A Payday Lender, a Pension Fund and Disclosure
A financial adviser is comparing two products for a client. Product A is a short-term lender charging a 1.5% fee per week on the amount borrowed, compounded weekly, with an advertised 'low weekly rate'. Product B is a managed fund with a 2% entry fee, 1.8% annual management fee and historical return of 7% before fees. The client, aged 58, has $80,000 and a 7-year horizon. The adviser receives a 0.5% trailing commission from Product B but nothing from Product A. The adviser recommends Product B, citing the higher historical return. The client also owes $12,000 on a credit card at 19.9% p.a.
1. Calculate the effective annual rate of Product A and the net return of Product B, and evaluate the advice.
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Product A: Weekly compounding at 1.5%: EAR = (1.015)^52 − 1. (1.015)^52 ≈ e^(52×ln1.015) = e^(52×0.014889) ≈ e^0.7742 ≈ 2.169, so EAR ≈ 116.9%. The 'low weekly rate' is misleading.
Product B: Net return ≈ 7% − 1.8% = 5.2% before entry fee. Entry fee 2% reduces the initial $80,000 to $78,400, so the effective first-year drag is about 2% plus 1.8%, giving a net first-year return near 3.2%, settling to about 5.2% thereafter.
The advice is conflicted: the adviser earns 0.5% from B and nothing from A, and recommends B on historical returns that are not guaranteed. The client's credit card debt at 19.9% is a guaranteed 19.9% return from repayment, far exceeding B's net 5.2%. The adviser should first recommend repaying the card; the conflict of interest must be disclosed.
2. Explain the ethical obligations and one regulatory concern.
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Ethical duties: act in the client's best interest, disclose the commission conflict, and ensure advice is suitable. Recommending a commission-paying product over debt repayment without disclosure breaches the duty of loyalty and the suitability standard. The adviser should document the comparison, disclose the 0.5% trailing commission, and explain why any recommendation beats the 19.9% debt repayment.
Regulatory concern: misleading advertising of a 'low weekly rate' without disclosing the effective annual rate can breach consumer credit disclosure rules, which typically require a comparison rate or annual percentage rate. The adviser should also check that the fund's fees are disclosed in a product disclosure statement and that the client understands historical returns are not forecasts. Recommending debt repayment instead of an investment is often the correct, fee-free advice.