Personal Finance

Will 2017 mark the beginning of the end for trailer fees?
By Rudy Luukko | 30/12/16

It won't take long in 2017 for the most controversial issue affecting financial advice -- the future of embedded compensation -- to be brought to a head.

About the Author
Rudy Luukko is a freelance writer who contributes to on topics involving fund industry trends and regulatory issues. He retired in May 2018 from his position as editor, investment and personal finance, at Morningstar Canada, where he had worked since 2004. He has also worked as an editor and writer for various general, specialty and institutional media, and he has co-authored courses for the Canadian Securities Institute. Follow Rudy on Twitter: @RudyLuukko.

On Jan. 10, the Canadian Securities Administrators will publish its long-awaited consultation paper on trailer fees and other compensation paid to advice-givers by fund companies. As the CSA put it in a Dec. 15 release, the paper will "explore the option of discontinuing embedded commissions and the potential impacts of such a change on Canadian investors and market participants."

The release of the paper will renew the debate over whether fund investors need to be protected from the inherent conflicts of interest in having mutual-fund companies making payments to brokers and dealers in return for selling their funds.

The prevailing opinion among securities regulators, led by Ontario Securities Commission staff, is that these compensation-related conflicts of interest must be curtailed. Demands to ban advisor payments that are baked into fund-management fees are strongly supported by consumer advocates such as FAIR Canada, the Small Investor Protection Association and the OSC's investor advisory panel.

Equally opposed are most fund-management companies and advice-giving firms and their respective trade groups such as the Investment Funds Institute of Canada and Advocis, The Financial Advisors Association of Canada. They argue that investors should continue to have the freedom to choose how they pay for advice, citing opinion surveys showing that there's widespread support in favour of existing compensation models.

They also contend that, notwithstanding the emergence of low-fee robo-advice firms with very affordable minimum investments, the elimination of trailer fees and other forms of embedded compensation would result in a large portion of the less affluent investing public being deprived of access to advice. That's because traditional fee-based advisory accounts typically require much larger minimum account sizes than most people can afford.

Once released, there will be a 150-day comment period set aside for the CSA consultation paper, much longer than the more typical 90 days. This is yet another indication that what the regulators have in mind is a major departure from the status quo, which would bring Canada in line with the United Kingdom and Australia, both of which have eliminated embedded fund compensation.

Along with what promises to be an intense debate over the future of trailer fees, various other advice-related regulatory developments will unfold in 2017. Among the most significant are greater transparency on the costs of advice and investors' personalized returns, and a proposed best-interest standard.

CRM2 will be an eye-opener on fees and returns

Starting early in the new year, regulatory requirements to specify in dollar amounts the costs of advice and service will kick into high gear. That's because the required annual fee summaries are based on 12-month reporting periods, and most of these reports coincide with the calendar year.

Falling under the umbrella of the client relationship model, phase 2 -- better known as CRM2 -- the annual reports on charges and compensation began to be phased in effective July 15. They'll be an eye-opener on what have been some of the less transparent costs to investors, most notably trailer fees and other embedded compensation.

Assuming that investors read the new reports, there's bound to be sticker shock among those who weren't aware of the extent of advisor compensation they were paying. That will be especially so for investors who assumed wrongly that they weren't paying anything at all.

However, thanks to mostly robust equity markets in 2016, advisors will have avoided the worst-case scenario of being compelled to disclose how much they made during a year in which their clients lost money.

At the same time as fee disclosure continues to be phased in, so too will be the CRM2 requirement to report money-weighted performance to investors. Time-weighted returns, which aren't customized to the individual investor's experience, can still be reported but won't be mandatory.

A best-interest standard? Not even the regulators agree

Potentially the most sweeping changes affecting the future of financial advice would be the adoption of a regulatory best-interest standard. As noted in a CSA consultation paper released on April 6, this would be a higher standard of conduct than the current requirement for advisors to deal "fairly, honestly and in good faith" with their clients.

Ursula Menke, chair of the OSC's investor advisory panel, told a Dec. 6 roundtable discussion convened by the OSC that most registrants are not subject to a "professional standard of care" and that they are in conflicts of interest because they're being paid by the providers of the investment products that they sell. "The imposition of a best-interest standard would go a long way to realigning the interests of investors and registrants," she said.

However, the proposed best-interest standard would not prevent advisors from selling only their firms' proprietary products. Nor would it require them to offer the lowest-cost products. It would also be a weaker standard than the "fiduciary duty" that applies to registered portfolio managers, which is why the Portfolio Management Association of Canada is seeking an exemption for money managers who are fiduciaries.

There's widespread opposition within the retail investment industry to the best-interest proposals. But fund companies and dealers aren't alone in objecting. The securities regulators themselves don't agree either.

Currently, only two regulators -- the Ontario Securities Commission and its New Brunswick counterpart – have come out in favour of implementing a best-interest standard. Most other jurisdictions are holding consultations and reserving judgment, except for the B.C. Securities Commission (BCSC) which is opposed.

Echoing industry criticisms, such as those voiced at the OSC's roundtable by Ian Russell, the Investment Industry Association of Canada 's president and CEO, the BCSC objects to the lack of clarity on just what a best-interest standard would mean. "The adoption of a broad, sweeping and vague best-interest standard will create uncertainty for registrants," the BCSC said, "and may be unworkable in the current regulatory and business environment."

At the heart of the debate over best interest is what more needs to be done to address conflicts of interest concerning compensation arrangements and sales incentives. To that end, as announced on Dec. 15, the CSA has conducted research into industry practices, as have the Investment Industry Regulatory Organization of Canada and the Mutual Fund Dealers Association.

The OSC investor panel's Menke is convinced that advisor conflicts need to be addressed to improve investor outcomes, and that improved disclosure is insufficient. "A key cause of lower returns for investors is the prevalence of conflicted compensation that increases the cost of investing to the investor," she told the roundtable. "Investors need the protection that a well enforced best-interest standard can give them."

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