Financial Advice and Discretion Limits

Abstract

Biased recommendations from financial advisors often lead to suboptimal portfolios and unnecessary fees. The compensation contracts used in practice lack high-powered incentive alignment and are incapable of mitigating conflicts of interest. However, all is not lost; individuals can attenuate the agency cost by limiting their advisors' choices via discretion limits. In this paper, I characterize optimal discretion limits. I show that discretion limits resolve much of the agency conflict and that the mechanism is robust. The analysis provides novel recommendations for policy and practice.