This article was published on 12 July 2005. Some information may be out of date.

Complexity of financial products no accident

Confirmation, at last, of what we’ve suspected all along: Providers of financial products may deliberately make them sound complicated.

And if enough of them do that, “it is in the interests of all providers to follow suit…. An individual supplier that provides simple (and accurate) information may appear to be of poorer quality than those who provide complex (but difficult to understand) information, and so lose out on market share,” says economist Arthur Grimes in a hard-hitting newly released report.

While a consumer is likely to choose the cheaper of two brands of petrol, the same person selecting a share fund “who has to decide between two otherwise similar products may choose on the basis of some complex, but irrelevant (and/or costly) feature of the product.”

Or a company might make a claim that’s too difficult to check. For example, it might say its fund managers have special stock-picking ability “arising from a well-established, rigorous in-house appraisal process, although the consumer is unable to verify whether this is indeed the case.”

The growth of the internet hasn’t helped the complexity problem, says Grimes. It has “made the provision of complex (and overwhelming) information even easier for suppliers, and so may have decreased the competitiveness of markets despite the increased provision of information.”

Grimes wrote the report, “Improving Consumer Trust in the Retail Savings Industry”, for the Retirement Commission. While he happens to be chairman of the Reserve Bank, he worked on the paper as a consultant, and the views are his own.

He notes that providers profit — at consumers’ expense — from would-be investors’ use of “intuitive thinking” rather than rational calculation. Some examples:

  • “People value what they have already more than what they don’t already have.”

    This can lead to a bias towards the status quo. Investors don’t want to switch products in case the new one doesn’t perform as well as the old one. It might, of course, perform better, but that doesn’t matter so much.

    As a result, people remain in poorer quality or more expensive products.

  • People’s perception of the merits of two options “depends on how the benefits and costs are expressed.”

    “Experiments have shown that people can swap between adopting low-risk and high-risk strategies purely as a result of simple word changes that effectively describe identical options.”

    Often we can’t see through the hype.

  • When making judgements, people tend to use criteria with no rational basis.

    “In finance applications, this may mean that people extrapolate past returns in forming their expectations of future returns from a certain asset class.” Frequently, however, future performance is quite different from past performance.

Complex products are often structured to take advantage of these types of behaviour, says Grimes. And their complexity allows managed funds to incorporate high fees into their products.

“The ability of suppliers to attract clients into such products, away from simpler and lower cost products, is particularly strong when episodes of large negative returns to certain asset classes are strong in investors’ minds,” he says.

International shares performed badly in recent years, and Grimes gives a hypothetical example of a complex capital-guaranteed share investment product that looks great but in fact offers an expected return, after fees, the same as term deposits.

He adds that New Zealand “appears particularly susceptible to the marketing of complex, high-fee products that may be inappropriate for consumers’ needs.”

It’s not a comforting picture. But Grimes has some sound suggestions on how consumers’ trust in investment product providers and financial advisers could be improved. I will cover those in my next column, in two weeks.

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Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.