Industry players and lobbyists in the financial services sector are warning of an impending “advice gap” that would be created if a ban on certain embedded commissions for mutual funds was extended to segregated funds.
These particular commissions are more commonly known as deferred sales charges, or DSCs, and they allow for financial salespeople to earn upfront payments that are not directly deducted from investors’ contributions. Rather, they are funded by higher continuing fund management expenses that many investors are not aware of.
Such extra expenses reduce investment returns, all other things being equal, and have been shown to incentivize sales tactics harmful to investors’ welfare. This commission structure has already been banned in Canada for mutual funds, and a similar ban will soon apply for segregated funds (which are similar to mutual funds but sold through life insurance companies).
Without a doubt, the business case for offering good-quality financial advice when compensation is tied to investment portfolios has been a challenge that has never really been solved for average households. That’s because compensation for investment salespersons has historically been tied to the size of portfolios. The more money a household has, the more attractive they are. Conversely, households lower down the wealth ladder are less attractive.
But a long time ago and for a brief moment in time, the embedded commission model that is now on the chopping block for segregated funds actually came close to addressing the issue for households with lower levels of savings.
DSC mutual funds lasted 35 years in Canada. When they originally came to market in 1987, they were innovative and indeed reduced barriers to investing for the average Canadian household. That’s because prior to that it wasn’t unusual to be charged 8 per cent or 9 per cent upfront for the privilege of having your money invested into a mutual fund at the time. If you had $10,000 to invest, your account balance on Day 1 would be $9,100 after 9 per cent was taken off the top. (You might have been able to negotiate the upfront commission down a few percentage points if you had a larger lump sum to invest.) On top of the upfront commission, you still had the annual expenses of the fund that would reduce your returns.
But the introduction of the DSC option allowed the mutual fund salesperson to get paid an upfront commission (usually around 5 per cent) while simultaneously allowing the investor to see their full contribution invested into the markets. In other words, you give your mutual fund salesperson $10,000, and $10,000 was put into the market on your behalf. But at the same time, $500 in commissions were generated. So where did the extra $500 come from? In effect, the investor unknowingly financed it through high, continuing annual expenses. This led to the boom times in mutual fund asset growth in Canada in the 1990s.
The trade-off was that if the investor wanted their money back, they would be subject to a deferred sales charge that initially started at around 5.5 per cent to 6 per cent in redemption charges and gradually declined to zero, generally after seven years. Despite this fee, there was a time when the DSC mutual fund was a welcomed option to get more households invested into the markets because the alternatives at the time were not as attractive.
Since the inception of DSCs, things have changed. Canadians have much more choice when it comes to investment products and ways to pay for advice. But perhaps most importantly, they’ve been exposed to too many instances of financial salespeople abusing the DSC model. Whether it is misleading investors into thinking they are getting free investment management, persuading investors to borrow funds to invest in DSC funds to generate higher commissions, or placing seniors with shorter time horizons into DSC funds that would be subject to redemption charges based on decumulation needs, the abuses of the DSC model are well documented. (Here is an actual case study of unsuitable use of DSC funds from the Ombudsman for Banking Services and Investments, OBSI).
As a result, DSCs on mutual funds were banned as of June, 2022, because according to the Canadian Securities Administrators (CSA): “With ample evidence of investor harm, especially for the most financially vulnerable investors, and no evidence of any benefits, we see no reason to preserve the DSC option.” Why this conclusion should somehow be different for segregated funds is unclear.
In response to a call for comments from the Canadian Council of Insurance Regulators and the Canadian Insurance Services Regulatory Organizations on upfront compensation for segregated fund sales, a number of insurance companies and associations representing financial salespeople voiced concerns about the impact on the access to advice for Canadians.
In a white paper recently published by Primerica, the argument is made that tighter regulation and the banning of deferred sales charges on segregated funds could lead to less access to advice for smaller investors, creating the so-called advice gap.
Unfortunately, any merit that might exist behind this reasoning is outweighed by the fact that the industry had 35 years to show it could responsibly police the use of deferred sales charges. Instead, the misuse and abuse of DSC funds created a trust gap.
Rather than defending old models of compensation that have outlived any earlier utility, it’s time for the industry to turn its energy to exploring new ways to provide quality financial advice to smaller households. It’s not so much an advice gap as it is a quality-advice gap.
Preet Banerjee is a consultant to the wealth management industry with a focus on commercial applications of behavioural finance research.