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Why should TER cut lead to reduced commissions?

Dhruv Mehta

Chairman

Foundation of Independent Financial Advisors of India (FIFA)

The new/reduced TERs are now a reality effective 1st April 2019. One of the biggest concerns for IFAs is the impact of lower TERs on their commissions and the prospect of a further margin squeeze. Memories of how the last round of TER cuts were handled at some fund houses are still fresh in IFA minds – which is why I think we IFAs must place our perspective on TER reductions in front of the industry and work together to achieve just and equitable conclusions.

Benefits of scale need to be passed on to investors

SEBI’s decision to reduce TERs was premised entirely on the fact that the MF industry’s scale has grown considerably, fund houses’ profitability has also grown handsomely over the years, but TERs had remained unchanged – which meant that scale benefits were not passed on to the investor. The move to cut TER was with a view to remedy this situation.

While moving these proposals SEBI observed that the benefits of such economies in debt funds have largely been implemented due to the fact that the predominant subscription of debt schemes are by corporates and institutional investors, who due to their sheer size, are in a better bargaining position. However, as far as equity schemes are concerned, where the predominant investor base is retail, such benefits of economies of scale have not been passed on to the investor.

At no point was the decision to cut TER driven by the regulator’s desire to cut distributor commissions. It was simply a recognition that scale benefits have accrued to fund houses, as evidenced by their growing profitability and that some part of this scale benefit ought to belong to the investor.

In our discussions with the Government on this subject, we were given to understand that the cut in TER was not a step to cut distributor commissions.

And yet we note with dismay that conversations in the industry are focused primarily on how distributor commissions are going to come down due to TER reductions.

Who really got these benefits of scale?

I think all of us need to understand the term “scale benefits” a little more to appreciate what should be a fair and equitable solution. Scale benefits accrue most for businesses that have higher fixed costs and lower variable costs. Such businesses tend to lose money on low scale and make a lot of money when volumes pick up.

In our industry, there are three main players who collaborate to serve the investor: fund houses, R&T agents and distributors. Fund houses have the largest proportion of fixed costs and the lowest proportion of variable costs compared to the other two. From the same office and with the same fund management team, you can manage either Rs.10,000 crores of AuM or Rs.50,000 crores of AuM. Your sales team may grow with volumes if you wish to expand your presence – but the fund management team and the top management team – which are the high cost aspects – do not increase in proportion.

An R&T agent has to add more staff to cater to a growing customer and transaction base, though continuous investment in technology can to some extent limit this linear relationship.

The case of a distributor is however very different. A single sales person can serve only a limited number of customers. That number goes up only marginally with help from technology, because an IFA’s job remains a high touch one – where personalised attention is his key differentiator. Distributors can grow only by adding staff, opening more branches etc. The proportion of fixed costs to variable costs in a typical distribution business is the opposite of what you see in a fund house. Scale benefits therefore accrue least to distributors.

Small IFAs are yet to see any scale benefit whatsoever

I am not suggesting that no scale benefits have accrued to distributors – but what we do need to keep in mind is this:

  • Scale benefits for larger distributors (banks, NDs and large IFAs) have been significantly lower than the benefits that have accrued to fund houses, and
  • A vast majority of IFAs have yet to experience what the term “scale benefit” is, since they are still not making enough money from MF distribution to make a meaningful and satisfying living from this business. They are still trying to reach a scale where they can make a reasonable income – only much after that can they think of “scale benefits”.

If the benefits of scale are to be passed on to investors, it must be passed on by those who enjoyed it most. This would be – in this order – fund houses, then R&T agents and then large distributors. Small IFAs need to necessarily be left out of this equation, if we are to think of what is just and equitable.

Imperative to find a just and equitable solution

One of our prominent FIFA members, Ashish Goel, had put forth a suggestion on Wealth Forum when the last round of 15 bps cut in TER was implemented (Click Here), which I think captures the spirit of what I am suggesting. His proposal at that time was:

  • Trail commission below 1% to no change, no cut
  • Trail between 1.00% – 1.25% to reduce trail by 5 bps
  • Trail between 1.25% - 1.50% to reduce trail by 10 bps
  • Trail above 1.50% to reduce trail by 15 bps

Essentially he was seeking to distinguish at two levels: larger distributors get higher commissions than smaller counterparts and second, newer transactions got higher trail than older ones. His proposal sought an equitable solution at both levels.

There can be many ideas that can and should be discussed, when arriving at the best way forward in the new world of lower TERs. All ideas should however recognize these basic principles:

  • Reduction in margins should occur most where scale benefits have accrued most and should occur least where scale benefits have accrued least.
  • A basic understanding of business models across all stakeholders who collectively serve a mutual fund investor will suggest that fund houses should bear the lion’s share of the TER cut as they have enjoyed scale benefits maximum, followed by R&T agents and then by large distributors.
  • No cuts of whatever nature should be passed on to small distributors, as it would go against the principles of natural justice if they are to be asked to give up what they never got.

The distribution community looks forward to working closely with all stakeholders to arrive at a fair and equitable solution to the TER cut issue and to achieve the goals of financial inclusion and financial independence of the citizens of our country.

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