Conflicts of Interest

A recent conversation is the inspiration for today’s post – wherein a conflict of interest put a future family member in an inappropriate financial product.

Firstly, lets define a conflict of interest: when one is faced with two or more competing interests. Consider an example we can all relate to: dieting. As someone on a diet, I face a conflict of interest every waking minute. My first interest is my health. This interest supposes that I should eat only leafy greens, fresh fruits, lean meats, whole grains, etc. Further, I should avoid sugars and refined foods – like donuts. 

However, I have a second interest: cravings for unhealthy foods. This second interest pushes me toward eating everything and anything in sight, most especially calorically dense, nutrient-deficient foods. These interests - eating healthy and food cravings - conflict with each other and are mutually exclusive. If I respect one interest, I must deny the other interest – and vice versa. I can never follow both interests at the same time. If I follow my interest to eat healthy, I will not eat donuts. If I yield to my cravings, I will eat donuts.

An extremely high-tech visualization of mutual exclusion

There are many financial services providers that suffer from conflicts of interest. What follows is a list of solutions of how to avoid conflicts of interest in three specific financial services providers.

Insurance Companies

Whether its life insurance or car insurance, certain insurance companies (stock companies) experience a conflict of interest – which is be problematic for you as a consumer. An insurance company that is stock-owned (as opposed to a mutual company, discussed in a moment) sells insurance policies. However, the stock insurance company’s goal is not to provide insurance at the lowest feasible rate; it’s goal is to provide an investment return to its shareholders. Therefore, a stock insurance company will sell insurance at the highest price that the market will bear.

The requirement of providing investment return to shareholders makes for larger premium payments for consumers

Consumers can avoid the conflict of interest in a stock owned insurance company by electing insurance coverage with a mutual insurance company. Mutual insurance companies are not owned by shareholders, but by the insurance policy holders. When a consumer purchases a policy with a mutual insurance company, that consumer becomes part owner of the mutual company. Since the policy owner is now the company owner, any excess profits produced by the mutual company now go back to the owner/policy holder as dividends. Thus, mutual insurance companies are structured to be incentivized to keep policy premiums as low as possible.

Policy owners of a mutual insurance company experience no conflict of interest from shareholders

Investment Services Companies

Similar to the organization structure models above, there are two types of investments services companies: those owned by shareholders and those owned by the individuals that purchase investment products. Not surprisingly, comparable (if not identical) products can be had for lower cost via a client-owned investment services company relative a stock owned company. Consider an example: a S&P 500 index ETF. 

Two companies, State Street Global Advisors and Vanguard offer a nearly identical S&P 500 index exchanged traded fund (ETF). State Street’s fund has a expense ratio of 9 basis points (.09%). The Vanguard fund has a an expense ratio of almost half that: 5 basis points. 

Why the difference for the exact same product? State Street is a publicly traded company that pays dividends to its shareholders. Vanguard has no share holders and therefore no such obligation. Vanguard’s obligation is to provide the best service possible to its clients - the owners of Vanguard funds.

Financial Planning

Certified Financial Planners work with clients to asses client needs before developing a financial plan. Fee-only Financial Planners will charge either a hourly rate, a pre-determined rate for a given level of financial planning, or may include financial planning services when charging a fee for assets under management – money under investment stewardship. Because fee-only Financial Planners are not compensated by selling various products (i.e. insurance policies or specific mutual funds), there is no conflict of interest when working with a fee-only financial planner. You can find a list of fee-only financial planners at the National Association of Personal Financial Planners.

The fee-only Financial Planning model is in stark contrast to the Financial Advisor or broker model. The Financial Advisor is essentially a commissioned sales person. Therefore, the Financial Advisor, or mutual fund salesperson, or insurance salesperson, has a conflict of interest. That salesperson must choose between the product that will net the most commission for themselves versus the product that is most appropriate given client needs.Which one do you think the salesperson is more apt to choose?