imgbd Advisor Speak

Time for commissions to be regulated

S K Bagaria, Mentor - ASK Circle, Kolkata

3rd October 2016

In a nutshell

Bagariaji identifies two core issues that are causing repeated regulatory upheavals for distributors and suggests what some may see as radical measures to effectively address these core issues as well as preserve business viability of distribution models. We need to effectively address conflict of interest and we need to ensure provision of good quality advice with accountability. Read on to understand Bagariaji's out-of-the-box ideas on how to effectively address these core regulatory issues. As he says: "The choice is ours to make - take a sensible step forward to protect long term viability of our business and serve our investors better, or resist out-the-box ideas and have a bitter pill put down our throats 3 years from now, which very few will be able to swallow."

There continues to be a negative perception of distributors in the regulator's mind, which is why we are seeing a continuous stream of new rules and regulations. For distributors, it is demoralizing and unsettling - which does not help. We need to work towards changing the regulator's perception about distributors. A lot of effort is being made at various fronts towards this cause, for which we are all grateful.

My belief is that unless we get to the core of the concerns and find out-of-box ideas to effectively address these core concerns, not much progress is likely to be made in regulatory engagement. There are two primary issues that are at the heart of all regulatory intervention in recent years:

  1. Conflict of interest arising out of commission based models, in a competitive market where commission structures from fund houses are a key factor that influence sales of their products

  2. Ensuring good quality advice to investors, with due accountability for advice and guidance given by the intermediary

As long as the regulator believes these issues are not satisfactorily addressed, there will be more and more regulations coming our way. The latest examples are commission disclosures and the proposed thinking to push distributors to become registered investment advisors. Its time to think out-of-the-box on both these issues, to find solutions that address regulatory concerns while ensuring business viability for distributors.

Commission structures

Upfront commissions have historically been the biggest inducements to churn and mis-selling. This has now been capped to 1% - I believe the time has come to eliminate upfronts altogether. The regulator has repeatedly said that there should be no room for upfront commissions in the TER.

On the other hand, trail commission is the sustenance of IFAs and must be protected. It has to be understood that while in all other financial products, the job of the distributor stops at the time of concluding the sale, in mutual funds his job actually starts the moment the investor buys a fund. The outcome is unknown, the holding period is undefined and the value of investment fluctuates daily in tune with markets. In this context, it is the ongoing guidance of the IFA that keeps investors on track. Service delivery is a continuous process in mutual funds, which again involves time and effort on an ongoing basis. The trail commission is what enables IFAs to deliver this service. Any move from distribution to RIA over a 3 year period which may imply gradual reduction in trail and eventually moving to a fee based model, is going to damage business viability completely.

Rather than moving towards a zero commission environment as a response to conflict of interest concerns, I think it is prudent for us to think about a regulated commission environment. TERs of fund houses are regulated. No reason why commissions should not also be regulated. Instead of the present practice of fund houses paying different commissions to different distributors at different points of time on different products, why not standardize commissions across the industry, based on transaction size?

I have the following indicative regulated commission sharing arrangement in mind:

Transaction Size                                        Sharing to TER (after deducting R&T and custodial costs)

Upto Rs. 100,000                                      65% to distributor, 35% to AMC

Between 100,000 to 10,00,000              50% to distributor, 50% to AMC

Above Rs.10 lakhs                                     35% to distributor, 65% to AMC

This structure recognizes the additional effort in sourcing business from retail investors. Also, since this is a TER sharing model, it can be applied to all categories of products. So for example, in debt funds with a TER of 1.25%, the same percentage can be applied as in equity funds with a TER of 2.00% - the commissions will naturally be lower in debt funds, but the sharing percentage can be the same.

When I say regulated, it means it will be applicable across all fund houses and all distributors - just like TER is uniformly applied to all fund houses - big and small.

When TER is regulated and commission sharing formula is regulated across all AMCs, and when there are no upfront commissions at all, I think we would have addressed the core issue of conflict of interest, while retaining the model of commission driven revenues for distributors rather than moving to a fee based model that our investors are clearly not ready for.

The urge to pay more commissions to larger distributors will not be catered to in this model. But then, when TERs are regulated, larger fund houses don't get the liberty of charging more TER because of their size. Rather, as fund sizes grow, effective TER actually reduces. The same principle should apply in the distribution business too.

On the issue of commissions, there are two other issues which we still need to address:

  1. Commission disclosure: The idea of absolute value of commission disclosure in account statements is an extremely negative one from a customer engagement point of view. We must continue to oppose it in every way we can. But even as we do this, if we are able to work towards a regulated commission environment, the need for such disclosures can go away automatically. In the interim, I believe it is high time that AMFI permits commission passback, which is going to be an inevitable consequence of the new disclosure requirements.

  2. Service tax: There continues to be an open issue on service tax on distribution commission which needs to be addressed. All services rendered by different service providers - fund houses, distributors, R&T agents, custodians etc - are now subject to service tax and going forward will be subject to GST. TERs are now fungible, with no caps on different expense heads. And, service tax is a Central levy that has to be borne by the investor - who is the final recipient of all our services. Taking all these 3 positions into account, there can be only one conclusion - that service tax on total TER be charged to the schemes, and thus to investors. It is high time that we end this discrimination of one set of service providers being allowed to pass on the incidence of service tax to the consumer while the other is denied this facility.

Delivery of good advice

A number of steps have been taken by the regulator to ensure that distributors sell correctly and responsibly, keeping the investors' interests first. There is now a grey area between what is regulated advice and what is unregulated advice, which is prompting the regulator to consider asking all distributors to move over a 3 year period towards the RIA model.

There are two broad aspects that define RIA:

  1. documented processes to ensure delivery of impartial advice, and

  2. revenue model that depends entirely on fees from investors.

We must embrace the first and resist the second.

I believe all serious distributors must become RIAs and ensure that we upskill ourselves to meet the requirements of providing good advice to our investors. But at the same time, we must ask SEBI to modify its regulation to allow RIAs to be distributors - ie to sell regular plans and earn regulated commissions.

If the delivery of advice to investors is regulated, and commissions are regulated, then we are taking care of the core issues that the regulator is concerned about. This will also mean that we are not moving into a fee based model, which all of us know, this country is simply not ready for now, and may not be for many more years to come.

To conclude

These suggestions might seem radical to some, and therefore may seem impractical. The reality is however that an environment that addresses both the issues of conflict of interest and delivery of good advice, is what will spur sustainable growth.

Closer we get to the ideal situation faster is our growth

Further we remain from the ideal situation slower is our growth

The choice is ours to make - take a sensible step forward to protect long term viability of our business and serve our investors better, or resist out-the-box ideas and have a bitter pill put down our throats 3 years from now, which very few will be able to swallow.

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