Investor Protection

The Great Debate

- Should Embedded Commissions Be Prohibited? Ken Kivenko

W

hat services are currently captured in the trailing commission (the amounts embedded in the management fee to pay dealers for distribution)? Is greater alignment between the services provided and the trailing commission needed? What is the role, if any, of trailing commissions in the discount brokerage channel? Should embedded commissions be prohibited? Research by regulators shows that most retail investors rely heavily on their dealer Representatives (investment “advisors”) recommendations on buying, selling or holding securities but they don't realize that they are charged indirectly via embedded trailer commissions and these trailers are paid on an ongoing basis. This, along with other factors, makes investors vulnerable to mis-selling. Investors buy actively-managed funds because they are seeking above-average performance. Ironically, it is the cost of these trailer commissions which contribute to the chronic underperformance of such funds over the long term. About 12 million Canadians own mutual funds with total assets exceeding $800 billion. Investors paid an estimated $4.6 billion in trailer commissions in 2011- we’re talking big dollars here. Trailers represented approximately 64 % of non-bank dealer Representative compensation in 2011 up from 27 % in 1996. There is currently no requirement for reporting of these trailer commissions in dollar and cents terms on client account statements (or on trade confirmation slips) although this will be provided over the next three years due to recent changes in securities regulations. Trailers represent about 34 % of the MER on average. Typically, one-half of trailers collected are paid out to dealer Reps. Funds sold on a front-end load basis pay 1 % on average. Index funds carry lower net management fees and lower

trailers (usually 0.25 %) which may explain their relative lack of popularity among dealer Reps. Despite the fact that Fund-of-funds reduce dealer Rep workload, trailing commissions on such funds are equal to or greater than stand-alone funds. This likely explains their phenomenal growth over the last five years. Sales incentives work – no shocker here. Trailing commissions are often referred to as “trailer fees”, “distribution fees” “service fees” and sometimes “advisory fees”. They are an amount of money paid by the manager of an investment fund to investment dealers (who may pay a portion to their sales representatives) for the distribution of securities of the mutual fund made through them. The amount paid is based on a percentage of the net asset value of an investor’s interest in the fund and is paid on an ongoing basis to dealers/sales representatives for as long as the investor owns his/her investment in the investment fund . Trailers are subject to GST/HST adding to the cost of fund ownership. Note that some fund companies like Steadyhand provide basic advice but do not charge trailers (they do have higher minimum initial investments though). Trailing commission rates vary based on (i) the purchase option selected and (ii) the asset class of the fund rather than any client-based level of effort rationale. This gives rise to a conflict-of-interest – this conflict is not revealed in the current version of Fund Facts. Research shows that conflicts-of-interest are particularly difficult to consider since they run counter to the high level of trust that underpins the client-advisor relationship. Another way in which the conflict-of-interest occurs when dealers who are affiliated with fund manufacturers,

z Canadian MoneySaver z https://www.canadianmoneysaver.ca z July/august 2013

offer an enhanced sales-based incentive to sell proprietary funds by virtue of a compensation grid. The Canadian Securities Administrators Discussion Paper on Fund Fees clearly states that the percentage of trailing commission paid on proprietary funds is greater than that paid on third party funds which is, in our view, noncompliant with subsection 4.1(1) of National Instrument 81-105, Mutual fund sales practices, so there appears to be an enforcement issue. Further, the regulatory system allows dealer Reps to sell mutual funds which have fees that are much higher than comparable products as “suitable” investments for their clients without disclosing to their clients the existence of cheaper alternatives. Although the terms referring to trailing commissions are commonly used in the industry, there is no precise definition of them in securities legislation. Nor is there any precise definition or disclosure of the services that dealers/advisors are to provide in exchange for the trailing commission. There is a common misunderstanding that 100% of trailing commissions are paid for ongoing services provided by the dealer representatives/advisors. In fact, the compensation is paid to the dealer in connection with the distribution of the financial products and is the source of revenue for investment/mutual fund dealers. This revenue pays for a variety of dealer costs including account opening, supervision, compliance, back office functions, client statement production, insurance, complaint handling, participation in OBSI etc. as well as the cost of rewarding advisors for consummating sales and compensating them for providing ongoing recommendations to clients. The dealer, not the fund manufacturer providing the cash, determines the level of service its sales representatives/ advisors are to provide and their compensation plan. It is clear that the trailing commissions are paid for distribution services including the advice that is ancillary to such distribution services and not for investment advisory services. Ancillary “advice” provided involves making “suitable” investment recommendations consistent with the Know-Your-Client (KYC), ensuring that the client fully understands the nature of the units held in the account and all of the implications of holding the units, portfolio monitoring and answering any questions that the client may have regarding the account, or the units held in the account. The Rep may also provide some basic

tax guidance and recommending investment strategies such as leverage as deemed appropriate. Too often we see sales pitches posing as planning and investor education. Despite the, at least partial disclosure, of embedded dealer compensation percentage rates disclosed in the Simplified Prospectus and in Fund Facts, many investors don't understand that trailing commissions are a significant portion of the ongoing costs of holding mutual funds. Even those in the know are unclear whether the fee comes out of the MER or is added to it. Representatives are not currently required to tell investors about how much they make on trailer commissions or other embedded compensation such as point-of-sale commissions they receive from fund companies for selling funds on a deferred sales-charge basis. It is no wonder that investors think that “advice” is free. In effect, the financial services industry has prospered by appearing to give away something for which it is actually charging a lot. Trailers add to fund costs and contribute to the erosion of investor nest eggs. In his book The Little Book of Common Sense Investing, index investing pioneer John Bogle uses the example of a mutual fund with a fee of 2.5 per cent. If the fund makes 7 per cent, the fee eats up about 40 per cent of returns; if inflation squeezes the real return of the fund to 4.5 per cent, the fee eats up almost 60 per cent of gains. The fact is that lower returns harshly magnify the relentless arithmetic of excessive mutual fund costs. Costs Count! As Bogle says, “The magic of compound returns is overwhelmed by the tyranny of compounding costs. Do you want to invest in a system where you put up 100% of the capital, take 100% of the risk and get 30% of the return?” The majority of retail investors do not understand the long-term impact that fund fees, trailing commissions and other costs that are charged to the fund have on their net long term return. Investor advocates point to the small amounts of assets ( about 1.5 % of total) in low- cost/ low trailer index mutual funds which history shows provides better longterm returns than their more expensive actively-managed cousins as one more example that trailers drive dealer Rep

Canadian MoneySaver z https://www.canadianmoneysaver.ca z JUly/august 2013 z

behaviour. This should not come as a revelation since the primary purpose of trailers is to incentivize dealers and Reps to transact sales. The sale transaction is the only factor for which dealers/Reps are rewarded. Customer satisfaction, account performance, customer service etc. don’t enter directly into the formula. Adding to investor vulnerability and lack of understanding is the fact that dealer representatives are now referred to as “advisors” or other misleading terms when, in fact, most are fundamentally” salespersons”. Investors are lulled into thinking that they are dealing with people duly trained to provide investment advice. In fact, until National Instrument NI31-103 on registration came along, “advisors” were registered as “salespersons”. It is possible to become a mutual fund registrant by taking a correspondence course and passing a multiple choice exam although a number of Reps far exceed this minimal baseline. Our regulatory system allows mutual fund dealer Reps to call themselves “advisors” despite the fact that they have obtained a restricted licence which only allows them to sell mutual fund products; these restricted salespersons sell the higher-fee products to investors who can ill afford to have high fees eat into their limited savings. In practice, we see that most dealers describe trailers as a payment for “advice” with no clarity of what the nature, scope or extent of the advice is (or even if it will actually be provided). There is in effect an attempt by some dealers to masquerade a product-based proposition as a valuable service-based proposition. There is thus no alignment between the services provided and the trailing commission paid. Because of the lack of clarity of the “advice” content of trailers, clients have no reliable signpost to help them assess the cost-benefit of the “advice”. When we consult the rules, regulations and Bulletins of the CSA and the MFDA/IIROC we do not find regulations defining the nature of “advice” or the parameters in which that advice should be delivered, monitored and reported. Current registration categories do not adequately describe duty to client. The regulations relate mainly to issuance of securities and the rules and regulations governing their transactions and the rules and regulations governing the disclosure, sale and purchase of securities for individuals. This is a gap that regulators need to fill.

As far as trailer commissions paid to discount brokers, there is clearly no advice or continuous portfolio monitoring services provided. There is therefore no justification for an ongoing trailer to be paid. Funds with trailers stripped out (e.g. F class) are most applicable here. The discount broker will be fairly compensated for its execution- only services through the regular per trade brokerage commission structure as is the case for closed-end funds, ETFs, common stocks etc. Some Representatives do go beyond the basic minimal “advice” and provide several elements of financial planning for larger clients. In most cases however the “advisor” is not required to act as a fiduciary. A 'Fiduciary' is someone who is obligated to put client interests first. Right now, the bar is set at a much lower level because advisors merely need to make investment recommendations that are "suitable" a term that is so nebulous and broad that it can mean a large number of things. By convention, cost does not enter into the suitability of the advice equation despite its critical role in determining fund and portfolio financial performance. The “advice” given today is tainted by conflicts-ofinterest, and being linked to a transaction. Under the prevailing regime, the final decision for making the investment rests with the investor. Respected industry participant and author John DeGoey says “[True] advisers should deal in terms of strategies /concepts, not whiz-bang products.” A “Best interests” standard would certainly provide investor protection that isn't there currently. Such a standard however is not compatible with an embedded commission structure. I add parenthetically that the new account opening form and process are not standardized and much improvement is needed if this information is to be used to make robust investment recommendations per KYC obligations. Until advice is actually regulated in some shape or form, standards are raised and financial advisors have a real professional body to define the rules and regulations governing the provision of advice and the discipline and punishment of those who ignore them, the retail investor will need to be responsible for policing his/her own financial position – this is the reality today.

z Canadian MoneySaver z https://www.canadianmoneysaver.ca z July/august 2013

Whether it’s due to their lack of time, experience, expertise, objectivity, desire, ability, or financial literacy, most investors realize that they can’t solve their financial complexities themselves. Yet, independent research undeniably demonstrates that commission-based advisers provide skewed advice that impairs financial returns. We are constantly provided with news about investor complaints against advisers and dealers in the media, from our neighbours and friends, regulators, OBSI and the Courts. If any profession like medicine, engineering or accounting had such a high complaint incidence rate, there would be a national call for action. A January 2013 CBC Marketplace mystery shopping report looked at Canada's five biggest banks - CIBC, Royal Bank, TorontoDominion Bank, Bank of Montreal and Scotiabank—and found most offer little clarity on how mutual fund fees work and how much they cost. There’s more. In May, Morningstar announced its findings from Third Global Fund Investor Experience Report covering 24 countries across North America, Europe, Asia, and Africa. Their researchers evaluated countries in four categories: Regulation and Taxation, Disclosure, Fees and Expenses, and Sales and Media. Morningstar weighted the questions and answers to give greater importance to factual, empirical answers as well as the high-priority issues of fees, taxes, and transparency. Morningstar assigned countries a letter grade for each category and then added the category scores to produce an overall country grade. The United States scored the best with an A score; Canada got a C+. Worse, Canada has the highest annual expense ratios for equity funds, the second highest for bond funds, and the highest for allocations funds. Under Fees and Expenses, Canada was the only country to score an F, the lowest possible rating. Morningstar has found that, all things considered, Canadian fund investors pay up to 0.50% more in annual fund expenses per year than do investors in fund markets of a similar size elsewhere in the world. Because Canada restricts competition by not permitting foreign-domiciled mutual funds to register for sale in Canada, investor choice is constrained. This is a serious socioeconomic problem as excess fees unduly erode investor returns and retirement savings. Changing age demographics add to the challenges and urgency facing regulators, industry participants and retail investors. That is why the debate /analysis on advice-giving regulation needs to be had now - investors need trustworthy, professional investment advice on

retirement, their child's education, saving for a home purchase and other life events. If embedded commissions become prohibited, the world won’t come to an end. In fact, according to the Canadian Investors' Perceptions of Mutual Funds and the Mutual Fund Industry 2011 report – 33 % of investors would prefer to pay for "advice" separately, while 59% continue to prefer to pay fees that are embedded as part of their mutual funds. Better fee and service disclosure may alter these numbers. Industry sponsored polls indicate there is a virtual client-advisor love affair so banning embedded commissions ( altering the method of payment) shouldn’t be too disruptive for clients as long as overall costs remain the same. If trailers are banned, some investors may balk at paying for “advice” or it may initially be deemed too expensive. I have every confidence that the innovators on Bay Street will find business models to service small investors, those with investable assets of say, less than $100,000, assuming that once they see the bill, actual services to be provided and assess the impact on returns they want to pay for “advice”. Smaller clients don't necessarily need constant ongoing advice -they could purchase one-off fee-only financial planning, which could be cheaper and more effective in the long run. It’s not as if the “advice” they are receiving now is in their best interests. Indeed, some investors might be better off paying down debt, establishing an emergency fund and investing in GIC’s ( including maybe even an index-linked GIC) until their financial situation and financial competency improves and securities regulations/ enforcement are tightened up. The embedded commission mutual fund fee structure no longer fits with a connected world that values transparency, professionalism and integrity. It’s time to not only raise the bar, but also the floor for advice givers. Paying for tailored advice rather than transactions would be a positive development especially when dealing with an aging population that is likely to transact less in the future. This issue is crucial for an industry entrusted with the life savings of Canadian financial consumers. The status quo on embedded commissions is a non option. Ken Kivenko, PEng, President , Kenmar Associates, Etobicoke, ON (416) 244-5803, [email protected], www. canadianfundwatch.com

Canadian MoneySaver z https://www.canadianmoneysaver.ca z JUly/august 2013 z