What you need to know about behavioural finance to implement the new product design & distribution obligations

The new product design and distribution obligations are due to come into effect in October 2021. If your organisation issues or distributes investment or credit products, now is your chance to prepare. This article examines what you need to know about behavioural finance and associated decision-making research to implement these new requirements successfully.

Background

The product design and distribution obligations are the latest attempt to remedy poor consumer outcomes. In broad terms, the new obligations require that products are distributed to consumers for whom they are suited. The obligations will apply to a range of financial products, including investments, super, insurance and various credit products. The obligations are particularly relevant for super funds, investment product providers, banks, credit unions and insurers, among others. They appear to indirectly impact financial advisers and mortgage brokers too.

Within these organisations the new obligations are relevant for people in roles covering:

• Sales, marketing, client engagement and advice (who might need to change their promotional and explanatory materials, call scripts and web sites).
• Product design (who might need to redesign products and their features).
• Technology, data and customer insights (who might help to implement changes to products or the way they are presented, or use data to assess consumers’ needs).
• Leadership, governance, legal and risk management (who might need to assess the adequacy of their organisation’s product governance arrangements).

The broad approach taken by ASIC, as evidenced by their draft regulatory guide and consultation paper, aligns with the behavioural finance and associated decision-making research in several ways. For example, consistent with this research, ASIC suggests that product issuers and distributors shouldn’t just rely on disclosure or on obtaining a consumer’s informed consent as a path to good consumer outcomes. Furthermore, ASIC recognises that people’s decisions and actions can be influenced by behavioural biases, by choice architectures and by conflicts. Below are 5 specific psychological issues product issuers and distributors need to consider.

1. How do you create an appropriate choice architecture?

ASIC mentions the importance of ‘choice architecture’ 16 times in their draft regulatory guide. By ‘choice architecture’ they refer to ‘features in an environment, noticed and unnoticed, that influence consumer decisions and actions. These features are present at every stage of product design and distribution.’

ASIC’s emphasis on the role of choice architecture is consistent with a resounding finding of behavioural research that people’s decisions can sometimes be influenced in important ways by how information is framed and presented to them. My own research demonstrates this too – people’s choices can be influenced by the order in which information is presented, the number of options they are given, and the categories used to describe their options. Their choices and subsequent behaviour depends on the complexity and uncertainty they face, the amount of information they receive and how it is layered and chunked into meaningful pieces, the ease with which they can make appropriate comparisons, the frictions they encounter in processes, and a product’s default settings.

The problem is that to a product designer or distributor who is not familiar with the relevant research, these things can sometimes seem inconsequential. In an entirely logical and rational world they would be – in that world people would make appropriate choices regardless of how information happened to be presented. But in a behavioural world populated by human beings these things can significantly influence peoples’ choices, actions and outcomes. Product designers and distributors therefore need to be aware of how choice architectures can influence consumers’ decisions and factor that into their approach.

2. How can you use questions to understand consumer needs?

According to ASIC, the new design and distribution obligations will require issuers to ‘design financial products that are likely to be consistent with the likely objectives, financial situation and needs of the consumers for whom they are intended’. But how can issuers know what consumers’ objectives, financial situations and needs are … or what they like or dislike … or what they understand or don’t understand? Perhaps the best approach is simply to ask them.

Unfortunately, as ASIC points out and the decision-making research confirms, there can be severe limitations in attempting to do this. You can’t simply ask people if they understand a product and expect to get a reliable answer. For a start, they might not be aware whether they understand it, resulting in them saying ‘yes’ when the real answer is ‘no’. And, as ASIC points out, if the consumer purchased the product previously, that’s not a sufficient indication that they understand the product either.

And you can’t ask how satisfied a consumer is either. ASIC research demonstrates that this too is an unreliable guide to whether a product is suitable; as ASIC puts it ‘consumer detriment may be apparent to consumers or be hidden’. Neither can you ask consumers to self-certify that they are in the ‘target market’ for the product – ASIC says that is not sufficient either. And asking about their risk preferences and their goals and objectives is also a tricky business that is beset with psychological traps, as I’ve discussed in detail in my most recent book.

So what can you do? The short answer is to choose any questions you ask consumers carefully, and to consider relevant psychological factors when interpreting their responses. For example, to assess whether a consumer understands a complex product, having them articulate a key component of it can allow an adviser (say) to assess whether the consumer truly understands it, rather than relying on consumers’ own (less reliable) self-assessments.

3. How can you use data and technology to understand consumers’ needs?

Rather than asking questions, an alternative approach is to use data and technology. This is a possibility that ASIC specifically allows for. Measuring consumers’ actual decisions and behaviours can mitigate the risk of their fallible memories and self-assessments. And the data doesn’t even have to be perfect – ASIC will be satisfied so long as the issuer has made a reasonable assessment of consumers as a group, not an assessment that is necessarily correct for every one of them.

But while the data presents opportunities, it also creates its own range of decision-making challenges. One of the challenges is how to deal with uncertainty. When making an inference about a consumer based on some demographic information (such as their postcode, say), one needs to be very careful about straying too far from what psychologists refer to as relevant ‘base rates’ (ie what applies for most people most of the time).

In psychological experiments and in my own workshop demonstrations people often fail to properly account for this uncertainty. People find beguiling patterns in the noise; they naturally and often unknowingly ‘overfit’ a narrative to fit the patterns they find, thereby creating an apparently compelling story about a customer they actually know very little about. When an inference is beset with uncertainty, it is easy to feel you know more about a customer than you do.

Factoring decision-making research into consumer data analytics is one way that product issuers and distributors can mitigate the risk that apparently sophisticated statistical predictive models lead to the very consumer harms that they are intended to avoid. A psychological lens needs to be applied somewhere between the data analytics people and the client engagement or marketing people. Without it, each can incorrectly thinking that they have benefited consumers when they have not.

4. How can you avoid misleading consumers?

While many of the new product design and distribution obligations shift the onus of ensuring product suitability away from the consumer, the shift isn’t absolute; a role for the consumer remains. To give the consumer the best chance to fulfil this role requires, at least in part, making sure they aren’t misled.

One of the problems of communicating with consumers about products is that they can easily get the wrong impression. One of my favourite demonstrations of this is where I present workshop participants from across the financial services industry with text labelled ‘Important information’. Despite the label, typically a large proportion of people ignore it – assuming that the text was, ironically, unimportant. When given the same test, more than three quarters of individual investors do the same.

The problem is that when faced with complexity and information overload (which describes much financial decision-making), people often look for simple decision-making shortcuts to reduce their cognitive load. In the case discussed above, the shortcut might have been ‘this information is important to the product issuer, but not to me as a consumer’. No doubt this interpretation is formed from investors’ experience reading disclosure documents. For these investors, ignoring the ‘important information’ seems entirely logical.

So how might consumers be misled? One way that ASIC specifically identifies is if consumers are deliberately or inadvertently led to believe their personal circumstances have been taken into account when only some aspects have been. Or that the product has been assessed as being suitable for them when in fact they have only been identified as being a member of a target market for whom it might be suitable. ASIC also discusses how consumers can be misled by specific words (such as using the word ‘cash’ when discussing mortgage-related investments), or promotional materials that make inappropriate comparisons between products.

How can these risks be mitigated? Sometimes problematic words can be changed or removed. Research suggests that sometimes it is the order in which information is presented, making some things seem more important than others, or making it seem that some things lead to others. Sometimes it is the headings that are used, or the way information is presented in a pie chart - the number of segments can be critical. And, as ASIC discusses, sometimes it is who the information is being presented by that matters. If information is presented by a financial adviser, for example, the consumer might be more inclined to believe that their personal circumstances had been considered.

Given that consumers can sometimes believe the exact opposite of the literal meaning of the words they read or hear, we cannot always rely on information to be interpreted as intended. If we don’t use the decision-making research as a guide we should not be surprised when misunderstandings occur.

5. How can product issues and distributors work together?

And finally, ASIC points out the need to focus on the relationships between product issuers and distributors. For example, to assess compliance with the new rules, ASIC intends to assess what steps have been taken to eliminate or manage the risk that incentives may influence distribution behaviours.

Psychological research is highly relevant in making this assessment. As was discussed in the Royal Commission, that research shows that conflicts of interest can have a more pervasive impact than many people expect. Conflicts don’t need to be financial, but can be conveyed by relationships, for example. If your boss is conflicted, because you are accountable to your boss you are likely to be conflicted too.

And conflicts don’t just cause intentional wrong-doing, but can also impact well-meaning people beyond their conscious awareness. And as ASIC points out, detriment can be caused not just by actions that are intentional, but also by ones that are ‘reckless or inadvertent’. Given this, eliminating only explicit conflicts and managing only intentional behaviour is not going to be sufficient.

Factoring in the relevant decision-making research requires product issuers and distributors to think more broadly about the impact of conflicts. It might also require product issuers to provide training to their distribution partners, not just on the features of their products, but on the relevant psychological issues the come with them too.

Warning: in case it wasn’t clear, this is not intended to be legal advice!

For more information, see Behavioural finance – a guide for financial advisers (specifically the chapters on risk profiling, understanding clients’ goals & objectives, client engagement, customer data analytics and conflicts of interest).