The DSC sold Mutual Fund under the Microscope

The DSC under the Microscope September,                               September , 2015

Lately, some dinosaurs of the fund industry have been promoting the benefits of the DSC ( deferred sales charge ) sold mutual fund. One benefit they claim is that all your money goes to work for you right away since there is no front end sales charge. In fact , according to independent research the typical FEL today is 0 %. Another “ benefit” claimed is the early redemption penalty keeps people invested during downtimes. First off , there is little robust evidence this claim is accurate. Besides, isn't it claimed that one of the main benefits of a financial “advisor” is to contain investor behaviour -for that service , a never-ending trailer commission is paid - so why is a redemption constraint needed in addition? How much investor punishment is too much?

Could it be that the real reason the DSC is popular with salespersons is commissions? Look to the commissions paid advisors who sell funds to understand why the DSC charge option persists. Fund companies pay dealers/representatives who sell DSC funds a juicy 5-% upfront sales commission .The dealer/salesperson ( aka “advisor “) also receives ongoing yearly compensation -called trailing commissions - of 0.15 to 0.5 % until you redeem the fund.Given their structure, DSCs give the incentive for an advisor to work hard to get their new clients into an investment but leaves little incentive to do any work thereafter. Once you’ve committed to the investment ,the advisor has received the lion’s share of their compensation and arguably has little direct motivation to continue fostering his or her relationship with the client.

Further , with a DSC sale (advisor getting his/her upfront 5% and trailer of 0.5%) they then move 10% each year to FEL to get the higher trailer commission of 1%....it is really quite the racket enabled by the existing compensation structure.


As noted , the prevailing standard investment industry justification for DSC charges is that they provide an incentive for investors to stay in their funds for the long term and not make self-destructive moves in and out of the market. There's some validity to this because retail investors do hurt themselves by jumping in and out of the market too much.The problem is that there is little definitive evidence that the DSC actually accomplishes this behavioural change . Additionally, if you're not getting the level of return you need this just traps you to stay with the same fund company. Investors might be interested in “buying and holding” but with a different fund; the DSC fee effectively prevents this.

In any event, flexibility matters more. Today's market swings are unprecedented and some investors are discovering that they have taken on too much risk. It's unacceptable to have to pay charges of up to 5.5% simply to adjust a portfolio to make it more suitable .And for retirees ,the need for more liquidity as unexpected expenses, particularly health-related and personal service expenses, rise , makes flexibility a key feature of portfolio design.

The real cost of buying DSC funds is often greater than is anticipated at time of purchase. In practice, what frequently happens is that the DSC either gets triggered by an early sale, or an opportunity is lost when the investor hangs on to a expensive/poorly performing  fund in order to avoid triggering the DSC penalty fee.Incredibly , some money market funds are sold on a DSC basis which makes no sense since the purpose of holding a money market fund is liquidity.Such funds do pay trailers which may explain why you are sold them.

When investors are sold deferred sales charge mutual funds, instead of front-end funds, their main motivation is to save on fees. In fact, however, investors who hold these funds pay more, not less, in fees. An investor who buys a mutual fund on the DSC sales charge method pays no transaction fee at time of purchase. And if the fund is held for up to seven years the early redemption fee can be totally avoided. There is a significant cost, however, if the fund is redeemed before the end of the DSC schedule.

At the time of purchase, this waiting period never seems to be a problem. The investor is optimistic about the fund’s potential, or he/she wouldn’t let himself be sold it, and at this point he cannot imagine any reason to sell it before the DSC fee expires. Paying no fee sounds more attractive than paying even a relatively low 1% or 2% up-front fee ( actually 0% is most common today). In this case, the certain cost of 1% or 2% seems greater than the possibility of having to pay 5% or 6% in the unlikely event that the fund is sold before the DSC period expires. The thinking is that the DSC fee doesn’t matter because it will never be applied. Fund salespersons can exploit this thinking to their advantage.

This thinking frequently turns out to be wrong, however, because many investors do sell before the DSC fee schedule expires.The average investor hold period is 6-7 yeas, meaning that about 50% of funds are sold before DSC expiry. Further, very few mutual funds are themselves more than 7 years old ( due to mergers and closings) . The reality is that new and better products are always becoming available, mutual fund managers leave the fund they were managing, fees are increased, fund mandates change, the funds gets merged with another fund and sometimes fund managers go into a deep slump. For these reasons, investors routinely make a decision to sell the fund before the end of the DSC schedule. The fee is usually about 5.5 %, if redeemed in the first year, 5% if redeemed in the second, and so on. The fee for early redemption can be based on the purchase price or the market value at the time the fund is sold. This will be defined in the Prospectus

From the financial advisor’s point of view, selling on a DSC basis is initially more attractive than charging a front-end fee. With a DSC purchase, the dealer/financial advisor makes a commission of about 5%, which obviously is more attractive than the 0%,1% or 2% they would earn on a front-end sale. The bottom-line reason for the DSC fee is that the advisor gets paid by the fund company as soon as you have been sold the fund. If you don’t keep the fund, the mutual fund company needs to get its money back. They do so through the DSC early redemption penalty fee that you pay.The original advisor could be long gone either via retirement ,hopping over to another dealer or selling more lucrative insurance products .

Trailer commission paid to the dealer/ advisor are generally higher on the “front end” version of a mutual fund. Typically, the trailer commission on a front end fund is 1% per annum , while the trailer commission on a DSC fund is 0.5% per annum. Except for a few firms like Fidelity, the management expense ratio (MER) is generally the same for both the front end and DSC versions. Over the long term, therefore, the representative actually earns more by selling front end load funds.That is unless he/she redeems the fund at the end of the redemption period and sells you a new DSC fund, starting the nasty cycle all over again, a process called churning.

In some cases, the mutual fund owner effectively becomes a prisoner to the DSC fee. Often, to avoid triggering the DSC redemption fee, the opportunity to purchase improved or lower cost investments will be lost. Too many people feel they have no choice but to hang in for a few more years until the DSC fee expires – and to keep hoping that the markets would improve.If the investor dies or a major financial emergency occurs, the penalty will still have to be paid . There is definitely a benefit for liquidity.

Bottom line: Each year Canadians incur tens of millions of dollars in early redemption penalties or hold on to losers. We find it hard to see any benefit of allowing yourself to be sold a DSC mutual fund.

For your financial health, Avoid DSC mutual funds

One of our major concerns is the impact of the Deferred Sales Charge (DSC) mutual fund on clients, especially vulnerable seniors.

A  Dec. 2015 report from the regulator of mutual fund dealers identified several problematic practices, including: clients over age 70 that were sold DSC funds ( aka back-end load); clients who were sold funds with DSC redemption schedules that were longer than their investment time horizon; and evidence of poor disclosure of the redemption fees at certain firms. The report stated “Overall, there was a lack of consistency across [dealers] on how to supervise transactions involving seniors who purchased DSC funds.”.

A DSC sold fund pays a 5% sales upfront commission to a dealer/advisor when a purchase is made. This structure creates many conflicts-of-interest that can skew the recommendations from advisors to the detriment of elderly clients. DSC sold funds carry significant penalties if they aren’t held for 6 years. Ready access to investments is important for retirees living on fixed income in case of an emergency.The DSC fund also glues clients to their salesperson even if service is mediocre. Mutual fund salespersons are not required to act in the client’s best interests.

We’ve seen cases where seniors are exploited by salespersons that keep them locked into underperforming funds for long periods of time. The underperformance directly reduces their retirement income security and limits their choice of funds.

When a fund company unilaterally decides to shut down a fund, unitholders must either switch to another fund in the same family and possibly incur an up to 2% switch fee or redeem with a penalty and crystallize unplanned capital losses or gains. It’s like being between a rock and a hard place.

We’ve even seen cases where retirees were sold Canadian money market Funds intended for short term parking of cash sold on a DSC basis. That is beyond exploitive.

And then there’s fund churning that causes a lot of early redemption penalty fees to be incurred. In a number of well documented cases , unethical advisors will recommend redeeming a mutual fund as soon as the redemption schedule expires and buy a new fund ,starting the dreaded redemption schedule all over again. A lack of liquidity is exactly the opposite of what retirees need.

The penalties are bad enough but in a RRIF they cannot even be offset against income. Any early redemption penalty fee paid is money lost in the RRIF (or RSP) forever.

Finally, even when an investor passes away, the DSC still applies, leaving beneficiaries a big headache - it is like a cancer that won’t go away.

An attempt by Securities regulators to ban the sale of such toxic funds is being vigorously opposed by some members of the mutual fund industry. Investor advocates want to protect investors by limiting access to the DSC option because it pays an outsized upfront commission to the dealer/ salesperson than other sales options, and a lower continuing commission for service to the client. Paying for advice well in advance of the provision of services is not smart especially if the advisor leaves the firm or retires.

Accordingly, there is not one consumer or investor advocacy group in Canada that supports the retention of the DSC sold mutual fund.

Here's what you can do:

      ·         Just don’t let your advisor sell you this toxic product 

·         Ask your advisor about the  Annual 10% DSC Free option if you already own such a fund 

·         Ask your dealer to waive switch fees and early redemption fees and switch  you into a lower cost product  that meets your needs

·         Ask your dealer to stop reinvesting distributions in your existing DSC funds

·         Buy a fund from a reputable fund company that has discontinued selling mutual funds on a DSC basis – these include Investors Group, Dynamic Funds and BMO Investments Inc. among several others

·         Shun fund firms and salespersons that promote the sale of DSC mutual funds

·         Tell all your friends , colleagues  and family to avoid being sold a DSC fund

For more information visit http://www.canadianfundwatch.com/search?q=dsc+  

The DSC Sold Fund Under the Microscope

If you want a real world education on advisor exploitation of seniors, read this
Classic Case of elder abuse and DSC sold Funds .It’s a MUST READ for every senior and retiree http://www.iiroc.ca/Documents/2012/3cb46f19-f9fc-4fbe-8e88-584c5337f054_en.pdf

One way to avoid all this complexity and expense is to consider using a robo-advisor.

DSC sold fund doomed in IIROC channel - if IIROC rules followed and enforced

Information asymmetries and investors’ assumption that those providing them personalized advice must act in their best interest means unsophisticated investors too often rely heavily on their Reps, which leaves retail investors vulnerable to exploitation. Numerous surveys confirm this unchallenged reliance on Rep recommendations. But rules and regulations exist to prevent mis-selling. As long as they are enforced by IIROC dealers, most retail investors should be safe.

DSC funds pay 5% upfront commission to the dealer .Five per cent is a big chunk of change for a fund company to pay up front. In order to make the money back, the fund company needs clients in the fund for 6-7 years. It is difficult to see how responsible IIROC dealer supervisors or compliance staff would ever consider this bondage to be in the best interests of the client. Reps should not recommend DSC funds if clients plan to invest for only a short time, if they have little money and can't afford to lose any of it, or if they have a low tolerance for market/price volatility. A well-documented compliant KYC process should help keep such clients away from DSC sold mutual funds.

Existing IIROC rules require a Dealing representative to resolve conflicts -of -interest in the best interests of clients ( Rule 42). Other rules require Reps to only make recommendations which are suitable for clients based on KYC. Mutual funds with embedded commissions create a conflict-of-interests with DSC sold funds dramatically amplifying that conflict with the outsized 5% upfront payment. So a Rep faced with deciding to sell a DSC vs. FEL (0%*) fund would have to recommend FEL to address the conflicts between compensation schemes. In addition, it can be argued that the liquidity of the FEL series vs. the locked in nature of DSC funds is itself a conflict-of- interest since decreased liquidity is not in the best interests of clients.
* an IIROC dealer could subvert this by not offering 0% front load funds

Also, even under a lowly suitability regime product cost enters into the picture. In the case of say, Fidelity funds, the MER of the FEL series of funds is less than the identical DSC series so the FEL should win again IF Reps are truly resolving conflicts in the best interests of clients. While clients can switch into money market funds at no cost (except for 0-2% switch fees), because DSC funds allow switches within the same family without triggering redemption fees, the DSC redemption schedule still remains. Any attempt to redeem for cash will result in a penalty. Directly recommending a DSC money market fund would have to be considered abusive selling as a m/m fund is intended to act as a temporary parking spot for cash and should not therefore be bound with illiquidity chains.

Furthermore, it is imprudent for Reps acting in a client’s best interests to recommend actively-managed mutual fund unless the reasonably expected return from such fund will cover the extra costs and risks typically associated with such funds. This is key, as most actively-managed funds simply are not cost-efficient if analyzed properly. If the potential closet indexing factor is considered by analyzing a fund's incremental costs in terms of Ross Miller's Active Expense Metric (see Reference), the number of cost-efficient actively-managed mutual funds is very low.

Before processing any order, Reps. must disclose the charges the client will incur for the purchase, sell, switch or transfer, or a reasonable estimate if the actual amount is not known at the time of the disclosure. We expect that such disclosure may be inadequate unless the Rep. informs the client of the FEL series or other alternatives. If the disclosure is balanced and fair, we would however expect a rational investor to reject the DSC series.

The accurate collection of the client’s time horizon is an essential component of the KYC process and it is imperative that Reps/supervisors consider this information when assessing suitability .If time horizon is less than 7 years or client is older than say 65 then it may not be suitable to lock a client into a fund for up to 7 years. Regardless of age, there is no logical justification for exposing a client to early redemption penalties when equal or better alternatives are readily available.


Additionally, Reps should consider the suitability of DSC purchases for accounts in a de-accumulation stage e.g. the suitability of DSC purchases in RRIF accounts. In most cases, suitability will be almost impossible to justify when FEL is an available alternative.

Further ,when product and account cost becomes a formal suitability factor when/if proposed client-focussed reforms see the light of day, the Rep would have to look at a spectrum of products that are suitable including index funds , ETF’s and actively- managed ETF’s. Given empirical research on actively - managed funds that shows chronic underperformance vs. Benchmarks, indexing would most likely be the optimum solution, especially for investors with modest account sizes. Any other Rep recommendation would be subject to scrutiny from compliance and likely eligible for a client complaint.

Of course, if the Rep has not met disclosure obligations, that too would be a basis for a complaint. It is inconceivable that any informed investor faced between being locked in and not, would ever choose to be locked in. An informed investor would likely also object to the 5% advance payment for advice if the alternative was pay as you go. Rep recommendations should not be limited as to whether the redemption schedule was disclosed to the client but rather a consideration as to the suitability of the recommendation to purchase the DSC fund. For example, investors who do not have an adequate emergency fund should not be sold a DSC fund.

So there you have it, with so many hurdles, there is no future for the DSC actively-managed mutual fund in the IIROC distribution channel. One BIG assumption –IIROC Dealer Reps care about their clients financial wellbeing AND supervision and compliance interpret and enforce the rules as intended.

Some argue that it is impossible for an SRO (junior regulator) to say that DSC is wholly unsuitable for everyone when it is allowed by the CSA. IIROC can (and does) certainly say that DSC is not suitable for certain clients by interpreting their suitability rules but they are not able to ban it entirely (as it is allowed by the CSA). According to one source ,just over 30% of DSC sold fund assets are with IIROC dealers. There is no doubt, an outright ban on this toxic product is in the Public interest. Caveat Emptor.

Kenmar Associates 

References:

Ross Miller's Active Expense Metric and its implications

If the Fund fails the metric test, passive would have to be considered. The DSC issue would automatically be resolved since low cost Index Mutual funds could not pay the 5% upfront commission. If index fund MER’s were increased, then ETF’s would have a field day.
http://landryinvest.ca/documents/articles/measuring_true_cost.pdf  

Vanguard CEO: High-Cost Active Management is Dead - Video | Investopedia

https://www.investopedia.com/video/play/vanguard-ceo-highcost-active-management-dead /

Ellis, Charles D., “The End of Active Investing,” Financial Times, Jan. 20, 2017

https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e

Ontario right to oppose mutual-fund trailer bans, says Primerica Canada CEO:WP

"...Calling the proposed ban “draconian,” he warned that its approval would leave many investors of modest means — “those without a large amount to invest who rely on commissioned advice without an upfront fee” — unable to receive advice from an advisor. “When this sort of drastic market intervention is proposed, it is appropriate for the minister of finance to step in, to look at the concerns and weigh the policy options to ensure a balanced policy outcome.”.."
https://m.wealthprofessional.ca/news/mutual-funds/ontario-right-to-oppose-mutualfund-trailer-bans-says-primerica-canada-ceo-249396.aspx?utm_source=GA&utm_medium=20181017&utm_campaign=WPCW-Newsletter-Opener&utm_content=&tu=. Investor advocates argue that clients without a large amount to invest can readily access robos , credit unions and banks without pre- paying for conflicted advice and without being locked in for 7 years in an actively -managed mutual fund. Such clients would also avoid all the dirty tricks that can ( and have been) be played with DSC sold funds. Such a product is clearly not in the best interests of families struggling to save for retirement. Professional advisors are unlikely to recommend DSC sold funds but fund salespersons might. The biggest beneficiary of DSC funds is the salesperson. Caveat Emptor . NOTE: If for some reason you change firms, you will have pre-paid the lion's share of the advice fee ,so your new Rep may want to alter your holdings so that he / she receives compensation related to his / her efforts. That portfolio adjustment can be expensive.

MFDA sweep re DSC sold Mutual Funds
http://mfda.ca/wp-content/legacy/bulletins/pdf/Bulletin0670-C.pdf

Deferred sales charges: Stealth wealth killers - The Globe and Mail

https://www.theglobeandmail.com/globe-investor/investment-ideas/deferred-sales-charges-stealth-wealth-killers/article1375562/

Investor Protection Takes A Step Backward - High Rock Capital Management

Article shows how the DSC Mutual fund abuses Canadian families saving for retirement.
http://highrockcapital.ca/scotts-blog/investor-protection-takes-a-step-backward

IIROC fines Branch Manager for deficient supervision of DSC funds

In this case, the Rep often sold mutual funds with deferred sales charges (DSC) and then repurchased similar funds, requiring clients to pay redemption fees and it reset the early redemption schedule on the newly purchased mutual funds. ($125,402 in redemption fees ere triggered)  The Rep also unnecessarily charged switch fees for the trades, which some clients said they weren’t told about. Clients were charged $367,459 in switch fees. 

http://www.iiroc.ca/Documents/2018/3b2c182a-4e81-49c1-b900-3d9672f9565d_en.pdf#search=george%20mitchell

Toothless investor Protection

https://boomerandecho.com/weekend-reading-toothless-investor-protection-edition/

Checklist for the DSC mutual fund investor

Thanks to D. McFadden 

For mutual fund investors, deferred sales charges (also known as “back-end fees”) can cause a lot of headaches when investors come to realize that their investments are essentially locked-in by deferred sales charge (DSC). The DSC is a fee that gets charged to a client (5-6% in year 1, declining to 0% in years 6-7) if they sell a mutual fund without transferring it to another mutual fund from the same company. There is no penalty fee if you switch funds within the same fund family but the dealer may charge a switch fee varying between 0-2%.

Investor advocates have warned investors for years about the DSC sold mutual fund. Securities regulators are proposing to ban them outright. If your fund salesperson attempts to sell you a DSC fund we suggest you ask Questions like:

1. Why are the MER’s of DSC funds identical to front load funds? Answer should be: The MER’s are identical because the fund companies have decided not to create a separate DSC series; this means that other fund investors are unknowingly subsidizing DSC unitholders.
2. What happens if I need access to cash during the redemption period due to a family or other emergency? Answer should be: A penalty must be paid per redemption schedule. No exceptions. 
3. Does the redemption penalty apply to original cost or current price of fund units? Answer should be: It varies by firm. Best to check with the firm. 

4. What happens if I take distributions in cash? Answer should be: If distributions are paid in cash they go toward the 10% of units that can be redeemed each year without attracting a redemption charge. 
5. Does the penalty still apply if I die? Answer should be: The penalty must be paid by the estate if the fund is redeemed. 
6. Can I redeem some units for free? Answer should be: Yes, 10% are free redemption units each year but privilege is not cumulative. Use it or lose it. 

7. Do I have to reinvest distributions? Answer should be: No, reinvestment is at option of unitholder.
8. What happens to my DSC units after the redemption period has expired? Answer should be: They remain as DSC units but with no redemption schedule ( at least one firm auto converts to Front load with lower MER). 
9. What commissions do you receive on this sale? Answer should be: The dealer and salesperson share a 5% upfront payment+ trailer commissions (typically 0.50% p.a.) for as long as you own the fund. 

10. Is there a cost to switch funds? How much? Answer should be: Yes. Cost can be up to 2%. Switch fees can be negotiated.
11. Is the redemption penalty tax deductible? Answer should be: Yes, in open account as it reduces returns; No in registered accounts where capital losses cannot offset gains.
12. Does it make sense to buy a money market fund on a DSC basis? Answer should be : No, since a money market fund is a temporary parking spot for cash, liquidity is key. 

13. What if the fund is merged with another fund I don’t like? Answer should be: A redemption from the merged fund will still involve an early redemption penalty fee. 
14. Can the MER be increased during the hold period? Answer should be: Yes, it could happen .
15. Why are regulators proposing to ban the DSC? Answer should be: There is a massive mis-alignment of investor-representative interests. 

16. Are reinvested distributions subject to a new redemption schedule? Answer should be: No . 
17. Do you sell other lower cost products? Answer should be: YES – Index funds, ETF’s among others. 
18. Are there other versions of the fund with shorter hold periods? Answer should be: Yes, no- load, front load (typically 0%) with no constraint on holding period and low-load funds are available with shorter redemption periods. Check with your fund salesperson. 

NOTE: In a number of well documented cases , unethical advisors will recommend redeeming a mutual fund as soon as the redemption schedule expires and buy a new fund, starting the dreaded redemption schedule all over again. A lack of liquidity is exactly the opposite of what investors need.

If after you receive honest answers, and you still want to buy a DSC fund, we wish you the very best of luck. DSC sold funds have been abused by salespersons. For example, when the redemption period expires, the salesperson will recommend selling the DSC fund and purchasing a new fund, thereby starting the redemption schedule all over again. In some cases, DSC funds have also been sold to clients with time horizons less than the redemption schedule. DSC investors, especially seniors, need to be wary of numerous shenanigans. Professional advisors do not recommend DSC series funds as they are not in your best interests. Be ALERT.

Open Letter to the CSA on embedded commissions and DSC

“There is nothing so useless as doing efficiently that which should not be done at all." - Peter Drucker

As we have publicly disclosed, Kenmar Associates will no longer respond to any CSA consultation regarding, Best interests, DSC or embedded commissions. Our team has spent hundreds of person-hours dedicated to regulatory reform with no positive result over the last decade. The CSA has announced that it will conduct another consultation on embedded commissions in September.This Open letter therefore should be viewed as a reaction rather than a response.

In the planned consultation the CSA will be proposing to prohibit the payment of trailing commissions to dealers, such as discount brokers, who do not make a suitability determination (presumably, this is equivalent to banning the offering of products such as mutual funds with embedded commissions being paid to dealers, including discount brokers, for services they cannot and knowingly will not provide). This can be likened to Health safety regulators consulting on whether poison should be prohibited from retail grocery shelves. Consulting on such an obvious case of financial assault on investors is disrespectful of retail investors. The CSA should be ashamed to admit that for well over a decade hundreds of millions of dollars have needlessly been diverted from the retirement savings of Canadians despite numerous pleas from consumer groups.

The basic securities law of dealing honestly, fairly and in good faith with clients has been brazenly breached with not a whimper of regulatory enforcement or concern for retail investor protection. Further, the CSA has not warned investors via Alerts and education that it is permitting this broad daylight robbing of their hard earned money.

The CSA is in effect going to be asking for comments on an issue that is clearly unlawful and harmful to investors. It is treating common sense and basic morality as sidebars to the discussion. It is well aware that Fund Facts which states that trailers are for the provision of services (albeit unspecified) and personalized investment advice. The CSA therefore knows there are elements of misrepresentation involved when discount brokers offer A series of mutual funds with embedded trailer commissions.

The CSA is also aware that even the trade Association for the investment funds industry has called on them to establish rules to ensure that mutual funds carrying an embedded advisor fee are sold only in channels where advice is permitted.

“Investors who buy funds directly, for example through a discount broker, should be confident that they are not inadvertently overpaying by selecting a series that includes fees for services that are not available through that platform,” - Paul C. Bourque, Q.C., IFIC’s president and CEO.  Source: https://www.ific.ca/en/news/limit-series-a-sales-to-channels-that-permit-advice-ific/

The CSA has not yet addressed the enabler of these abusive trailer payments, the mutual funds. The mutual funds are knowingly reducing fund assets by paying discount brokers (sometimes even related parties) for nothing. These assets aren’t some intangible collection of cash. They are the retirement savings of millions of Canadians. Are there provisions in NI1-107 that exempt funds from protecting unitholder assets?  If not, why isn’t the CSA prosecuting those entities for a breach of fiduciary duty? Why must investors have to resort to Class Actions for such an in-your-face attack on their life savings?

Earlier this month IIROC abruptly suspended Section 2 from its notice that accompanies guidance for order-execution-only (OEO) services and activities, published in April this year. The section says IIROC expects OEO firms to make available, whenever possible, series of funds that don’t pay trailing commissions for ongoing advice. When no such series is available and an OEO firm offers a series with a trailing commission, IIROC says in the section that it expects the firm to address the conflict—by rebating to the client the portion of the trailing commission or by “taking other similar steps.”  So for now, those expectations are on hold and investors will continue to be exploited. In the meantime, OEO firms remain subject to IIROC’s rules concerning conflicts-of-interest, including the requirement to address conflicts considering the best interest of the client, says the IIROC Notice. That may be, but will IIROC protect investors by enforcing its rules with its Member discount brokers? Will the practice of unduly collecting trailers cease? Will there be rebates?

The Canadian Foundation for Advancement of Investor Rights (FAIR) has criticized IIROC’s decision.  Frank Allen, Executive  Director  of FAIR was “ dismayed that IIROC cites the upcoming CSA rule proposal prohibiting the payment of trailing commissions to online brokerage firms (discount brokerages) as the reason for the suspension.”  SIPA, individual investors and ourselves support FAIR in being critical of the IIROC action. The suspension leaves affected Retail investors subject to mitigation risk and one can reasonably argue that the statute of limitations time clock is already ticking.

Even if the CSA were to ban discount brokers from offering products with embedded service commitments we are concerned that such a ban might include exceptions or be open to future regulatory exemptions. There is even the possibility a cost-benefit analysis will be required, again delaying affirmative action. Kenmar are therefore calling for a cancellation of the consultation and an immediate banning of any dealer from offering a product or security that contains an obligation to provide a service or function that it cannot and/or will not provide. That would be common sense- it is the right thing to do and it will save people hundreds of person- hours of wasteful activity.

As to the planned consultation re a proposed ban on the DSC-sold fund, there is the same question. Why? Does the CSA not have enough data to make a decision? Has it not heard the voice of consumers pleading for a prohibition? Were Roundtable conclusions unclear? Is the client complaint data ambiguous? Is there any research that supports not banning DSC-sold funds? Is there any identifiable benefit to clients of a DSC-sold fund? Does the CSA buy the feeble arguments from a small minority of industry participants on the benefits of DSC? The CSA knows the answers and yet it continue to consult , dragging out the agony for investors for another year or two and more if there is a extended transition period.

Several responsible firms and Dealing Reps have stopped selling DSC Funds even as the CSA waffles on making a definitive decision. As with many CSA regulations we fear there will be carve outs or exemptions so that even a ban is nothing more than an illusion. Accordingly, Kenmar respectfully request that the CSA cancel this planned consultation since it clearly knows the answer. The CSA should make a decision- ban the sale of DSC-sold funds while defining the rules regarding unitholders currently holding such toxic funds. Such a positive action would help restore confidence in the CSA and definitely would be in the Public interest.

If despite all logic and fairness, the planned consultation proceeds, we draw the CSA’s attention to a public statement from the Ontario Securities Commission’s Investor Advisory Panel (IAP). The IAP is calling on the CSA to prevent possible further investor abuse by making their proposed bans on deferred sales charge (DSC) mutual funds and the payment of trailer fees to discount brokers retroactive to the launch of a consultation slated for September. The IAP says that it’s concerned about the possible risk to investors while the consultation plays out. It says that “In proposing the elimination of DSCs and the discontinuance of trailing commission payments to discount brokers, the CSA has noted that these fee practices are problematic, inappropriate and harmful.”

Kenmar fully support this backup choice approach and respectfully again request that the CSA immediately issue an educational pamphlet and Investor ALERT on the harmful effects of DSC-sold Funds and products with embedded trailing commissions offered by IIROC regulated discount brokers.

The CSA website states: The CSA protects Canadian investors from unfair, improper, or fraudulent practices and fosters fair and efficient capital markets. By cancelling the upcoming consultation and making the necessary decisions, the CSA can demonstrate that it is serious about protecting investors. This is an incredible opportunity that should not be missed.

Sincerely,

Kenmar Associates

The real impact of retaining the DSC sold mutual fund

 

When the Ford government failed to go along with other provinces in banning the toxic DSC fund, it had a profound impact on confidence in financial markets and their regulation. Some of the unintended consequences include:

·         It showed how special interests can be brought to bear on the Government to the detriment of ordinary citizens

·         It alienated other provincial jurisdictions that had thought the OSC was on board with a ban

·         The intervention was the likely cause of Maureen Jensen’s early departure as OSC Chair. Ms. Jensen was regarded as   an outstanding thought leader in modern securities regulation 

·         It showed how government can ignore empirical evidence and research in making policy decisions

·         It showed how the government can blatantly ignore the voices of financial consumers in reaching decisions.

·         It placed an emotional strain on OSC staff who had worked for years on reaching a conclusion to ban the DSC

·         It placed the OSC in the uncomfortable position of having to develop restrictions on DSC to limit the damage of the government’s policy decision

·         It ignored a 2019, OSC Investor Advisory Panel (IAP) report that found evidence of potential  shortfalls  in the financial advice Canadians get,  particularly those with smaller accounts

·         It restrained fair comparisons of lower cost, high quality investment products and services, and discouraged  competition and innovation in the Canadian asset-management space 

·        Some of the proposed restrictions can only work to further marginalize small investors, especially minority investors and seniors. Investors with the least money and/or shorter time horizons have the most to lose

 

·         It exposes Ontarians of modest means to a very bad product that will impair their retirement income security

·         The value of academic research and researchers declined

·         Independent researchers were intimidated and bullied for supporting a ban  

·         The professionalism of advice suffered a setback

·         It caused the CSA to provide an exemption  for DSC on the implementation of  CFR conflict of interest rules that will come into effect at the end of June

 

·         It will have a chilling effect on OSC staff contemplating investor protection reforms

·         Funding and support for investor advocacy groups declined

·         Despite the Ontario government's mandate to reduce bureaucracy and red tape, this does the exact opposite. It creates an elaborate checklist that must be enforced when people purchase DSC mutual funds and one that must be applied by national firms on only a subset of a subset of a subset of Canadians

·         It harms the reputation of the entire Canadian mutual fund industry

·         Canada’s already low international investor protection stature took a hit.

 

The decision will also complicate fund disclosure and add to investor confusion. There will now need to be a Fund Facts for Ontario investors and a separate one for the rest of Canada that excludes the DSC material.

It must be very stressful for OSC staff  wrestling with the best way to satisfy their government overlord and still look like a normal regulator. 

Our message to the Government of Ontario  - reverse position and do the right thing for the people, instead of the financial services industry. This would stop wasting precious OSC staff resources on retention of a harmful product and let them focus on their prime objective - investor protection. That would be in the Public interest.

 

 

Simple Do’s and Don’ts for Investors by advisor Bruce Loeppky

I am in contact with some investor advocates and am shocked that things are still happening that I hoped would disappear or at the very least be very infrequent events by this point in time. Investors are still being ripped off by rogue financial advisors; clients are still buying DSC mutual funds and still borrowing to invest when they shouldn’t. These are three of the most common problems plaguing the financial services sector.

1. Rogue ‘Financial Advisors’

There are a number of things you can do (or look for) to ensure that you never get put in the position of losing your nest egg to an unscrupulous ‘financial advisor’;

Don’t EVER sign a cheque to your ‘financial advisor’. Always to the firm or fund company. That way you will have the company’s protection if things go sideways. If you sign a cheque to your ‘financial advisor ‘he will deposit it into his own bank and it won’t go through the companies normal processing so they will be unaware of its existence. If it goes through their system they have a record of it and can probably rectify the situation. Is he living an extravagant lifestyle? That can be a sign. Sometimes where people get too successful. they feel they are untouchable.

2. To DSC or NOT DSC?

Why are people still buying DSC mutual funds when they essentially lock you into a fund company for 6-7 years, unless you pay the penalties for early redemption? Don’t invest with a Front End (FE/or ISC) Option that takes away 1-5% of your investment before the starting line either. ONLY invest FE 0% to give you full flexibility.

There is NO advantage to purchasing mutual fund with the DSC option. It limits your flexibility and costs you money if you redeem early or move to another fund company.

If your Financial Advisor forces you to decide between DSC and FE 3-5% for example, look for somebody else or go to the bank until you find somebody that offers that option. Banks and credit unions always offer FE 0%.

The DSC option should go the way of the dinosaurs in my opinion. The ONLY time I would OK its use is if you are working with a newly licenced advisor and he needs to use it to stay in business while he build his practice. The option does provide more immediate income to the financial advisor.

3. Borrowing to Invest (Leveraging)

This is the most over used strategy in the industry and I saw it abused many times while at investors Group where the use of it was promoted frequently as a method of earning more money and growing your book of assets faster, but at whose expense?

Only examine this strategy IF; you have a good/steady job, you maximize your RRSP’s every year, your home is paid off or you have a very low small mortgage, high income(s) and you have no debt. I have seen too many people come to me who borrowed $100,000 only to have it sitting at $65000 after a correction and are upset about the method in which the leverage was sold to them.

Most people can deal with a loss IF one of your potential scenarios showed a 30%-40% loss one year. The problem is that most projections show a steady 7% growth rate and the numbers all look very rosy and unrealistic.NO markets or investments rise as a steady 7% year after year. Every 10 years you will see a major correction and illustrations should reflect that reality.

Trust your Gut

If your gut is telling you something, listen to it.If the numbers sound too good to be true they likely are. If you have had investments work well (or not) for many years and somebody (often a new financial advisor but not always) advises a drastic change, check with your accountant or another financial planner/advisor to get a second opinion. Don’t put everything in the same investment. Stay diversified with different bonds, and both Canadian and foreign equities. Don’t rush into anything.

Don’t move forward if you feel pressured or must make a quick decision. I read recently about a gentleman who owned a business and had about 2 million invested and made a change (Exempt Market product I think) and within’ 3 months lost everything and was forced to sell his cottage to stay afloat. He was coasting along wanting for nothing after a successful career and ONE mistake changed his position dramatically and it will never go back to where it was.

All it takes is ONE big error and you’re in trouble. Make sure you (or your parents/grandparents) don’t make it.Nobody needs that stress, especially when you’re retired.

NOTE: The views expressed here represent the views of Mr. Loeppky and do not necessarily coincide with our position. We thought it important to allow advisors to let their voice be heard.

Kenmar review of “A Major Setback for Retirement Savings: Changing how Financial Advisers are Compensated could Hurt Less-Than-Wealthy Investors Most “

                                                                                                           April 12 , 2016

Kenmar review of “A Major Setback for Retirement Savings: Changing how Financial Advisers are Compensated could Hurt Less-Than-Wealthy Investors Most “
http://policyschool.ucalgary.ca/sites/default/files/research/financial-advice-lortie.pdf
Except for the title , a few unsubstantiated assertions and conclusion ,there's a lot to like about this paper. The University of Calgary school of Public Policy must've woken up one day and decided it's time to write about embedded commissions. A report of this depth must have cost it at least $100,000 to produce -the timing couldn't have been better – mostly for industry participants.

On page 1 we are presented with this paragraph “ We find that critics of current embedded compensation practices tend to base their policy prescriptions on a truncated analysis of the likely consequences that would unfold if implemented.3 These consequences are much broader and pervasive than investment outcomes. From a public-policy point of view, the “outcome” that truly matters is the impact of financial advice on households’ accumulation of financial wealth and, therefore, how it is affected under different remuneration models. We make the case that voluntary personal savings are unlikely to deliver adequate retirement income unless individual investors have access to expert advice from competent and well-regulated professional advisers and asset managers on terms that are reasonable and conform to their expressed preferences, regardless of whether advice is delivered using commission- or fee-based advice models.”

This essentially critiques the CSA research for undue emphasis on performance , arguably the main reason for investing in the first place. Even if “ outcomes” were defined as accumulation of financial wealth it's not obvious that advisors impact that much of that wealth accumulation ( eg home ownership ) for small investors. Of course for some , putting a child through university might be the goal rather than wealth accumulation. The other built in assumption is that today's mutual fund salespersons are in fact experts , competent and well regulated is an unsubstantiated assumption . A correspondence course and multiple choice exam is hardly proof of proficiency.In fact, investor advocates would argue that it is nothing more than industry hype , an illusion achieved via sharp marketing programs to mask the true nature of the role of the “advisor” as a saleperson .

The Report does contain some solid facts , statistics and excellent reference research materials in an attempt to support the argument that conflicted advice is better than no advice at all. If we didn't know better we might be swayed.

So where do we take issue with the report? First off , it refers to those providing advice as advisers as opposed to their actual registration as sales persons or dealing representatives. It also assumes that the advice is actually delivered but does admit that it could indeed be conflicted. Given the low qualification requirements for mutual fund “ advisors” even if advice is provided , it isn't based on a high standard of proficiency.

The Report doesn't deal with the issue that larger mutual fund investors are unknowingly, and likely unwillingly, subsidizing smaller investors. It also ignores the fact that funds sold by discount brokers collect embedded trailer commissions but don't provide a dime of advice.

As is well known , different advisors do different things (some more; some less) for their clients. In the real professions (law, accounting, etc.) those who do more charge more - and clients willingly pay it. Under the embedded commission model, there's a 'one compensation model fits all' approach - regardless of how much (or how little) the "advisor" does . This could mean that some investors are being overcharged under the embedded commission model.

The report labels investments in mutual funds as savings when in fact they are investments. They are naturally higher for advised accounts than for non-advised accounts. This is to be expected since the advisor is incentivized to sell more funds even if it may be better for the client to reduce ,say , 18% credit card debt or increase life insurance coverage. Without knowing the debt level it is meaningless to refer to account amounts as “savings “ and an advantage of an advised account. Focus should be on income adequacy in retirement rather than savings.

Too many advisors recommend leverage which in most cases is a wholly unsuitable investment strategy for the small investor. The cost impact of bad advice is not reflected in the report but for those who have ever experienced conflicted advice, it can be life altering.

It's easy to think that value of the service you’re getting is implicit, particularly when various pro-embedder Reports like this one routinely reference a 2012 report by the Centre for Interuniversity Research and Analysis on Organizations (CIRANO) which states that investors who have used a financial advisor for 15 years or longer had 2.73 times the level of assets as investors who don’t use an advisor. Sounds great, right? Well, not quite. If you dive a little deeper into the methodology of CIRANO’s research, you’ll find that someone who has fired their advisor—presumably for poor performance—is counted as a non-advised household (even if they used an advisor for more than 15 years!).

The report provides some rationale that a certain fraction of retail investors will refuse to pay for advice if charged separately. [ A study involving retail investors from eight European countries found that between 26 to 30 per cent of respondents were unwilling to pay upfront for advice.87 ] This means that 70-74 % would be willing to pay . In Canada , investors have been told for so long that advice ( such as it is) is free, that the figures will undoubtedly be higher. If a prohibition is applied, the industry, Regulators and governments will need strategies and programs to demonstrate the cost-effective value of professional advice and help make it affordable via productivity improvements , use of technology and creative tax and other strategies .

If the report had reported on studies about the integrity of advice they want ,they would have found that the overwhelming majority of investors want to be provided advice that is in their best interests. A U.S. Study by Financial Engines https://corp.financialengines.com/docs/Financial-Engines-Best-Interest-Report-040416.pdf found that over nine in ten (93 percent) said it is important that all financial advisors be legally required to put their clients’ best interest first when providing advice on retirement savings. We expect Canadian results would be similar especially since most Canadians assume , incorrectly, that this is the prevailing case.

There is no consideration of the pain and anguish caused each year by hundreds of these "advisors' through unsuitable investments, excessive leveraging, account churning , unduly expensive fund choices , early redemption charges and even fraud. These behaviors can be traced to the lack of a Best interests standard, a standard incompatible with embedded commissions.

The argument goes that if they refuse to pay for advice and go it alone they will suffer much worse than the estimated 2 1/2% annual penalty for investing with conflicted advisors. We don't understand why that would be the case .If a fee-based account was set up ,clients would still pay the 1% charged monthly but then would have a clear idea of cost/ services provided and the advisor would be free to recommend lower cost funds , inexpensive index fund's or tax-efficient ETFs. The net result would be increased retirement savings and improved retirement income security.

The report counters this by pointing to research that fee-based accounts are no panacea either. That is true where regulatory enforcement to counter reverse churning is absent which does appear to be the case in Canada. Regulators need to face up to that challenge.

To say that “ .., although studies that investigate adviser behaviour have found surprisingly little evidence that advisers provide unsuitable advice as a matter of course and that other structures of remuneration lead advisers to adopt practices that are better aligned with their clients’ interests ” is plain wrong .The suitability standard along with conflicted advice has caused harm to Canadian retirement income security. The fiduciary/ Best interests structure has demonstrated far better performance and client satisfaction. As an aside , as this report was issued, the US Dept. of Labour decided to proceed with a Best interests duty for retirement accounts.

The report does not suggest imposing a cap on commissions or doing away with DSC funds ( the word deferred doesn't even appear in the report). In essence, the Report strongly recommends the status quo.

The report states “ The existence of a regulatory body that provides oversight to a profession is a signal to consumers that they need not spend resources on costly monitoring in order to reduce self-serving behaviour by the adviser and that there is a mechanism for redress if that behaviour were to occur. “ We totally disagree that mutual fund salespersons constitute a profession ,that CAVEAT EMPTOR is not required and that redress in Canada is robust. There is not a shred of evidence to support that statement.

We also disagree with “ A compelling body of empirical research demonstrates that regardless of their level of financial education and wealth, left to their own devices, individuals’ investment and savings decisions are, as a rule, sub-optimal compared to the results obtained by “advised” investors. “ In fact there are many studies that show quite the opposite. Given that Canada's fund fees are the highest in the world , it is not obvious that unadvised folks would do worse . In fact if they just bought a low cost balanced fund , a life cycle fund or used a robo advisor they could well be far better off. Since the average hold period for funds is about 5 years , it's not even evident that advisors are able to claim they are able to control investor behavioural biases.

Given the emphasis on the financial illiteracy of Canadians one would have thought the solution would involve a Best interests advice standard as investor protection . Of course that would make it hard to justify an embedded commission  model which is the apparent goal of the paper.

We do agree that trust in the financial advice industry would certainly be enhanced if there were more discipline and standardization on the use of titles, which, in addition, would facilitate compliance with proficiency requirements. Problem is regulators refuse to tackle the issue. In a 2015 OSC mystery shopping experiment ,a total of 48 different titles emerged. The Report does not actually say that it is necessary to support its conclusion.

We also agree that active consideration should also be given to the benefits that would accrue from the establishment of a professional designation for financial advisers, which, as for other professions, would entail formal training with an agreed curriculum and more extensive continuing education requirements than what presently exists. Again , industry lobbyists continue to fight such an initiative. It's not clear whether this is a firm recommendation or merely a nice to have with a conflicted advice regime.

The paper does make a case that the UK RDR initiative led to less Britains receiving conflicted advice or any advice. “ Testifying before the U.K. House of Commons work and pension committee, the chief executive of the FCA admitted that the “advice gap” and the number of people being orphaned by their advisers was a “concern.” Since then a separate report has been issued that provides many examples as to how to close the so-called “ advice gap: https://www.fca.org.uk/static/fca/documents/famr-final-report.pdf . It should be noted that the FCA has not reverted back to a commission oriented advice system or backed off on increased advisor proficiency standards. Conversely, the FCA Consumer Panel which represents the voice of investors says : “We have not seen any evidence to show the existence of a gap in the supply of professional advice, apart from in the provision of compulsory pension advice, e.g. on defined benefit to defined contribution transfers. Consumers do not always seek professional advice, even when they could benefit from it: some are not aware of what is available; they do not want to pay for advice because they do not understand the price or value of it; they cannot afford it; or they prefer to take decisions themselves. .” https://fs-cp.org.uk/sites/default/files/financial_services_consumer_panels_response_to_famr_24122015.pdf

Nevertheless, the potential for a "advice gap"  should be addressed by regulators as part of its implementation strategy and learnings from the UK experience ( which includes anticipating the countermeasures the industry may employ to undermine the initiative) applied to tactics.

We think the paper underestimates the positive impact robo advice will have . [ “Drawing on the experience of the discount brokerage industry, it is unlikely that automated digital wealth-management platforms will close the “advice gap” that would be created by a regulatory regime prohibiting the bundling of advice with financial products.” ] We believe technology- based advice at the competitive pricing levels and payment approaches being offered in Canada will be especially attractive to small investors, younger Canadians and millennial If the US is any guide, many Canadians will sign up thereby closing or greatly narrowing the postulated gap. The advice provided will be more client focused and should easily beat mutual fund based advice returns simply by using cheaper products and charging lower fees. The fees may also be tax deductible adding to their competitive advantage.

We vehemently disagree that “ The evidence presented in this paper suggests that the operation of the Canadian market for financial advice has, heretofore, been successful in producing beneficial outcomes for households that obtain the service, and for society as a whole. “ . If it was so successful there wouldn't be a pension crisis, a record debt to income ratio for Canadians , thousands of investor complaints each year and pleas from investors/investor advocates for the introduction of a Best interests standard.

Furthermore , most investors have no idea how their account has performed. It was only due to the relentless efforts of investor advocates , against fierce industry opposition , that mandatory performance reporting will be required under CRM2. How advice was provided without knowing returns should have alerted the author of the Report that something ain't right.

Recent regulatory sweeps on DSC sold funds raised many issues. A OSC IAP supported research project on risk profiling found just 16.7% of questionnaires reviewed would be considered ‘fit for purpose’. A recent IIROC Bulletin noted that that its recent compliance reviews have found that most of the firms it reviewed "lacked a meaningful process to identify, deal with, monitor and supervise compensation-related conflicts." The 2015 MFDA Enforcement report listed blank unsigned forms as issue #1.This is a snapshot of what passes as advice , the type of advice that Canadians would lose if embedded sales commissions were prohibited .

The report raises a number of valid points while omitting others. Compared to some other reports , this one is more analytical and evidence based.Overall , despite its shortfalls, we believe this Report constructively adds to the debate on the impact of embedded sales commissions on retirement income security. We remain convinced that a Best interests standard is required for all financial advice givers and planners.