In releasing today their latest consultation paper on fund fees, securities regulators emphasized that they've made no decision to ban embedded compensation to dealers. At the same time, the Canadian Securities Administrators left no doubt in the 169-page document -- entitled CSA Consultation Paper 81-408 -- Consultation on the Option of Discontinuing Embedded Commissions -- as to which way they are strongly leaning.
"To address the investor protection and market efficiency issues that have been raised regarding embedded commissions, we believe that transitioning to direct pay arrangements must be considered and evaluated," said Louis Morisset, CSA chair and president and CEO of the Autorité des marchés financiers, in a release.
The paper says investors should have compensation models that empower them and that better align their interests with those of fund managers and sales representatives. The CSA's view is that embedded compensation paid by fund companies to dealers -- primarily trailer commissions that are paid on an ongoing basis and point-of-sale commissions on deferred-sales charge funds -- create conflicts of interest, aren't aligned with service levels and limit investor awareness, understanding and control over the costs of advice and service.
Aiming to create a level playing field within the securities industry, the proposed ban on embedded commissions would apply to mutual funds, exchange-traded funds and other types of investment funds, including those sold under prospectus exemptions, as well as structured notes.
But the regulators concede in the paper that they have no authority over embedded compensation bundled into the management fees of segregated funds offered by life-insurance companies, which are structured as insurance policies.
The proposed ban would require any dealer compensation to be paid directly by the investor. Along with fee-based accounts that charge a percentage of assets under management, these payments could include point-of-sale commissions (also known as front-end loads), or hourly fees. In all cases, the CSA said, the compensation would need to be negotiated and agreed to by the investor.
The release of the paper, which will be met with strong opposition within the mutual-fund industry and commissioned-based advice-giving firms, signals the start of a 150-day comment period that is scheduled to close on June 9.
One trade organization, the Investment Funds Institute of Canada, didn't wait until today before issuing a statement asking the regulators to reconsider their proposed ban. "If regulators have concerns about specific sales misconduct, existing rules give them the enforcement tools they need to address the concerns they have identified," said Paul Bourque, IFIC president and CEO, in a Jan. 5 release.
"We recognize that such a change could have a profound effect on the fund industry and on investors in Canada, including potential unintended consequences," the CSA paper said. "Therefore, a decision on whether to discontinue embedded commissions will only be reached after careful consideration and assessment of the possible impacts on investors and market participants and consultation with stakeholders."
Under a direct-pay model, the CSA said it would expect dealers to offer their clients compensation arrangements that suit their particular investment needs and objectives and the level of service desired. One of the flaws of trailer commissions, as noted by the regulators, is that the "one-size-fits-all" amounts paid do not necessarily correspond to the level of advice and service received.
In contrast to industry executives who contend that restricting choices in how dealers are paid will reduce access to advice for people of modest means who most need it, the regulators present a positive scenario for investors.
The CSA concludes that the mass market of investors, with investable assets of less than $100,000, are the most vulnerable to an "advice gap." But they contend this gap is not expected to be significant since dealers owned by deposit-taking institutions and insurance companies will continue to serve mass-market households, as will new low-cost providers such as online (robo-advice) firms. "It is anticipated that if we were to discontinue embedded commissions, existing and new market innovations would help ensure that mass-market households still have access to advice."
Mid-market investors, with investable assets between $100,000 and $500,000, will benefit from lower fund-management costs, the CSA says. "A transition away from embedded commissions will likely drive a shift in products recommended by representatives and made available on the dealer product shelf toward lower-cost and passively managed funds, which could improve investor outcomes."
Affluent investors, with investable assets above $500,000, would be least affected by the discontinuation of embedded commissions, the CSA says. That's because this market segment is the most likely to already be using non-embedded forms of dealer compensation.
The regulators say do-it-yourself investors in all wealth segments will benefit from the discontinuation of trailing commissions because of significantly lower costs. As the CSA observed, discount clients often bear the costs of full trailer commissions, even if they receive no advice.
As a result of banning embedded compensation, the CSA says, the number of fund series available in Canada would decline sharply. "This would significantly simplify fund fee structures which are currently very complex and difficult for investors to understand." With fewer fund series, there would be savings on disclosure documents and marketing materials, according to the regulators.
Meanwhile, the CSA predicts that new lower-cost product providers would enter the market, since embedded commissions currently represent a barrier to gaining entry to distribution channels. In addition, smaller emerging asset managers with good track records would be better able to compete for sales in a "post-trailing-commission world."
The potential entrance of lower-cost product providers, the CSA added, would be likely to increase the competitive pressure to decrease fund management costs even further. Meanwhile, it says actively managed funds that are higher-cost and underperforming would be at risk of redemption pressures.
The paper estimated that banning embedded commissions could bring about declines in management-expense ratios of 25 to 50 basis points for actively managed equity funds and 10 to 25 basis points for actively managed fixed-income funds.
