Regulators move closer to ban on mutual fund fees

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Securities regulators are proposing a sweeping change in the way mutual funds are sold in Canada, saying they will launch a public consultation on a proposal to ban trailer fees and other embedded commissions in mutual fund sales.

The Canadian Securities Administrators, an umbrella group for all provincial securities commissions, issued a statement Wednesday announcing an intention to launch a focused consultation this fall to consider moving Canada toward a model that would ban embedded fees in favour of requiring investors to pay fees directly for advice.

Britain and Australia have already banned the use of trailer fees, which are fees paid to advisers annually as long as their clients hold a mutual fund. Many customers do not know their advisers receive the fees from some mutual fund companies, which can serve as an inducement to recommend certain funds over others.

Ontario Securities Commission vice-chair Grant Vingoe said regulators are not announcing they have made a final decision to ban trailer fees, but are signalling their focus is now on that option. He added the OSC does not anticipate backing a different decision.

"Since it's such a powerful antidote to the harms involved, in Ontario we would need very persuasive evidence to move away from it," he said in an interview. "But we're very open to commentary that addresses how we should do it and how industry would transition from the present situation to these direct pay arrangements."

The CSA said it will publish a consultation paper in the fall, which will be open for public comment for 120 days, that will seek advice on how to adopt a new fee regime, including how to transition to a new system.

The Investment Funds Institute of Canada, an industry association for mutual funds, urged regulators Wednesday to delay issuing the consultation paper until they can see the impact of other reforms that are under way, including new disclosure rules that are being phased in to make sure investors see the costs they are paying for advice.

IFIC chief executive officer Joanne De Laurentiis said regulators are also consulting on a new standard to require financial advisers to work in the best interests of clients. She said it is troubling that regulators don't appear to have a plan to show how all the proposed new reforms will fit together.

"The regulators are taking the industry and investors on a bumpy ride without any kind of road map or even a clear or agreed upon destination," she said.

Regulators have been consulting on changing mutual fund fees for the past four years and have already sought comment on the merits of banning trailer fees.

John De Goey, portfolio manager at Industrial Alliance Securities Inc., said it is disappointing the CSA is announcing more consultation rather than taking action. He said regulators have talked about banning trailer fees for over two decades, and the evidence is "overwhelming" that they impact investors.

"The CSA should be ashamed of its collective slothfulness," he said. "[Former OSC commissioner] Glorianne Stromberg recommended an outright ban in 1995. Let that sink in. It's been 21 years and the CSA is still studying instead of acting."

A key concern about direct fee arrangements is that the upfront cost of paying a financial adviser can be expensive for investors with small portfolios, leading some people to lose access to professional investment advice.

British regulators said the sale of high-cost mutual funds fell dramatically after they banned embedded commissions in 2013, but the change also meant many large banks moved away from providing investment advice to retail clients because they could not do the work at the level of cost investors were willing to pay.

Mr. Vingoe said research suggests Canada has a relatively expensive market for advice and it has been hard for new entrants to emerge and compete with advisers who are paid trailer fees from mutual funds. A change in fees could encourage new companies to emerge, he said, noting the "advice gap" is closing in Britain as new companies are coming forward to serve retail clients.

Greg Pollock, CEO of Advocis, a membership association for 12,000 financial advisers across Canada, said he would like to see clear evidence that things are improving in the U.K. for people who could not afford to pay flat fees for advice.

He said regulators have to be aware of the "unintended harm" that could occur if financial advice becomes more expensive for retail clients, and said investors should be able to choose whether they want fee-based accounts or accounts with embedded fees.

Mr. Pollock added it is more important to raise professional credential standards for advisers "than tinkering around the edges with compensation models." Mr. Pollock said his association surveyed member firms' clients and they were overwhelmingly supportive of the current fee model.

"Sometimes I feel like regulators are looking for solutions to problems that don't exist," he said.

However, independent investment counsellor Dan Hallett, who is vice-president of HighView Financial Group, said the mutual fund industry should blame itself for the move because it has not done enough over many years to encourage full disclosure of the fees investors are paying when they buy mutual funds. The lack of transparency has pushed regulators toward a total ban to protect consumers.

"It didn't have to come to this and the industry wanted to avoid this, but they didn't do what had to happen," he said.

He said customers may find flat-fee advice expensive at first, but they are often surprised to find out how much they've paid in embedded fees without knowing it. He likened the transition to the introduction of the GST in 1991, which replaced an embedded manufacturer's sales tax with a sales tax.

"When the GST came out it caused a bit of an uproar at first, but then people got used to it. I suspect the same thing would happen here."

As part of the current review, launched in 2012, regulators commissioned independent research about the impact of trailer fees.

One study, led by York University researcher Douglas Cumming, suggested advisers selling mutual funds are clearly motivated by the presence of trailer fees, finding mutual funds that pay trailer fees tend to perform worse over time than all other funds, and attract more inflows of cash even when they perform badly.

Mr. Vingoe said the reasonable conclusion from the research is that "economic incentives" have pushed mutual fund companies to create more expensive funds and have encouraged advisers to sell them.

"Across many different areas, compensation arrangements influence behaviour, and often produce conflicts of interest," he said. "What we've tried to find is the approach which is most finely tuned to addressing that problem.... Everything else at the moment, in our minds, comes up short of this proposal."

Regulators said all of the research they reviewed showed "sufficient evidence to consider regulatory action on embedded commissions" but said they need to consider the impact of banning trailer fees on product providers and investors.