Banning embedded commissions A series of three articles by Susan Yellin

par Susan Yellin | January 20 2014 10:00AM

What Canada can learn from the Australian and U.K. experience

Australia - UK - Canada

There are, of course, different sides to this question as witnessed in June when investor advocates, the investment funds industry and Canadian advisors lined up as the Ontario Securities Commission, taking the lead for the Canadian Securities Administrators, held a roundtable into Canada’s mutual fund fee structure.

In Australia, where banning commissions took effect July 1, the belief is that it’s only a matter of time for Canada.

“It’s interesting to think how far in front Australia is internationally in terms of already having banned commissions,” said Dante De Gori, general manager, policy and conduct with the Financial Planning Association of Australia Ltd. “For Canada, it’s not a matter of if, but when [it will follow suit].”

However, Jon Cockerline, director, policy and research with The Investment Funds Institute of Canada disagreed, saying the differences between Canadian investors and regulators and those in the UK and Australia vary so much that a direct comparison cannot be made.

“It’s so simplistic to look at another country and say we should do the same thing here unless you know the context for the imposition of the regulatory policy there.”

The Insurance and Investment Journal contacted some key players in the U.K. and Australian markets to look at why the UK and Australia moved to a (mainly) fee-only commission system.

The United Kingdom

The UK’s Retail Distribution Review (RDR) went into effect Jan. 1 2013, following highly publicized cases of advisors mis-selling products to investors, said Mike Gould, senior advisor, retail distribution with the Investment Management Association, the group representing UK investment management industry members.

In particular, said Gould, were instances where gadvisors sold endowment policies to pay for mortgages, reaping a “fairly generous commission” but which might not necessarily have been the best option for the investor.

The regulator concluded that investors were not clear on how they were paying their advisors for financial advice and the different kinds of advice available.

The result was RDR, with its three-pronged goal: ending commissions, embedded or otherwise, with charges paid by consumers up-front to ensure they were aware of what they were paying; establishing “independent” and “restricted” advisors – those who can advise on any product or service and those that have a limited list of products and providers they can advise on and raising the minimum level of qualification for advisors.

For advisors, the change has meant moving from a top-down, big picture approach to a bottom-up, fee-for-service method where investors are more in control of how much they pay and who they pay it to, said Phil Billingham, CFP and a member of the board of directors of the Institute of Financial Planning in London.

But he said it’s not quite accurate to say that the industry has moved totally to a fee-only model.

“An advisor can tell a client how much the fee is and it is up the client to determine if that is fair. Let’s say the cost is $5,000,” Billingham said in an interview. “The advisor can say: instead of you writing me a cheque for that $5,000 you authorize the provider – the fund manager for instance – to deduct that $5,000 from your investment and that pays me.”

As well, a financial advisor can continue to receive trailers for advice on investments that were purchased before Dec. 31, 2012. And commissions continue on insurance and mortgage products, among a few others.

Last year, the UK also began an automatic pension enrolment program that includes contributions from employees and employers with the government providing tax relief.

The project is being rolled out over six years and has seen many UK advisors moving into retirement planning, with others specializing in high net-worth clients, said Billingham.


While there are between 16,000 and 17,000 financial planners in Australia, their role as chief providers of advice and products is somewhat overtaken by the government’s Superannuation Guarantee, the official term for compulsory retirement contributions made by employers on behalf of their employees.

Superannuation, which began in 1992 with most employers contributing the equivalent of three per cent of all employees’ salaries, is now up to 9.25 per cent and is scheduled to rise to 12 per cent by July 2019. (The contribution is deducted from employees’ salaries and in certain cases, employees can add more.)

Under this scenario, businesses contribute the superannuation contribution into a “super fund” of their choosing, which is used as the default if an employee has no other preference. Advisors may recommend which fund employees go in, but on the whole, most Australians do not make an active choice and end up in the default fund, said Martin Codina, director of policy and international markets with the Financial Services Council, the organization that represents investment fund managers and users of financial advice in Australia. Putting money into a super fund comes with tax incentives for employees.

The advisor’s role is more prevalent with high net-worth clients or as clients age and get closer to retirement, but they do provide holistic advice on everything from setting goals to debt management for those who want it, Codina said in an interview.

The global crisis of 2006 saw the collapse of a number of investment firms and when the government called an inquiry, there was consensus that a number of Australians had lost major chunks of their life savings.

Even though that may have heightened the debate over banning advisor commissions, Codina said discussions on the subject had been going on for some time, especially in light of superannuation.

“The view was held that in a compulsory system it was inappropriate for advisors to be earning a commission. It wasn’t justified that an advisor would earn a commission simply because 10 years ago they recommended you go into a specific fund,” said Codina.

“[But] in the absence of superannuation being compulsory, I’m not sure we would have banned commissions or as early as we did.”

As of July 1, Australian advisors no longer receive embedded commissions for investment financial products. However, an advisor selling a product like a pure life insurance policy with no investment component can still receive a commission, Codina said.

Unless employed by a firm and getting a salary, the only way most advisors now get paid is through the client, on a fee-for-service basis, not the product provider, said De Gori. Fees to clients must be disclosed individually, can be negotiated and are agreed to individually – and can be “turned off” at any time by the client if they find a better deal elsewhere, he said in an interview.

IFIC’s Cockerline said Canada paints a different picture than either the UK or Australia. Canada has not had the kinds or scope of mis-sellings as in those other countries, and there is a greater reliance on individuals to save for themselves with the result that there is a greater depth and diversity of advice in Canada. There are also more layers of regulatory oversight in Canada.

And while clients with fee-for-service advisors do get disclosure, said Cockerline, it’s not necessarily superior disclosure to the current MER model and advisors’ trailers, which are already outlined in the prospectus.

“In a fee-for-service model, you know what you’re paying but you don’t know what the rest of the market is paying. You don’t know if you’re making a deal or not. Compare that to a world where it’s public information as to what the market value is.”


The UK sees uptick in number of advisors

Mark Twain’s tongue-in-cheek remark about the 1897 newspaper article mourning his demise may well be equated to what has come about for financial advisors in the United Kingdom after regulators there banned most advisor commissions, including trailers.

On Jan. 1, 2013, the UK regulator brought in Retail Distribution Review (RDR), aimed at ending commissions and replacing them with an up-front, fee-for-service model. At the same time, it raised the bar on minimum qualifications for advisors and set up “independent” and “restricted” advisors, outlining the kinds of products and services these advisors can or cannot sell.

There had been great fear that RDR would push away a good chunk of the robust advisory network in the UK. But in July, the Financial Conduct Authority released a report stating there was actually a six per cent rise in the number of advisors, a result, it believes, of advisors re-entering the market.

“There are a lot of scare stories coming from across the pond,” said Phil Billingham, CFP and a member of the board of directors of the Institute of Financial Planning in London. “The vast majority of advisors left not because of the fee problem but because of the qualification problem. The ones who left are older and didn’t want to write more exams at this stage of their lives.”

The FCA said six months after introducing RDR, 97 per cent of advisers had attained the appropriate level of qualification, with the final three per cent being recent entrants who are still studying within the timelines allowed by the rules.

But whether investors like the idea of paying by fee only is still not clear, said Mike Gould, senior advisor, retail distribution with the Investment Management Association, which represents UK investment management industry members.

In an interview, Gould said the average charge for advice hovers around £160 pounds (C$260) an hour. “There is a lot of concern that some people who had received advice in the past will be reluctant to pay [now]. So there are certainly concerns that some people may be excluded from advisor advice and concerns about what they will do instead.”

It was this anxiety, especially over smaller investors, that was voiced at the June roundtable held by the Ontario Securities Commission into Canada’s mutual fund fee structure.

“The vast majority of advisors left not because of the fee problem but because of the qualification problem. The ones who left are older and didn’t want to write more exams at this stage of their lives.”

– Phil Billingham

One of those was Greg Pollock, president and CEO of Advocis, the Financial Advisors Association of Canada, who said that doing away with the current embedded fee model would most affect those with only modest amounts to invest and the least ability to pay.

“The average Canadian invests $2,500 to $2,800 a year into all investments, including mutual funds. For advisors who will start charging separately for the services they already provide in exchange for trailer fees…financial advice would become unaffordable, and therefore inaccessible, to the average Canadian.”

He supported giving consumers a choice of how to pay to ensure a competitive marketplace, rather than following other jurisdictions that have banned third-party commissions.

However, Marian Passmore, associate director of The Canadian Foundation for Advancement of Investor Rights, said it only makes sense to ban a business model that benefits the fund manufacturer over the investor.

“Only banning conflicted remuneration, including trailer commissions, will reduce the bias and misalignment incentives currently affecting the client-advisor relationship and this will lead to better outcomes for consumers,” Passmore said. “That is the choice that should be made.“

As of July 1, Australia joined banning commissions and actually went further, said Martin Codina, director of policy and international markets with the Financial Services Council, the organization that represents investment fund managers and users of financial advice in Australia.

The legislation that brought in the ban also did away with “conflicted remuneration,” a broadly defined term that includes monetary or non-monetary payment, Codina said in an interview.

Industry transformed

“The industry, in terms of payment, has been transformed,” he said. “There are now very few payments permissible between a product provider and a distributor and an advisor.”

There has been some grandfathering of commissions for business conducted prior to July 1. But even then, there is nothing stopping the client from saying he wants to renegotiate the agreement or take his business to a new advisor.

Only one in five Australians receives financial advice, probably stemming from the country’s Superannuation Guarantee, a compulsory retirement contribution made by employers and which is now up to 9.25 per cent of employee salaries. There are exceptions, but generally, employees end up in the super fund of the company where they work.

Super funds can offer low-cost advice to clients – but the advice must be generic, such as what the fund invests in, said Dante De Gori, general manager policy and conduct with the Financial Planning Association of Australia (FPAA) Ltd., the main financial planners’ organization in Australia.

While financial planning is a holistic profession, interested investors can receive single pieces of advice and this is generally seen as the more efficient and cost-effective approach, De Gori said in an interview.

The problem is that many clients erroneously believe they didn’t pay anything before the ban went into effect and are willing to pay only in the neighbourhood of $300 for advice, with the result that middle- and low-income employees may find paying an advisor a struggle, he said. High net-worth investors have always been willing to pay for good advice and some advisors are now targeting only that market, he said. Many investors wait until they are well into their 50s before talking to an advisor.

An inquiry was held on the issue of advisor compensation in 2009 and it was at that time that the FPAA decided that irrespective of what the inquiry came out with it, it would ban its members from commissions.

“At that time, it was not welcomed [by advisors]. It was a tough period for them,” De Gori said in an interview. The FPAA took the reins and provided the right tools and support to members, including seminars and ongoing discussions,

FPAA members realized it might take a couple of years from the time they held their first conversation with clients to a full, fee-for-service model – but they could make it work.

Advice-only model

In the end, members transitioned over to an advice-only model a year before others, leaving those who did not scrambling to catch up, said De Gori.

Many advisors who had struggled at first with the fee-for-service, now see the new regulations as a way for them to concentrate more on the client’s best interests, said De Gori. Previously, he said, advisors might not get paid if they told a client to pay down debt instead of buying a product because advisors would only get paid if they sold a product.

Codina said the mutual fund industry’s biggest problem in Australia was that it tried to walk both sides of the issue.

“The industry tried to say: go and see an independent financial advisor, advice is important…and then at the same time, the industry pays those same advisors and the advisors live off the commissions they receive from the product providers. That taints the perception in the community that they are professionals rather than salespeople.

“Eventually they have to make a choice: are they going to be salespeople or are they going to be professionals?”


Fiduciary duty: are the Australian and U.K. experiences instructive for Canada?

Along with the removal of embedded commissions, one of the most talked-about issues in the Canadian investment funds industry these days is the potential of changing the current standard of care financial advisors provide to their clients.

The Canadian Securities Administrators (CSA) sent out a consultation paper on the standard of conduct for advisors and dealers last year exploring the appropriateness of introducing a statutory best interest – or fiduciary – duty when advice is provided to retail clients.

At the end of 2013, the CSA sent out two reports stating it required further consideration of the issues raised during its consultations on both fiduciary responsibility and changes to the mutual fund fee structure “to co-ordinate their policy considerations on these initiatives.”

“We anticipate communicating in the coming months what, if any, regulatory actions and/or research we intend to pursue,” the CSA said.

Duty of care

Right now in Canada, financial advisors have a duty of care to act fairly, honestly and in good faith. This includes knowing the client’s financial circumstances, objectives and risk tolerance. It also requires advisors understand the products they offer so they can recommend suitable products to each client.

But a key point is that currently –  in most cases – the decision on which product to buy is up to the client, said Ralf Hensel, director of policy, fund manager issues at the Investment Funds Institute of Canada (IFIC).

However, there are some investors who want their advisor to make all the investment decisions for them.

“If a client says to you, ‘Here’s my money, invest it for me’ and the advisor says ‘Fine, I’ll do that’, they are putting themselves in a fiduciary relationship,” said Hensel. “But if the investor says, ‘I want you to recommend some products for me but I still reserve the right to make the decisions’, then that’s not a fiduciary duty, that’s the duty of care.”

Currently, there are “managed” accounts in which an advisor, with the client’s consent, makes investment decisions on behalf of the client, but doesn’t need to approve every decision. As well, Quebec has the duty of loyalty and duty of acting in the client’s best interests in some circumstances. But for the most part, the standard in Canada is duty of care via suitability, Jeff Scanlon, senior legal counsel at the Ontario Securities Commission (OSC) told a recent roundtable.

“We anticipate communicating in the coming months what, if any, regulatory actions and/or research we intend to pursue.”

– Canadian Securities Administrators

On July 1, 2013, Australia introduced a statutory best interest standard for its advisors so that advisors must act in their clients’ best interests and place these interests ahead of their own when developing and providing personal advice. The Australian Securities & Investments Commission says this means advisors “must make ‘reasonable inquiries’ to obtain accurate information from the client and conduct a ‘reasonable investigation’ into relevant financial products. This is designed to protect advisors from clients claiming that the advisor should have done something onerous or unreasonable in order to act in their best interests.”

“Best duty is probably the most welcomed part of the entire set of reforms,” said Dante De Gori, general manager policy and conduct with the Financial Planning Association of Australia (FPAA) Ltd., the main financial planners’ organization in Australia.

Tougher standards

However, De Gori said tougher standards mean increased costs of compliance that could get passed on to clients.

He also said advisors are concerned that if they put a client in, say, a growth fund and the markets fall, clients will lay all the blame on the advisor even if the market decline is international or in one particular segment.

The reform on duty to clients in Australia followed surveys that showed evidence of conflicts of interest, sub-par advice and the belief by about two-thirds of retail and institutional investors that advisors were not acting in their best interests.

In the United Kingdom, there has been a qualified best interest standard since 2007. However, as part of a more sweeping set of regulations called the Retail Distribution Review (RDR), regulators also banned commissions as of Jan. 1, 2013, required more robust proficiency requirements and made clearer the kinds of advice investors could receive from independent and restricted advisors –  those who can advise on any product or service and those that have a limited list of products and providers they can advise on.

Fiduciary responsibilities

All three of these regulations help the advisor fulfil their fiduciary responsibilities, said Mike Gould, senior advisor, retail distribution with the Investment Management Association in London.

“With those rules already there what the regulator was trying to do is effectively make the retail financial advice market more professional so that these advisors are better equipped to exercise their fiduciary duty,” Gould said in an interview.

He said there is a definite move on the part of a number of countries in Europe to bring in regulations similar to RDR.

“So the UK may have jumped the gun a bit but that is certainly the direction. If in Canada, some version of RDR is adopted that seems to be in line with what’s happening in most Western economies. The objectives set out in RDR are difficult to argue against.”

IFIC’s Hensel says the term “fiduciary” may not mean exactly the same thing around the world, but has been well-defined by Canadian courts.

It is, in fact, in the advisor’s best interest to serve their clients well because they will keep coming back, he added.

If Canadian regulators decided to implement fiduciary duty for everyone, it will raise a number of questions.

“Does this mean that advisors have to guarantee the client’s results? I think that’s unrealistic to ask of the advisor community because it transfers responsibility for market outcomes to the advisor, but no one can predict the future,” said Hensel.

During a roundtable this past summer hosted by the OSC, Harold Geller, a lawyer with Doucet McBride LLP, said it is now up to regulators to ensure that any description about best interests includes the advisor’s responsibilities.

“Best interest is a …new statement,” said Geller. “And I think that the securities commission and the CSA, in issuing it, should make clear that this is a fundamental principle. It means that the client’s interest always must be put first and the advisor … if they’ve recommended something which arguably is not in the best interest [of the client], they’re going to have to justify it. I think that should be the standard because they’re the ones in the power position.”

And while some at the roundtable voiced the opinion that introducing fiduciary duty will change the entire business models of some companies, Lindsay Speed of FAIR Canada said the industry will adapt.

“It’s our expectation that new models will develop and that the industry, in its ability to innovate, will be able to deliver services, basic services that people need, at a lower cost and therefore have better outcomes for investors,” Speed said.

Other investor advocates raised their concerns that most clients already believe their advisors have a “best interest” standard of care and that regulators should ensure that investors are protected in whatever new proposals they bring forward.

The OSC’s Scanlon said during the roundtable that the rules put forward in Australia and  the UK are “instructive” and “helpful” as the CSA reviews the prospect of introducing fiduciary responsibility into Canada.

“But I don’t think this is a situation where, because we see what’s going on there … that that’s necessarily the only solution for us,” Scanlon said. “I think we just need to ensure that we are doing what’s right for Canadian investors and Canada’s capital markets.”