When paying separate fees hurts: Why investors favour commissions

Behavioural biases, visible fees and regulatory hurdles keep financial planning niche; experts say easier fee collection could widen access

A prospective client, Mahesh, was recounting his experience on a cruise. He had spent far more than he had budgeted for on-board extras. The cruise fare, which covered accommodation and standard meals, had been prepaid. But for shows, events, drinks and snacks, the cruise issued a ship-specific credit card, and all extra spending went on this card. When Mahesh settled the bill, he realised how much he had overspent. I explained that by separating payment from consumption, the cruise operators had reduced the pain of paying and made overspending easy. 

The Nobel Prize–winning economist Richard Thaler described this behaviour in his paper Mental Accounting Matters. He showed that when payment is separated from consumption or made less visible, the pain of paying falls and people spend more. When the cost is explicit and immediate, the pain of paying is high. When it is prepaid or delayed or embedded in some manner, the psychological barrier is much lower. 

I was reminded of this when I saw the recent BSE report on the state of the financial planning and investment advisory profession. After more than 12 years of regulation, India has only 376 licensed financial planners (after removing inactive and equity-only advisors). The main reason is the pain of paying a separate visible fee for advice. Investors hesitate when the fee has to be paid out of pocket. The same investors are comfortable paying for mutual fund services through the total expense ratio, which includes fund-management charges and distributor commissions. These amounts are deducted inside the scheme, and investors are unaware of how much they are paying. Since it is never presented as a separate payment, the entire process is painless. This structure, supported by strong product governance, has helped mutual funds reach investors nationwide. 

Richer investors have adopted portfolio management services (PMS)  for a related reason. PMS fees are transparent, yet the  investor does not write a cheque. The amount is deducted from the invested corpus, so it feels like a reduction in investment value rather than a separate outgoing payment. Even a  visible deduction is easier to accept than paying a fee directly.

 

This pattern is not unique to India. The pain of paying separate fees has kept financial-planning services confined to a niche everywhere. When investors can choose between inbuilt commissions and direct fees, most choose commissions. The United States shows the same behaviour. Fee-only advisors have grown since the 1990s, yet only a small number of investors choose such services. The picture is different only in countries that have banned  commissions. The United Kingdom did so after the Retail Distribution Review in 2012. 

 

Australia followed with the Future of Financial Advice reforms in 2013. Several European countries, including the Netherlands, Denmark and Finland, also have bans. These bans explain why more investors in those markets pay fees for advice.

 

There is another reason for the low number of financial planners in India. For years, trading-call providers registered as investment advisors even though the regulations were not meant for them. The Securities and Exchange Board of India (Sebi) had to tighten regulations, which made it harder for genuine financial planners to operate. Sebi has since partly corrected this by clarifying that trading-call providers do not belong in the advisory category. Sebi has also recognised that financial planning is a multidisciplinary service that spans regulated and unregulated domains. These steps reflect Sebi’s willingness to refine the framework when the evidence supports change. The next step is to reduce the pain of paying by allowing fees to be collected through deductions from investments, like PMS, and to clear the operational barriers erected during the period when trading-call providers entered the advisory space. 

Truth be told, behavioural economists have demonstrated that the “pain of paying” fees keeps investors like Mahesh away from financial planning. If Sebi can reduce this friction through the right operational changes, far more investors will be able to plan their financial lives. A “Financial plan for every Indian by 2047” would then become a realistic goal.

 

The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor; 

X: @harshroongta