us valuable feedback on earlier drafts.
100-word abstract We extend an influential contribution to the literature on agency theory and then use this extension, along with other theoretical contributions, to shed light on agency problems affecting funds management and financial planning in Australia. The case for pure fee for service in actively managed funds and plans turns out to be weak. The amount of money exposed to risk by an active manager should be less than the entire investible wealth of the client, especially in the case of investors on the cusp of retirement. Asset-based fees on actively managed funds should include a fulcrum component.
30-word abstract Extending an influential contribution to agency theory helps to structure our financial planning debate. For example, the case for pure fee for service turns out to be weak.
1. Introduction This paper compares and contrasts mainstream agency theory with financial planning practice in Australia. It appears to be the first attempt to do so. It extends an influential mainstream contribution to the literature on agency theory and then uses this extension, in conjunction with other theoretical contributions, to shed light on actual contracts between investors, financial planners, licensees and product providers. The case for pure fee for service in actively managed funds and plans turns out to be weak. The amount of money exposed to risk by an active manager should be less than the entire investible wealth of the client, especially in the case of investors on the cusp of retirement. Assetbased fees on actively managed funds should include a fulcrum component, contrary to current practice.
The background to this paper is the continued growth in financial planning and funds management as the baby boomers move towards retirement. At present only 13 per centof Australians are at least 65 years of age, and 7 out of 10 retired households rely principally on the Age Pension. Only 15 to 20 per cent of Australians have received financial advice from planners at some point during their lives.
However, the 65-plus population is projected to hit 23 per cent of the population by 2050 and selffunded retirements are becoming more widespread, so the number of Australians receiving advice from financial planners should rise. Funds under advice in Australia stand at $519 billion (Rainmaker Group 2013). There are 760 advisory groups, 8,300 financial planning practices, and 18,200 financial planners. There has been ongoing vertical integration within the industry, as small practices enter into ‘sponsorship’ relationships, primarily with the big-four banks and the major insurance companies. At least 80 per cent of financial planners are sponsored. On the other hand, self-managed superannuation funds account for 31 per cent of total superannuation assets of $1.4 trillion (Australian Prudential Regulation Authority 2012). This alone suggests that the market for advice is contestable, as a consequence of a substantial competitive fringe of comparatively self-reliant investors.
The financial planning industry has come under scrutiny in the wake of the global financial crisis centred on 2008 and the collapse of Storm Financial in 2009. The 2007 budget had abolished taxes on the earnings of superannuation funds in drawdown mode and allowed higher personal contributions.
As a consequence there were strong inflows into superannuation during the 2007 financial year – decisions which worked out badly for many investors in the wake of the global financial crisis. The year 2009 saw two official inquiries into industry practices. The Ripoll inquiry reported in 2009 and the Cooper inquiry reported in 2010. These served as inputs to the government’s Future of Financial Advice (FoFA) and MySuper reforms. Questions raised in the Australian debate on financial planning
1. Should fee-for-service supplant asset-based fees?
2. Should commissions from product providers to planners be banned?
3. Do recommended asset allocations tend to be too risky for clients on the cusp of
4. Do financial plans tend to be ‘cookie cutter’ ones rather than customised to the particular circumstances of clients?
5. Do typical fee structures encourage ‘closet indexing’ by fund managers?
6. Is there inadequate disclosure of dollar (rather than percentage) amounts charged in
We arrive at affirmative answers to all these questions except the first one.
Section 2 sheds light on the first, third, fourth and fifth questions by extending the model of Dybvig et al. (2010). That model is a direct descendent of the classic agency model due to Ross (1973). It derives optimal contracts in financial plans when both the investor-principal and the planner-agent have log utility. It does not distinguish between planners and managers, and this is useful to the extent that the managed funds industry shows strong vertical integration, as is the case in Australia. Efficient fee structures always involve asset fees, and generally tie a component of remuneration to portfolio performance relative to a suitable passive benchmark to discourage closet indexing.
We introduce generalised log utility1 into the setup of Dybvig et al. Generalised log utility has the realistic implication that relative risk aversion is a declining function of wealth, unlike its log, quadratic, power and exponential competitors.2 It is the simplest way to capture habit-dependent utility whereby a retiree is concerned to prevent her living standard falling below some predetermined level, and is also consistent with a desire to ‘keep up with the Joneses’. It can rationalise conservative asset allocations on the cusp of retirement whereas simple log utility generates aggressive allocations. Generalised log utility captures the concern of some investors with preventing shortfalls in wealth below some subjective reference level, and the present value of protected future consumption is the natural interpretation of that level. In this way it sheds light on the important question of excessively risky allocations for people on the cusp of retirement.
Section 3 examines Australian industry practice. Unsurprisingly, typical contracts set out in actual Statements of Advice and Product Disclosure Statements turn to be much richer than could be captured by a single theory. Accordingly, Section 3 draws informally on the results of Stoughton et al.
(2011), Bateman et al. (2007) and Grossman and Stiglitz (1976), in addition to the formal theory of Section 2. These contributions shed light on the agency problems raised by intermediated investment management, multiple time periods, and general equilibrium. Put another way, Section 2 does not shed light on all six questions, and therefore needs to be beefed up by other theories, at least informally.
Take our second question, on commissions. It presupposes a three-way split between investors, advisers and investment managers (notwithstanding the considerable vertical integration in Australia.) Stoughton et al. (2011) do introduce such a split (in contrast to Dybvig et al.) and it sheds light on commissions. Investors can engage an adviser, or pay a fixed cost to access actively managed funds without intermediation by advisers, analogous to Australia’s self-managed funds. Investors divide into sophisticated or unsophisticated ones, depending on whether they anticipate equilibrium outcomes in the financial planning industry and are impervious to promotional material. Commissions from managers to advisers can take the form of cash or soft-dollar compensation such as conferences in resort locations. All this helps explain Australian practice.
2. Agency Theory This section extends the theory of fee structures for actively managed funds that mitigate agency problems when both the principal and the agent have generalised-log utility functions. One new result is that efficient fees include a fixed component reflecting the agent’s protected consumption. This generates a new rationale for a flat component of fees, analogous to fee-for-service. But the optimal contract retains roles for asset-based fees. Another new result is that, from both an investor and manager standpoint, the participation decision is not all-or-nothing; the amount placed with the active manager is equal to the investor’s wealth less the present value of the total protected consumption of the investor and the manager. Remaining wealth is allocated to safe assets. In practice, this suggests that an investor should place part of her retirement money in term deposits rather than entrust all of it to a financial planner.
Our setup retains some features of Dybvig et al. (2010). Notably, the asset-based fees derived there are retained here as a component of the overall fee structure, including a symmetrical asset-based fee for performance relative to a passive benchmark.
Dybvig et al. (2010) consider three optimization problems corresponding to increasingly severe agency problems. In the first-best case, agency problems are absent. In the second-best case the manager reveals truthfully the observed signal to the investor but has private information about her effort level. In the third-best case the adverse-selection problem and the moral-hazard problem are both present. It is the second-best case which yields the most interesting results, so we disregard the
third-best case, and comment only briefly on the first-best case. Our main result is this:
2.1 Proposition The optimal contract between an investor and an active manager whose effort level cannot be verified by the investor first carves out the total protected wealth of the investor and the agent. It then subjects the remaining wealth of the investor to a fee structure with a flat component and two asset-based components. One asset fee is a standard proportional fee on fund earnings. The other is a
symmetrical fulcrum-style performance fee:
On the left-hand side of equation (1), φ ( s, ω ) is the fee paid by an investor when the manager’s unobserved effort ε (0 ≤ ε ≤ 1) generates a private signal s ∈ S about future returns, and the state of the world is ω ∈ Ω. On the right-hand side, C m is the protected consumption of the manager, w0 is investible wealth, w is the present value of the total protected consumption of the investor and the manager, λR is a Lagrange multiplier on a participation constraint, R P is the return to the actively managed portfolio, λε is a Lagrange multiplier on an incentive-compatibility constraint, and R B is the return to a passively-managed (zero-effort) benchmark portfolio.
2.2 Proof See Appendix 1
3. Financial Planning Practice This section compares and contrasts our claimed optimal structure (1) with actual fee structures and associated advice documented by the Financial Planning Association and Morningstar. Consistent with (1), actual fees contain both flat and proportional components. On the other hand (and as one might expect) there appears to be little or no advice to the effect that investors set aside part of their wealth in safe assets. Rather, the plan discussed here recommends that investors elevate their preexisting exposures to growth assets. Moreover, there appears to be little or no use of fulcrum fees by either planners or fund managers. Performance fees exist and are mostly set in practice by managers rather than planners. They are not of the fulcrum variety, as they are neither symmetrical nor based on the natural benchmark, i.e. the best passively managed allocation for investors with age and wealth comparable to that of the actual client. Consistent with these gaps between theory and practice, there is evidence of the kind of index-hugging behaviour that fulcrum fees would discourage.
The Financial Planning Association is the dominant industry association for Australian financial planners. Roughly two thirds of licensed planners belong to it. The FPA has promulgated an ‘Example’ Statement of Advice on behalf of a hypothetical couple aged 57 and with a dependent teenage daughter (FPA 2008). The couple’s accumulated superannuation is $550,000. The associated model plan places the breadwinner into salary sacrifice and a transition to retirement pension, thereby reducing the couple’s short-term annual tax bill from $38,975 to $22,941.3 It makes persuasive recommendations for retaining life insurance associated with the client’s pre-existing superannuation fund at work. It says: ‘The FPA liaised with the Australian Securities and Investment Commission regularly during the development process to arrive at this final version’ (FPA 2008, p2).