Ban on embedded fund compensation wouldn't eliminate conflicts

What to expect if dealers can no longer be paid with trailer commissions

Rudy Luukko 1 December, 2017 | 6:00PM

This year's intense debate over the fate of embedded advisor commissions paid by mutual funds pits two powerful camps against each other that have seemingly irreconcilable differences.

In favour of changing the ground rules are various investment-industry participants, consumer-advocacy groups and regulators. Their arguments concerning conflicts of interest, high fees and lack of transparency are well documented in the consultation paper released in January by the Canadian Securities Administrators. As regulators have repeatedly emphasized, the status quo is not an option.

The opposing camp positions itself as the defender of consumer choice and preservation of access to advice for small investors. The anti-ban proponents include most mutual-fund companies and commissioned advisors, along with their trade organizations.

After conducting and commissioning extensive research, holding panel discussions to debate conflicting views, and reviewing 142 comment letters in response to the consultation paper, the regulators are getting closer to making up their minds on what to do. Through the CSA, their common voice, the regulators expect to release their preliminary policy recommendations sometime this spring.

The big question is: Will regulators decide to impose a ban on embedded commissions? A related question, no less pertinent, is this: Would such a ban improve the Canadian investor experience? A ban would improve the transparency of the price of advice. But it wouldn't eliminate conflicts, lower the cost of advice, or guarantee good advice and service. It would disrupt a market in which low-fee competition is already robust, and in which fee-based arrangements are growing in popularity. And it would remove choice from the many investors who remain satisfied with the very compensation regime that the regulators insist needs to be reformed.

Consider the following:

Banning embedded commissions won't eliminate payments to advisors from fund managers.
One of the major benefits of a ban, according to regulators, would be to eliminate compensation that influences the product choices of advisors. To a large degree, that's wishful thinking. As previously reported, mutual-fund companies can get around a ban by implementing direct-pay arrangements. With these alternatives to trailer commissions, investors agree in writing to allow fund companies to draw down from their account, if necessary by redeeming units, to pay their dealers for advice and service. Another workaround for mutual-fund salespeople who are dually licensed is to sell segregated-fund policies, which are overseen by insurance regulators and not subject to a trailer-fee ban. This is known as regulatory arbitrage. Thirdly, as the regulators have heard during their consultations, integrated firms such as banks can circumvent a ban by reallocating costs and revenue streams internally. By definition, the product choices of proprietary sales forces who sell only the house brand of funds are conflicted. Banning embedded compensation for mutual funds would eliminate only one form of conflicted advice.

A ban won't reduce the price of advice.
Advice that's charged separately from managed products isn't necessarily cheaper than advice that's paid for out of embedded commissions. Trailer commissions tend to be similar: the prevailing rate is 1% a year for equity and most balanced funds, and 0.5% for fixed-income funds. Fee-based advisors have the flexibility to tailor their fees to individual client circumstances. In some instances, that can translate into fees of 1.25% to 1.5% a year, which is more generous than what mutual-fund companies pay in trailer commissions. Alternatively, fee-based advice can cost below 1% of client assets, depending on the size of the account. One regulatory initiative that would bring down the cost of advice would be a ban or meaningful restrictions on the point-of-sales commissions, typically 5%, that dealers receive on the sale of deferred-sales-charge funds. Generally, direct payments for advice offer more price flexibility for investors, but not necessarily savings.

Paying directly doesn't guarantee good advice and service, but it is more transparent.
The costs of advice can be good value or poor value, in relation to services rendered, regardless of how compensation is paid. That depends on the proficiency, dedication and integrity of the individual advisor. There are excellent advisors, and ones to avoid, in both the embedded and non-embedded compensation channels. Direct payments by investors do have the advantage of greater transparency and more frequent disclosure on client statements. With embedded commissions, under recently implemented disclosure requirements, investors receive only an annual statement of commissions and other charges paid to advisors.

The shift away from embedded commissions is already happening.
Within the $141-billion universe of about 550 Canadian-listed exchange-traded funds, there is a large and growing selection of mostly low-cost managed products with no embedded commissions. Though ETF assets in Canada are only one-tenth of those of traditional mutual funds, they grew at 30% over the past 12 months ended in October, or three times as rapidly as those of mutual funds. The thriving ETF market undercuts the argument that embedded-commission models have impeded the growth of lower-cost alternatives. In recent years we've also seen the emergence of robo-advisors, mainly using ETFs and charging less for investment advice than traditional advisor channels. Within the mutual-fund industry itself, there's a continued shift toward fee-based purchase options and away from embedded commissions. Also serving investors are several direct-sales mutual-fund companies that don't pay trailer commissions. Overall, low-fee competition and non-embedded compensation is alive and well in Canada. These trends are being driven by market forces, which are far more powerful than the regulators or fund managers.

Many investors are satisfied with embedded commissions.
There is no doubt that embedded commissions influence the investment choices that dealers put forward to their clients. These advisors may rule out from consideration any mutual fund or ETF or other investment that does not pay them trailer commissions. This limits investor choice. But so does any bank that sells only its own brand, or any brokerage or fund dealer that -- even if advisor compensation is fee-based -- will sell only those products that are on its approved list.

What's also true, and that hasn't had much influence on the regulators, is that many or even most fund investors are satisfied with paying for advice indirectly through trailer commissions. According to the 2017 opinion survey of mutual-fund investors conducted by Pollara and sponsored by the Investment Funds Institute of Canada, 53% of respondents prefer that their advisors be paid through fund fees that reduce their investment return. That compares with 37% who prefer to pay their advisors directly. The remainder expressed no preference. Released in November, the national survey was based on phone interviews in July with 1,000 adult Canadians who make some or all the decisions on mutual-fund purchases in their households. Banning embedded commissions would eliminate a choice that remains widely popular among a large body of investors who are satisfied with the advice they receive and how they pay for it.

An embedded-commission ban would be a market disruptor for the financial-advice industry.
The extent of disruption is a matter of speculation, but the potentially biggest losers would be independent fund dealers whose clientele tend to have smaller accounts of less than $100,000. If regulatory change compels dealers to ask their clients to pay separately for advice, they may lose market share to competitors, particularly the banks. Some investors who pay indirectly through embedded commissions may decide that advice is a service that they don't need if they need to pay for it directly. And many would be resistant to any price increases. The Pollara survey found that half of respondents said they'd remain with their advisor if their fees increased under a direct-pay system, while the other half would discontinue their relationship. Then again, it might be the advisors who pull the plug, since advisors who use fee-based arrangements tend to avoid serving small accounts. This happened to some extent in the United Kingdom after that country implemented its own ban on embedded commissions. There would be alternatives for unwanted small investors, since banks and most robo-advisors have low account minimums. Other mass-market investors would, at least temporarily, become part of what defenders of embedded commissions refer to as the "advice gap," either by choice or because fee-based advisors don't want their business. This is an unintended consequence that regulators and industry stakeholders would want to avoid, or at least minimize.

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Rudy Luukko
