There’s no question that the retail investment business is a fiercely competitive one. Unfortunately for consumers, financial advisors don’t necessarily compete on the attribute that should matter most to clients — the cost of investing. Regulators in certain other markets are looking to change that. But will Canada follow suit?

One of the advantages of the retail investment business is that it’s a closed shop — only those licensed to do business in a given jurisdiction can compete for clients. Advisors don’t face cheap competition from China, for example, as other industries must. The flip side is that being insulated from global competition means regulators have more latitude to intervene in the industry without fear of driving business offshore. Regulators aren’t forced to try to harmonize their efforts or risk regulatory arbitrage.

So, it is perhaps just coincidence that three major English-speaking, developed economies — the U.S, Britain and Australia — are all moving down a similar path to curtail the influence of embedded sales commissions in their retail investment businesses.

In late July, the U.S. Securities and Exchange Commission proposed a series of changes to the regulation of mutual fund distribution fees in that country to limit the amount of fees paid and encourage price competition by brokers, among other things. In announcing the proposals, SEC chairwoman Mary Schapiro has indicated that the SEC is proposing these changes because many investors aren’t aware of the embedded sales charges they are paying and don’t understand who’s receiving them.

The SEC is proposing to limit the total that clients pay in so-called “12b-1 fees” (which are similar to trailer commissions). Under the proposal, if one class of a fund charges no trailer fees and has a 5% front-end sales load, then the aggregate trailers paid over time in the various classes of the same fund that do pay trailers cannot exceed 5%. The SEC is also seeking to encourage price competition by allowing broker-dealers to establish their own sales charges, tailor them to different levels of service and charge unitholders directly.

This move by the SEC to try to curb embedded compensation and generate more cost competition follows a similar initiative pioneered by Britain’s Financial Services Authority. By the end of 2012, the FSA (or its successor, to be known as the Consumer Protection and Markets Authority, following regulatory restructuring in Britain) will outlaw embedded commissions in that jurisdiction, too, requiring advisors to negotiate sales charges with clients up front.

Other proposed changes to retail investment regulation in Britain include raising proficiency standards and drawing a bright line between independent firms that offer advice and sales forces that just pitch products or execute trades.

There, too, the goal is to improve transparency, foster competition and minimize the conflicts of interest that are inherent in a relationship that purports to be advisory but is actually paid for with product sales. Ideally, separating the cost of advice from the cost of a product will allow for more flexible, competitive pricing, while, at the same time, putting an explicit value on advice.

Similarly, in Australia, the government has introduced a ban on what it terms “conflicted remuneration structures,” including commissions and any form of volume-based payment. In addition, asset-based fees can only be charged on unleveraged assets. And Australia also is introducing a new plan to have clients pay directly for advice, and a requirement that they annually opt in to continued advisory services. These changes are slated to take effect in July 2012.

Further, Australia is introducing a statutory fiduciary duty for financial advisors, which requires them to act in the best interests of their clients, and to place the interests of their clients ahead of their own when providing advice.

(The SEC is studying whether to extend a fiduciary duty to brokers, as part of its work to implement regulatory reform developed by Congress in response to the recent financial crisis.)

The issues that these regulators are taking on are not particularly new. They have been raised in Canada in the past, too. Glorianne Stromberg, a former commissioner with the Ontario Securities Commission, had identified them in her two influential reports on the Canadian investment industry back in the 1990s. And the OSC broached them again several years later in its fair-dealing model, which identified conflicts inherent in embedded compensation models, initially contemplating outlawing them.

That idea was later dropped by the OSC, but some of the less controversial aspects of the FDM have been adopted as part of the Canadian securities commissions’ registration reform efforts. The self-regulatory organizations are still planning to implement others as part of the so-called “client relationship model.”

But issues concerning retail compensation structures, the incentives they create and the conflicts of interest that may ensue have not been broached by Canadian regulators since the early days of the FDM.

What is new is that policy-makers in these jurisdictions are now taking bold action to try and eradicate these persistent conflicts of interest.
@page_break@Embedded compensation distorts the economics of the client/advisor relationship, undoubtedly overcharging some clients for the level of ongoing service and advice they receive, but undercharging others. Embedded compensation also prevents differential pricing, limits competition and, most important, hampers clients’ ability to control their investment costs — a significant factor in households’ ability to save for retirement.

Indeed, although Canadian securities regulators have proven reluctant to interfere with compensation schemes in the retail investment business, concern about the underlying cost of investing has come to the attention of Canadian policy-makers in recent months as they review the adequacy of the retirement system in Canada.

An interim report from the Senate standing committee on banking, trade and commerce released this summer reveals that the committee heard a good deal of testimony indicating that the costs of saving for retirement through vehicles such as RRSPs are simply too high.

According to the report, the committee heard from a number of witnesses that the high cost of private saving vs saving within a large pension plan puts ordinary retail inves-tors at a significant disadvantage. Former Bank of Canada governor David Dodge told the committee that individuals at the retail level face “an enormous cost”, and that they must save much more than they would in a group pension.

According to one estimate, the difference between the fees and expenses charged by large pension plans and the costs paid by RRSP investors means that individuals have to save about 30% more to achieve the same pension.

Dodge noted that the most serious problem with the current RRSP system is the “dearth of easily accessible and efficient investment vehicles for individuals and, even worse, a lack of efficient or low-cost annuity vehicles for individuals.”

Various others testifying before the committee suggested that the fees charged to retail investors are “excessive”, “obscenely high” and “scandalous.”

The investment industry has long disputed accusations that its fees are excessive. And, in mid-August, the Investment Funds Institute of Canada released a report that aims to demonstrate the “value of advice.” The IFIC report indicates that market research has found that households that use advisors have much higher investible assets than households that don’t use advisors.

Although there is undoubtedly a correlation between households with lots to invest and the presence of an advisor, this doesn’t mean that there’s a causal relationship between the two. In fact, if anything, the causality probably runs in the opposite direction — households with lots of money to invest naturally attract advisors eager for their business. It’s not clear that the presence of an advisor is the reason higher net-worth households have more assets.

In fact, past academic research into the value of financial advi-sors has been unable to detect a concrete financial benefit. A U.S. study comparing broker-sold funds with funds sold directly to investors couldn’t find any tangible benefit to using an advisor: “Relative to direct-sold funds, broker-sold funds deliver lower risk-adjusted returns, even before subtracting distribution costs.”

The study also didn’t detect superior asset-allocation decisions, better timing of markets or less performance-chasing by clients of brokers. The report concluded that either clients receive intangible benefits (such as greater piece of mind that comes from investing with advice or saving time) that justify the use of brokers or that brokers are acting in their own self-interest and not for the benefit of clients.

Moreover, research also has consistently shown that cost is a crucial determinant of investment performance. Recently, Morningstar Inc. published the results of the latest study in the U.S. to validate this conclusion. Says that report: “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”

The challenge for policy-makers becomes how best to help inves-tors minimize costs, whether it involves expanding the public pension system, devising greater access to large pension funds for retail investors or trying to make the private market more hospitable to better decision-making.

The Senate committee heard testimony indicating that there are low-cost options available but that people aren’t using them — “Perhaps because they are getting bad advice.”

Other testimony blamed the high costs on a lack of transparency surrounding fees, and called for fund firms to be required to disclose the amounts investors pay in their annual statements. This sort of disclosure, it was suggested, would “allow Canadians to see if their high fund fees are worth improved performance, and also encourage funds to compete on cost.”

It remains to be seen if the Senate committee will act on all it heard about the excessive cost of investing in Canada. And, if it does, whether it will follow the U.S., Britain and Australia down the path to outlawing certain compensation arrangements. The committee will issue a final report later this year, setting out its recommendations.

In the meantime, the report of the standing committee on finance, which was also released earlier this summer, does recommend greater government scrutiny of industry fees. IE