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Insurance regulators are reviewing the industry’s practice of paying upfront commissions to advisers who sell segregated funds, as investor advocates argue the payments should be banned outright due to a conflict of interest that can harm financial outcomes of clients.

The Canadian Council of Insurance Regulators (CCIR) and the Canadian Insurance Services Regulatory Organization (CISRO) are conducting a joint consultation on the use of upfront commissions – also known as chargebacks – in the sale of segregated funds. The review is looking at the impact of banning upfront commissions or whether other measures can be taken to improve investor outcomes.

A chargeback is an upfront commission a life insurer or other fund provider pays directly to a financial adviser on the sale of a segregated fund, which locks the client’s money into a contract for an allotted period of time, typically for longer than 4 years.

The upfront commission can range from 3 to 7 per cent of a client’s total deposit. If a client decides to take their money out of the fund before the allotted time expires, the adviser agrees to pay back all or a portion of their commission to the fund provider, depending how long is left in the contract. (Advisers usually have to pay 100 per cent of their commission if a client cashes out within the first year.)

“An [adviser] may benefit financially if the customer stays invested to the end of the chargeback period, even if staying invested is not aligned with the customer’s interest,” the CCIR and CISRO said in a joint discussion paper published in September.

The joint paper also says while chargebacks may provide a way for clients to pay indirectly for “affordable” advice and services, the commissions could also increase the incentive for advisers to missell segregated funds, such as relying on upfront compensation rather than considering fund performance or other features of the fund for a client.

Regulators asked for input from industry stakeholders and received a number of comment letters earlier this month. But CCIR spokesperson Tony Toy said the letters would not be publicly available until 2023.

Several of Canada’s largest life insurers that offer segregated funds with chargeback commissions declined to comment – including Manulife Financial Corp., Sun Life Financial Inc. and Canada Life.

But investor advocates – many of whom publicly posted their own letters online – are asking regulators to no longer allow these commissions, stating the conflicts that arise for advisers largely outweigh any benefits offered to clients.

“No compensation structure should exist that incentivizes the sale of one investment product over another due to the conflicts of interest it creates,” said Jason Pereira, president of the Financial Planning Association of Canada.

“Advisers should be incentivized to provide service to clients not only at the time of sale, but over the life of the relationship with the client.”

Mr. Pereira, who is also a partner of Woodgate Financial Inc., expressed concerns that the cost of upfront commissions could be passed onto investors in the form of higher investment fees.

“There is a cost of capital to the issuer that comes from financing commissions up front that will take years to recuperate from management fees,” he added. “The net cost of this financing is, in turn, passed on to investors through higher management expense ratios.”

The use of chargebacks in segregated funds has been on the rise as the industry prepares for a ban on deferred sales charge (DSC) segregated funds. DSC funds also pay upfront compensation to advisers that – similar to the chargeback option – lock in a client’s money for a certain period of time. But unlike chargebacks, DSCs force the client to pay an early withdrawal fee to access their own money.

As of June 1, 2022, the Canadian Securities Administrators, an umbrella group for all provincial and territorial securities regulators, banned the sale of all DSC mutual funds. Insurance regulators are now taking steps to similarly prohibit the sale of DSC segregated funds by June 1, 2023.

Segregated funds are similar to mutual funds but have a built-in insurance contract. Policyholders are given a guarantee on a portion of their principal investment, typically 75 per cent, and their money is put into a portfolio of underlying mutual funds.

But FAIR Canada, an investor advocacy group, is asking regulators to ban chargeback commissions, similar to the ban on DSC segregated fund sales.

“Except for the fact the adviser pays the penalty, chargebacks are essentially DSCs masquerading under a different name,” FAIR Canada said in a comment letter to the CCIR and CISRO. “Both involve payment of sizable upfront commission to the adviser. Like DSC, chargebacks create conflicts of interest that risk distorting the advice process.”

Chargebacks are not entirely new to the industry: Insurer IA Financial Corp. Inc. has offered chargebacks for about 20 years. But the DSC ban, which was announced earlier this year, has left life insurers scrambling to launch new products to help maintain relationships with advisers who rely on upfront payments.

Earlier this year – after the DSC ban was announced – Equitable Life Insurance Co. of Canada added the chargeback option to its series of segregated funds. Last month, Canada’s third-largest insurer, Canada Life, launched a chargeback commission flash sale, offering advisers a 4-per-cent upfront commission – up from its usual 3 per cent – for sales made over the next six months.

The Canadian Life and Health Insurance Association, an industry group that represents majority of Canada’s life insurers, said in an e-mail to The Globe and Mail that its members “strongly support” the continued use of adviser chargebacks.

“Access to advice will be lost for the majority,” CLHIA chief executive Stephen Frank said in an e-mail.

Mr. Frank estimates that segregated fund accounts worth $50,000 and below – which is about half of all segregated funds investors – are at “serious risk of being uneconomic for advisers to serve” in other commission options such as trailer fees, which pay out annually for every year an investment is held by a client.

“There are approaches that could manage risks effectively while also allowing chargebacks to be maintained, such as establishing a standardized length of chargeback schedules,” he added.

But while some insurance companies market upfront commissions as an opportunity to “protect” clients from withdrawal fees, investor advocates say the commissions prevent advisers from giving unbiased advice.

“Insurers are keenly aware that the amount of the upfront commission influences sales,” says FAIR Canada. “By incentivizing the sale of certain products over others, they further demonstrate the risks upfront commissions pose to a fair and efficient marketplace when compensation, rather than advice, drives the business.”

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