BeFi Bulletin, Summer 2011

Consumers certainly seem to need help choosing the most appropriate financial products. But are financial advisors, as they now operate, the answer? Advisor and client interests are not perfectly aligned. As Santosh Anagol of The Wharton School described, financial advisors can recommend products that are best for their clients, products that earn themselves the highest commission, or some permutation of the two. And when clients favor suboptimal strategies due to behavioral biases, advisors can either try to correct these mistakes or instead cater to preexisting biases.

A team from the innovative nonprofit ideas42 (Antoinette Schoar, Markus Noeth, Shannon White; presented by Piyush Tantia) set out to investigate investment recommendations made by real-world financial advisors. They sent undercover "mystery shoppers" to solicit advice from 200 locations around Boston and New York. Consumer and advisor incentives aren't well aligned when it comes to the decision between actively managed and index funds. Individual investors fare better with index funds, while advisors can earn more from the actively managed variety. Initial pilot results from the study found that advisors were heavily biased towards actively managed funds, recommending them in 50% of all visits while recommending index funds during only 7.5% of visits. Most advisors asked relevant questions about such things as income and risk tolerance. However, they tended to support mystery shoppers' returns-chasing portfolios, reinforcing rather than combating behavioral biases. Advisors catered to potential clients' preexisting beliefs, in some cases not advising against poor strategies such as investing in the company stock of one's employer.

A second "mystery shopping" study was conducted in India, where the capacity of individuals to invest in formal financial products is rapidly expanding. In the words of Santosh Anagol , who led this research with his colleagues, consumers are "moving from cows to life insurance and mutual funds." Undercover shoppers put agents' life insurance recommendations to the test. While it is difficult to construct a scenario in which whole life insurance is a better option for the consumer than term insurance, agent incentives are not aligned with this. Agents receive commission of 35% on whole but only 5% on term insurance.

Undercover shoppers were provided with scripts from the researchers describing a variety of personal circumstances and made hundreds of visits to insurance agents in major Indian metropolitan areas. Even when shoppers explained that they weren't looking for an investment product (making term insurance the clearly appropriate choice), agents overwhelmingly recommended whole or endowment policies. Some shoppers followed scripts that indicated they possessed sophisticated knowledge of life insurance, while some followed scripts indicating lack of sophistication. While sophisticated shoppers were 15% less likely to receive recommendations for whole or endowment insurance, this was a small effect since 80% of overall recommendations were for these types of insurance.

Catering to the preexisting and sometimes misguided beliefs of clients was also investigated. Mystery shoppers were assigned to provide information about their life circumstances and goals that had strong implications for the suitability of term or whole life insurance. Shoppers were also assigned to express a "professed need," telling agents that they thought either whole or term would be suitable for themselves without providing a persuasive reason why. Evidence of catering was found, with agent recommendations twice as responsive to shoppers' professed need for term insurance as to shoppers' provision of information indicating that suitability of term insurance. When it came to whole life insurance, nearly everyone who expressed a preference for it received a recommendation for this form of insurance.

In the United States, the shift from defined benefit to defined contribution retirement plans calls for consumers to make more complex financial decisions. India is a fast-developing country where consumers are increasingly investing in formal financial products. In these contexts, effective financial advisors could potentially remediate gaps in consumer knowledge of important financial products. However, mystery shopping studies in these two different countries investigating different types of financial products find that financial advisors commonly recommend products that are poor for the consumer. Consumers who need the most help learning about products do not seem to be getting it; advisors cater to consumers' pre-existing beliefs even when these beliefs are misguided.

In their respective discussions of the studies described above, Jean Young of Vaguard and Dan Weinberger of Metlife suggested that financial advisors can improve the quality of consumer financial decision making under some circumstances. A current challenge is to encourage use of financial advice in circumstances where it will help consumers and to discourage its use where it will hurt consumers.

Based on their findings, researchers at ideas42 advise increasing regulatory attention to financial advice. They point to the need for both better understanding of consumer interaction with the market for financial advice and the need for better evidence about which policy interventions work. Possible policy interventions include independent audits and advisor ratings, regulating incentives, and providing consumers with trusted benchmarks of good advice.