Search, adverse selection, and the services of financial experts

Financial Services Review, Winter 2003 by Ligon, James A

Abstract

A financial expert holding a particular qualification may make an unobservable investment in the expert's skills. Experts making such an investment can better customize their services to clients' needs, which some clients value. Quality enhancement is more likely the more customers prefer customization, when profit margins for customization are higher, as customer search frequency and the speed of information dissemination increase, and as the expert's discount rate, the cost of the quality enhancement, and the number of experts in the market decrease. The latter result indicates expansion of the number of providers holding a particular qualification is not unambiguously desirable. © 2003 Academy of Financial Services. all rights reserved.

JEL classification: D14, D40, D82, D83

Keywords: Search; Asymmetric information; Personal financial planning

1. Introduction

Financial consulting, financial planning, and estate planning are vitally important to the financial well being of individuals and businesses. Financial consulting, financial planning, and estate planning services may be performed by a number of professionals holding a number of different designations, including licensed attorneys, Certified Public Accountants (including those holding the Personal Financial Specialist designation), Certified Financial Planners (administered by the CFP Board), Chartered Financial Consultants and Chartered Life Underwriters (administered by the American College), Certified Financial Services Counselor (administered by the American Bankers' Associations), Chartered Financial Analysts (administered by the Association for Investment Management Research), individuals holding a Ph.D. in finance, economics, or related disciplines, and others. Although the diversity of regulatory authority makes it difficult to quantify the actual proportion of Gross Domestic Product devoted to such activities, the number of individuals devoting full or part time to financial consulting and planning activities indicates the importance of the profession. The 2001 Annual Report of the CFP Board indicates that there were 38,408 CFP® practitioners in the United States and 66,121 worldwide at year-end. A December 16, 2002 AMIR press release indicates that the total number of CFA charterholders was 49,026 located in over 110 countries. Koreto (2002) reports that in july 2002 there were approximately 32,000 persons holding the ChFC designation. Goodman (1996) reports that the older CLU had approximately 79,000 awardees as of that date. According to a note in the March 2003 Partner's Report, the AICPAs PFS designation had been awarded to approximately 3,000 individuals, although the AICPA was considering eliminating this specialty designation.

The number of persons holding these designations has grown significantly in recent years with the number of individuals holding the CFP® designation about 10% higher in the United States and 30% higher worldwide than in 1996, the number of individuals holding the CFA designation has more than tripled since 1994, the number of individuals holding the ChFC designation is up about 10% from 1996, and the number of individuals holding the PFS designation has roughly doubled since 1996. The results of Elmerick, Montalto, and Fox (2002) suggest this growth may continue because of increasing demand. They find that, other things equal, households are more likely to seek comprehensive financial planning advice whenever the householder is under age 35, which they suggest is a generational effect rather than a pure age effect. Planning use also rises with income and net worth, so as these younger households, who Elmerick et al. suggest are more amenable to planner use than previous generations, age and become more wealthy, the demand for planning services will likely increase.

Increasingly, planning services are performed on a fee-for-service basis. Pahl (1996) reports that the percentage of CFP® practitioners offering commission only services has dropped from 64% in 1987 to 19% in 1994, although a significant majority (72%) of CFP® practitioners still received some commissions. As the move to fee-for-service provision continues, the market for financial and estate planning services takes on characteristics similar to other markets for experts' services including by-the-hour legal, auditing, tax preparation, and consulting services, fee-for-service medical and dental services, and automobile and appliance repair services. The theoretical literature regarding the markets for such services, which Darby and Kami (1973) term "credence goods," is not extensive. Arrow (1963) provides a broad overview of the informational aspects of such markets. Examples of formal theoretical analyses of similar market environments include Wolinsky (1993), Nitzan and Tzur (1991), and Pitchik and Schotter (1987, 1993).

Although a large contingent of the accounting and finance literatures is applicable to improving the delivery of financial consulting and planning services, there is essentially a virtual absence of literature regarding the organizational structure of the market for such services. Black, Ciccotello, and Skipper (2002) recognize this deficiency in the theoretical literature for personal financial planning. They argue that personal financial planning should be theoretically grounded in modern portfolio theory as applied to the overall client portfolio including human capital and liabilities as well as financial assets. They consider alternative models of the planning process including the specialist model (where the individual client contracts directly with specialty financial professionals) and the planner model (where the financial planner operates as a coordinator of other financial professionals and a liaison to the client). This study represents a contribution to the literature regarding the organizational structure of the market for planning services.