Get ready for a commissions ban

While CSA hasn’t yet decided to ban embedded commissions, it has mapped out how it’d do so in great detail.

The focus of CSA’s long-anticipated consultation paper is not surprising: it says embedded commissions create inefficient markets and “give rise to conflicts of interest that misalign the interests of investment fund managers, dealers and representatives with those of the investors they serve.”

The paper released Tuesday also says that such commissions “generally do not align with the services provided to investors,” and that DIY and underserved investors “indirectly subsidize certain dealer compensation costs that are not attributable to their investment in the fund, which means they indirectly pay excess fees.”

While it had considered capping embedded compensation, enhancing disclosure and using fund manager-focused initiatives, CSA ultimately offers three regulatory options to address its concerns about commissions:

• using existing tools, namely enhanced transparency of fund fees under POS and CRM2, and review of sales incentives under NI 81-105 Mutual Fund Sales Practices (NI 81-105);
• exploring the CSA 33-404 proposals to strengthen the obligations of dealers and reps toward clients; and
• discontinuing embedded commissions and transitioning to direct pay arrangements.

Direct pay arrangements could include “upfront commissions, flat fees, hourly fees, fees based on a percentage of assets under administration or other arrangements.”

Trailing commissions are the most popular form of compensation for mutual funds. CSA finds that at the end of 2015, back-end, low load, front end, and retail no load funds made up 67% of assets and increased by 58% over the five years ending 2015.

On the other hand, fee-based options were only 6% of industry assets at the end of 2015, but “fee-based assets had the highest rate of increase over the five years ending 2015, increasing by 248%.”

6 benefits of axing commissions

CSA outlines six benefits to eliminating embedded commissions.

• Reducing the number of fund series and simplifying fees.

Citing Morningstar, CSA says eliminating commissions would cause the number of fund series to fall from 13,899 to 4,901 – a 65% decline. At the same time, average assets per fund series would rise from $86.6 million to $245.5 million, creating potential economies of scale.

• New lower-cost product providers may enter the market

Eliminating commissions would reduce barriers to entry, says CSA. The paper estimates MERs for index funds offered by new entrants could be up to 40 bps lower than average index fund costs today. It also suggests MERs for active funds offered by new entrants could be up to 75 bps lower than average actively managed fund costs today.

• Increased price competition

CSA says that more competition could cause MERs to drop 25 bps to 50 bps for actively managed equity funds and 10 bps to 25 bps for actively managed fixed income funds shortly after the discontinuation of embedded commissions. “This estimate is based on incumbent investment fund managers reducing their existing fees by one third to two thirds of the difference between their fees and those charged by new low-cost market entrants,” says CSA.

• Advisors would start recommending lower-cost and passive products

Based on what happened after the commissions ban in the U.K., CSA expects index fund market share to increase from 1.5% of the market to between 5% and 10% five years after the transition away from embedded commissions.

• Shift in assets across existing investment fund managers

CSA points out that funds with negative alpha and poor performance records would be under further risk if commissions are banned. In fact, the paper says, “87% of investment fund managers offering actively managed funds today have some funds with negative alphas, which could be at risk of redemption if embedded commissions were discontinued and these managers were not able to adjust their fees or improve performance.”

• Product distribution and advice would improve

Specifically, CSA posits that more advisors would become discretionary managers, and more clients would demand such services. To show their value, advisors will need to “show the client that the use of discretionary advice creates a savings discipline, simplifies their life and frees up their time,” suggests the paper.

Addressing concerns

The comment paper recognizes several issues that would arise with a commission ban. Among them:

Regulatory arbitrage: CSA recognizes that advisors who sell non-securities products, like segregated funds, could potentially put clients in funds that are still allowed to pay commissions. As such, CSA says it “will accordingly continue to liaise with insurance regulators to address the potential risk of regulatory arbitrage between investment funds and individual segregated funds.”

Advice gap: CSA acknowledges that lower-asset investors could be discouraged “from seeking financial advice, particularly where they are indirectly paying for, but are not receiving, [quality] advice […] as they may be unwilling to pay a fee for such advice.” But, it suggests that robo advisors could fill the gap.

Pressures on independent firms: A ban on embedded commission would create expenses, new processes and revenue loss. This will particularly affect independent firms, CSA says. But it points out this is already an issue. “This may already become a trend to a certain degree with the introduction of the annual report on charges and other compensation (CRM2), whether or not embedded commissions are discontinued.”

What could happen

CSA offers two options for implementing a commission ban.

Option 1: Discontinue all embedded commission payments within a 36-month transition period after the ban takes effect. Advisors could no longer sell DSC funds after the transition period is over.

Option 2: An alternate option could be to transition to direct pay arrangements in phases, by phasing in a dealers’ account base over multiple periods, CSA says. This approach would require dealers to transition a certain percentage of accounts by a certain date, a further percentage by a later date, and so on until all accounts have fully transitioned. It also suggests a 36-month transition period.

CSA is open to hearing about longer or shorter transition periods.

Want to comment?

Submit your comments in writing on or before June 9, 2017 to:

The Secretary Ontario Securities Commission 20 Queen Street West 19th Floor, Box 55 Toronto, Ontario M5H 3S8 Fax: 416-593-2318 comments@osc.gov.on.ca

Me Anne-Marie Beaudoin Corporate Secretary Autorité des marchés financiers 800, square Victoria, 22e étage C.P. 246, tour de la Bourse Montréal (Québec) H4Z 1G3 Fax : 514-864-6381 Consultation-en-cours@lautorite.qc.ca