Jessica Mosher of the OECD Directorate for Financial Affairs looks at the potential benefits, risks and challenges robo-advice platforms present for increasing the accessibility and affordability of financial advice for investing savings for retirement.
Robo-advice is a much talked about application riding the new wave of FinTech, the term used to describe financial innovations that are enabled by digital technologies. Robo-advice platforms use algorithms to provide investment recommendations and execute the selected investment strategy. There is nothing new about the use of algorithms for investment and financial advice, however. High frequency trading relies on algorithms, for example, and financial advisors have been using software and algorithms to inform their own advice to clients for decades.
So what is new? Today, these two functions are being combined and increasingly used at a retail level, enabling pretty much anyone to easily open up a brokerage account and solicit investment advice. This has huge implications for increasing the coverage of individual pension savings accounts and increasing pension adequacy, both through higher levels of savings and increased participation in capital markets which can bring higher returns on assets. Right now, a particular combination of market, regulatory and technological change is driving both supply and demand for these types of platforms.
The pension landscape is changing as increasing life expectancies put financial pressures on traditional defined benefit pension schemes. In response, many employers are shifting from traditional plans to individual defined contribution pensions which require individuals to make contributions and to manage investment decisions themselves. However, the results of a recent OECD survey show that levels of financial literacy are often low and many individuals have no experience with investing in the capital markets. This means they are not prepared to make these types of investment decisions themselves, particularly when the implications of these decisions can have huge consequences for their financial well-being in retirement. Pension savers need some help to make the right decisions.
The financial advice gap
In theory, financial advisors could provide this kind of help but the regulatory landscape surrounding financial advice has also been changing dramatically over the last several years. Advisors are increasingly subject to disclosure requirements that ask them to prove the suitability of the advice they provide to clients and divulge the compensation they receive for that advice. Regulation is also moving to limit more opaque and typically conflicted remuneration structures, such as commissions. This has resulted in fee-based structures becoming more common, such as fees based on assets under management. But these types of fee structures may provide disincentives for advisors to serve lower wealth clients. So, while the costs of advice are becoming more transparent to consumers, many may simply decide that financial advice is too expensive, and advisors also have less incentive to serve this market. Individuals in certain income brackets risk having difficulty finding advisors willing to advise them anyway. This is creating an advice gap where those who need financial advice are not able to obtain it.
On top of the push for greater transparency regarding the cost of financial advice, the costs of investment management are coming under increasing scrutiny. Active managers in particular are being criticised for not adding any value for their clients. A recent article in The FT recently reported that active pension fund managers provide only 16 basis points higher returns than the market for their clients, and that they keep three-quarters of the added value that they generate. Such revelations are leading to a shift to passive investment strategies as many decide that the costs of active management are simply not worth it.
A role for the robo-advisor
These trends have laid the groundwork for the robo-advisor platforms riding the wave of technological innovation to step in and provide a solution to unmet demands for financial advice and for those looking for a lower cost solution to active management. And they have come out in force, proposing value primarily through lower costs and increased accessibility. Lower costs are achieved through the improved efficiency that automation can offer, by bypassing the middleman, and by offering investments such as exchange-traded funds. These platforms also focus on accessibility with intuitive, easy-to-use services, simple terminology and, of course, they are open 24/7.
The challenge for regulators
One of the main challenges these platforms present to regulators is whether and how existing regulation governing financial advice do or should apply. This includes whether the recommendation qualifies as financial advice, how the suitability of investments is determined, what qualification and licensing requirements apply to the provider and how consumers will obtain access to dispute resolution and redress.
Regulators have already faced these challenges with traditional financial advisors, so addressing them will mostly involve ensuring that robo-advisors fall within the scope of existing regulation and deciding how these requirements should apply. But robo-advisors also bring new challenges to the table. These include the audit and supervision of algorithms, consumer engagement, and the sustainability of these business models, which have yet to endure significant market turmoil. Recent market volatility has confirmed these concerns, with several platforms suffering disruption to their service amid the sell-off.
Ultimately, however, regulators are viewing the emergence of robo-advice as a positive development that can help close the advice gap and help individuals to increase savings and investment for retirement, in particular. In many cases, new legislation is probably not required and regulators just need to make sure that the existing definitions imply that robo-advice is incorporated. Robo-advice platforms also tend to welcome falling within the regulatory perimeter because it lends them a credibility which can be beneficial to obtaining the trust of new customers.
Room for regulatory improvement
On top of the existing regulatory framework, we need to strive for consistency in regulation, both to create a level playing field within jurisdictions, such as between asset managers and insurers, and across jurisdictions to be able to take advantage of the financial portability that the new digital world can provide. Regulators and supervisors will also need to move towards a culture more open to innovation. Increased flexibility may be required in interpreting how regulations should apply and supervising algorithms will require a different skillset than supervising humans. We also need to adapt to the digital world in terms of compliance requirements, particularly in the domains of accepting digital forms of identity verification and electronic signing of documents.
We also need to keep an eye on future developments because innovation will not stop here. For robo-advice, this will include moving into the pension decumulation market, where investment and withdrawal strategies can be much more complicated than for pension accumulation. Machine learning also promises to be a big challenge going forward in understanding how these platforms are operating and ensuring that the investment recommendations remain suitable.
Policy measures to improve the quality of financial advice for retirement
OECD/INFE International Survey of Adult Financial Literacy Competencies
G20-OECD/INFE report on adult financial literacy in G20 countries
OECD/INFE Core Competency Framework on Financial Literacy for Adults
G20/OECD High-level Principles on Financial Consumer Protection