What is double dipping in finance?

Understanding double dipping

To better understand how double dipping occurs in the financial services and investment industry, let us consider two key contexts: managed money accounts and wrap accounts.

Managed money accounts

Managed money accounts are investment accounts that are actively managed by an investment manager. Clients incur a fee for the management of their assets which tends to be 1% to 3% of the total assets under management (AUM).

Here’s how double dipping may occur:

1. Management fee – the client pays a fee to the investment manager to manage their assets.
2. Commission – the client’s assets are then invested in a mutual fund, exchange-traded fund (ETF) or other investment vehicle where the fund manager has an interest and where management fees also apply. The fund manager may receive a commission or share part of the management fee with the fund.

In this context, the fund manager receives a direct fee from the client to manage their assets. They also receive an indirect fee (in the form of a commission) from the fund where the client’s money is invested.

Wrap accounts

Wrap accounts are a type of money managed account where various investment and brokerage services are bundled together and sold for a single fee.

This fee – which also covers administrative costs and received commissions –  is also based on the total AUM.

Double dipping can occur as follows:

1. Wrap fee – the client pays the wrap fee to cover all investment and brokerage services.
2. Commissions – the fund manager then places trades that generate commissions or rebates. As in the money managed account example, the client’s assets may also be invested in a fund where management fees are applicable.

Here, the fund manager receives a wrap fee from the client that, in theory, should cover all related costs. However, the manager also earns income from commissions on trades, commissions for sending business to the fund as well as any revenue earned from the fund’s management fee.

Why does double dipping occur in financial services?

In the financial services and investment industry, the drivers of double dipping include:

1. Compensation models.
2. A lack of transparency.
3. Conflicts of interest.
4. Entrenched industry practices, and
5. A lack of client knowledge or awareness.

Many of these drivers interact with (or reinforce) others.

Compensation models

Financial advisors and investment managers often enjoy diverse compensation models that incorporate multiple revenue streams.

As touched on earlier, revenue can be earned via direct fees from clients, product sale commissions, trade commissions and revenue-sharing agreements.

The structure of this model encourages double dipping to occur.

Conflicts of interest

Related to the fund manager’s compensation model is the potential for conflicts of interest.

When an individual is incentivized to recommend products that offer a higher return, they may act in their own best interests and not in the best interests of the client.

One example is the practice of churning, which is the excessive trading of assets in a client’s account to generate commissions.

Churning is illegal and unethical, but for the client, it increases their management costs and potentially weakens their investment position(s).

A lack of transparency

The fee structures in financial services can also be complex and opaque. Clients may not fully comprehend fees if they are not clearly disclosed or buried in fine print.

Embedded fees are one context where transparency can be lacking. These fees are not directly billed to clients and instead are included within the expense ratios of investment products such as mutual funds and ETFs.

Think of expense ratios as costs the client must absorb to cover the fund’s management, administrative and marketing fees.

Entrenched industry practices

Historically, fund managers and brokers primarily earned a living through commissions on the sale of financial products such as bonds, stocks, mutual funds and insurance policies.

However, the commission-based model frequently caused conflicts of interest without advisors acting in their own best interests. Regulations were introduced and the industry shifted to a fee-based model, but the commission-based model has persisted.

The main drivers of this include the persistence of complex fee structures, the ongoing use of revenue-sharing agreements and the frequent introduction of new financial products with opaque fees or terms.

A lack of client knowledge or awareness

The relationship between a client and their advisor is often based on information asymmetry. In other words, the advisor has more knowledge about a financial product than the client.

When clients do not fully comprehend the fee structure or implications of a product or service, they essentially trust the advisor to manage their assets and dispense fair and impartial advice.

Other clients may possess the requisite knowledge, but double dipping still occurs because they are disengaged, distracted or otherwise unaware of the practice.

Other contexts where double dipping occurs

Aside from financial services and wealth management, variations of the practice have been observed elsewhere and are commonly associated with fraud.

Chargeback scams

In a chargeback scam, an entity (usually a consumer) profits from the same transaction twice.

These scams represent a significant cost to merchants, with every $1 defrauded by the consumer costing the business around $3.60 in compliance infrastructure, support teams and other expenses.

Here’s how the scam works.

1. The consumer purchases with a credit card and receives the product or service as usual. The payment is processed and the merchant is paid for the transaction.
2. Upon receipt of the item, the consumer disputes the transaction with the credit card issuer. Typically, they claim the purchase was unauthorised or that the item was not received.
3. The issuer then issues a chargeback by reversing the transaction and crediting the consumer’s account.
4. When the chargeback is upheld, the consumer receives their money back while the merchant loses both the payment and the goods or services provided. The consumer, on the other hand, keeps the product or service and the initial sum of money spent.

In some instances, a criminal may also steal the identity of a consumer and carry out a chargeback scam. However, the practice is generally considered a form of fraud no matter the initiator.

Insurance claims

Double dipping in insurance refers to a situation where an individual or entity attempts to receive compensation from multiple sources for the same loss.

This fraud can be facilitated in various ways,

• Multiple policies that cover the same risk. For example, someone may insure a car with two different policies and file a claim with both insurers in the event of an accident.
• Claims for the same loss across different types of insurance. Here, the policyholder claims under both policies for the same item without disclosing their other claim.
• Overlapping claims from government and private insurance. In some contexts such as natural disasters, affected individuals may claim governmental disaster relief payments while also filing an insurance claim disaster-related losses.

How can double dipping be prevented?

In finance, the prevention of double dipping involves:

• Robust disclosure requirements – fund managers must disclose all fees and commissions to the client clearly and concisely. In Australia, ASIC requires these to be detailed in an annual fee disclosure statement (FDS).
• Conflicted remuneration bans – in 2013, Future of Financial Advice (FOFA) reforms banned conflicted forms of remuneration in retail investment products. These included certain commissions and volume-based trade payments.
• Unbundled fee structures – many Australian financial advisors have moved toward fee-for-service models where clients pay a flat, transparent fee or hourly rate for advice. A clearer separation has also been made between the cost of products and the cost of financial advice to provide extra clarity.
• Technology and compliance tools – so-called RegTech (regulatory technology) is now used to track and monitor fee structures and identify potential instances of double dipping. To do this, RegTech employs artificial intelligence, machine learning, robotic process automation (RPA), cloud computing and advanced data analytics.

Client responsibility

Some onus must also be placed on the client to prevent double dipping.

While becoming as knowledgeable as a fund manager may defeat the purpose of hiring one in the first instance, clients should at least be aware of the different fee structures that relate to their financial products and services.

They can also be more proactive. This means keeping detailed records, monitoring statements for duplicate transactions and where possible, consolidating the management of their funds under a single advisor or firm.

Summary:

• Double dipping in finance refers to a situation where an individual or entity receives two incomes from the same financial product, service, transaction or arrangement. The practice is unethical at best and in many cases is illegal.
• The drivers of double dipping in investment and wealth management include diverse compensation models, conflicts of interest, a lack of transparency, entrenched industry practices and a lack of client knowledge and awareness.
• Other contexts where double dipping occurs include chargeback scams where consumers purchase a product, claim they have not received it and then initiate a chargeback with the credit card company.
• The prevention of double dipping requires robust disclosure requirements, unbundled fee structures, automated technology and a ban on all transactions with a conflict of interest. Responsibility also falls to the client to better understand the investment landscape and the products or services they are utilising.