The Finance Ministry Committee that reviewed steps to curb mis-selling and rationalisation of distribution incentives across financial products, has submitted a very exhaustive and well researched report. To see the full report, Click Here.
The Ministry has clarified that the recommendations are those of the Committee and not the Government's and that the Government will take a final view only after conducting public consultations. Stakeholders can forward their views to the Government by 5th October 2015 - for more details, Click Here
If this report is accepted in full by the Finance Ministry, or at least all the broad principles are accepted and only changes in some details are made after stakeholder consultations, there are many significant implications for the regulators, for the fund industry, for insurers and for distributors. Here are some of the potential implications:
SEBI will be a big winner in the inter-regulator turf wars. Insurance distribution is set for major upheaval, and a big winner of this upheaval could be the fund industry. The debate over advisor vs distributor seems to have been parked aside for the time being. Trail commission is here to stay, and there is no immediate desire to push distributors to become fee-only advisors. Introduction of a distributor-investor form finally clears the air on what constitutes a good sales process. Fears around mis-selling due to hazy regulations, can now recede. Introduction of a common distributor registry with common minimum distributor regulations could mean that the MF distribution SRO goes into cold storage, to be replaced with a distribution SRO that cuts across all financial products. Lower TERs, lower trail commissions for mutual funds
SEBI will be a big winner in inter-regulator turf wars
SEBI, IRDAI and PFRDA have been engaged in inter-regulator turf wars for years, mainly due to overlapping nature of products that each one regulates. We witnessed a highly public turf war over ULIPs a few years ago, and are now witnessing a much more subtle one on pension products. If FinMin accepts this committee's recommendations, SEBI can emerge a big winner in these turf wars. Here are some of the key recommendations that point towards this direction:
"Regulation of financial products must be seen in terms of the product function and not form. These functions (for the purpose of this committee) are: Insurance, Investment and Annuity.
The lead regulator, according to function, should fix the rules of the game. In bundled products, the lead regulator for the function of the sub-part must fix rules of the game."
SEBI will now have the final say in regulations around the investment component of ULIPs, investment component of traditional insurance plans as well as pension plans regulated by IRDAI and PFRDA. There will be uniformity in investment regulations, and SEBI will drive them.
The committee refers to the Finance Ministry's effort to create a Financial Authority (FA) as part of the proposed Indian Financial Code. FA is intended to become the super-regulator of financial markets, taking up the responsibilities of SEBI, IRDAI and PFRDA. This may take some time to implement, but distinction of roles and responsibilities between the 3 regulators, as suggested by the committee, could well be the first step in this direction.
For the fund industry, harmonising the rules across all investment products could well be the first step towards un-bundling ULIPs - where life insurers will eventually offer ULIPs with a variety of mutual fund products with robust track records wrapped around life covers that the insurers provide. The fund industry has been clamouring for this for a very long time - it looks like the stage is perhaps getting set for this eventuality.
Insurance distribution set for major upheaval - bonanza for the fund industry?
Life insurers are likely to represent very strongly against some of the recommendations of this committee. Here are some of the recommendations that can cause a major upheaval in their business:
"Investment products and investment components of bundled products should have no upfront commissions.
All investment products, and investment portions of bundled products, should move to an Assets Under Management (AUM) based trail model.
Upfront commissions on pure insurance products and pure risk portions of bundled products should be allowed, and should be decided by the lead regulator since pure risk is a difficult product to sell.
Financial products should have flexible exit options. The cost of exit must be limited. The current rules as decided by Securities and Exchange Board of India (SEBI) for mutual funds and Insurance Regulatory and Development Authority of India (IRDAI) for Unit Linked Insurance Plans (ULIP)s are robust. The same principles should govern surrender and lapse costs in traditional plans, and form the basis for future products as they are innovated by the industry.
The costs of surrender for each product should be reasonable. After deduction of costs, the remaining money should belong to the exiting investors.
Lapsation profits, or profits from exit charges, if any, should not accrue or be booked by product providers"
"Regulators should create a common distributor (including employees of corporate agents) regulation. Each regulator may add rules specific to products regulated by them.
Regulators should create a single registry of all distributors. Anybody facing the customer should be registered. The registry should identify each individual distributor with a unique number. The registry should have the past history of regulator actions and awards for each individual distributor. Strict penalties should be defined for distributors who are not registered"
Three recommendations, when pieced together give us a sense of the unfolding scenario: The three recommendations are: (a) No upfront commissions on the investment portion of insurance products (including ULIPs and traditional products), (b) flexible exit options across all financial products and (c) a common distributor registry and common minimum distributor regulations across all financial products. As we all know, insurance distribution in our country is presently closed architecture (an agent can work only for one insurer), and high upfront commissions are paid mainly based on customer unfriendly exit options.
If customers get easy exit options from insurance products (like they do in mutual funds), will a closed architecture distribution model sustain in insurance, or are we likely to see insurance distribution go open architecture?
If you have a common distributor registry across all financial products, can a closed architecture sustain? Perhaps not. The insurance industry will have to fundamentally re-think their distribution models, if these recommendations are accepted by the Finance Ministry.
In an environment where commissions are no longer way higher than mutual funds, and in an environment where a common distributor registry effectively gives all product manufacturers easy access to over 20 lakh registered intermediaries, the fund industry with only 40,000 active distributors, can look forward to a huge expansion in its distribution footprint in the years to come.
We may well see a shrinkage in number of active insurance agents when upfront commissions go away - just as we saw in mutual funds since 2009 to 2013. But for the fund industry, easy access to even half the 20 lakh active insurance agents, on a level playing field, promises to be a huge bonanza in terms of distribution expansion in the years to come.
Advisor vs distributor debate parked - for the time being
The debate over advisor vs distributor seems to have been parked aside for the time being. The committee has clearly recognised that retail investors are reluctant to pay for advice, that distributors who are remunerated via commissions do play a key role in investor education, servicing and market expansion and that therefore, this is not the right time to enforce a total ban on all forms of commissions. Trail commissions are seen as the most practical revenue model for financial intermediation - in its present stage of evolution in our country. Here are the relevant extracts from the report:
"The Committee deliberated on the suggestion of a complete ban on commissions. This is especially pertinent because several economies such as the UK, EU and Australia have already banned commissions, especially upfront commissions on the sale of retail financial products.
While it was agreed that commissions can influence distributors to not act in the interest of the customer, it was also felt that commissions play an important role in incentivising the distributors to seek new customers. The agents role in educating customers, doing risk evaluation and primary underwriting, long term servicing and claims assistance were emphasised by the life insurance representatives.
Considering the low access of financial markets, it was felt that this was an important function that could not be ignored. These views were also strongly expressed by the association of insurance and mutual fund distributors to the Committee. For example, the Financial Intermediaries Association of India (FIAI) expects that financial distributors will play a critical role for channelization of savings in proper asset classes for long term wealth creation, and a no-commissions world will make it difficult for intermediaries to function.
The Indian market also suffers from a lack of a market for advice. Retail customers are not accustomed to paying for holistic advice. A body of financial advisors capable on advising on the entire portfolio of products is also not available. It was, therefore, felt that a complete ban on commissions in such an environment would be counter-productive."
The committee has however clarified that the long term goal should be for financial markets to work towards an advisory model where investors pay their advisor, which sits alongside a direct model, for those investors who don't need advisors. Here is the relevant extract:
"Financial products are advised products since average people are not able to make the needed calculations involving real return, time value of money, tax impact and the IRR. Over the long term, Indian markets should be guided to an advisory model where customers seek advisors, and remunerate them directly for holistic portfolio advice, plus the Over the Counter (OTC) model where customers purchase products over the counter without any intermediation. In this world, product provider led commissions will not be permissible, and advisors will function under a regime of higher fiduciary standards."
No time line has been set for the move towards a fee only advisory model. Given the recognition of present ground realities on investor willingness to pay for advice as well as the nascent stage of the advisory profession, it would perhaps be safe to presume that we are unlikely to see a determined regulatory push towards RIA over the next few years. A new SEBI Chairman will assume charge next February, and will have a lot on his plate to execute, if the Finance Ministry does accept this committee's recommendations. There is a good chance that we will see less zealous efforts from SEBI to get distributors to become RIAs. That said, the present regulations and the accompanying FAQs do seem to suggest that multi-product distributors ought to become RIAs. Stand-alone mutual fund distributors perhaps have no need - for the time being - to worry about whether RIA will be forced down their unwilling throats.
Haze over mis-selling set to clear - finally
While mis-selling has been made a serious offence, distributors have for long been demanding a simple set of rules on what constitutes a good sale and what constitutes mis-selling, and have also been asking for clear guidelines on documentation to be put in place from a good selling perspective. This committee has prescribed an investor-distributor form, which aims to do precisely that. Here are relevant extracts:
"The product provider and the distributor should ensure that they have built and implemented sufficient processes and systems to ensure that proper disclosures are actually made. The checks should be stronger for vulnerable categories such as senior citizens. The product providers should add a second layer of in-house approval before a sale is concluded for such customers. The product providers should be required to provide details of the same to their regulator on a periodic basis.
To focus on such disclosures and its format that can be easily understood by a retail investor (compared to the present unreadable information memorandum/offer document), a single-page Distributor-Investor Form should be mandated, which in bold states the key features of the product, its suitability and costs. The form should be in a machine readable format so that these can be easily databased for future reference, audit and analysis. For each sale, this form should be made available to the investor and a copy be available with the distributor, which may be inspected by the regulator when need be. These forms should be made available to the investor in the language preferred by her. Both the buyer and seller should sign on this form. An indicative form is shown in Annexure D. This is all the more important given the rising sales of mutual funds, for example, in the lesser literate B15 cities.
The regulators may also consider mandating a "Personal Illustration" format 62 Recommendations which the product provider/distributor should give to the customers. An indicative format (used by LIC, UK) is shown in Annexure E"
The proposed Investor-Distributor form is fairly simple yet comprehensive and can serve as the sole documentation that is required to be archived for compliance purposes, as evidence of a good sale. The confusion on whether a detailed risk profile is mandatory or not can now be put to rest, as the form contains a section where the investor signs off on his risk profile and his overall asset allocation. If this recommendation is accepted, at least distributors will know exactly what to do to ensure that their sales processes are in conformity with regulations.
What happens now to the MF distribution SRO?
The committee has called for a common distributor regulation and a common distributor registry, with product regulators adding to the common regulations, as they deem necessary. Here are the relevant extracts:
"There is an urgent need to bring the distributors, and their sales employees (and sub brokers), under a regulatory framework. (SEBI has recently issued regulations for advisors but no regulations exist for distributors). All distributors, across regulators, along with their sales employees, should be assigned a unique number so that monitoring, surveillance and enforcement becomes unified and simpler. They should be subjected to detailed regulations incorporating rules, educational qualifications, entrance exams, code of conduct etc. There should be a combined database of all distributors across all financial products. The sector regulator can impose additional conditions on their distributors. Also, the database of customers of the distributors should be available for inspection by the regulators and for customers who are shopping for a distributor."
Regulators should create a common distributor (including employees of corporate agents) regulation. Each regulator may add rules specific to products regulated by them.
Regulators should create a single registry of all distributors. Anybody facing the customer should be registered. The registry should identify each individual distributor with a unique number. The registry should have the past history of regulator actions and awards for each individual distributor. Strict penalties should be defined for distributors who are not registered"
If we are going to have a common distributor registry and a common minimum set of distribution regulations with a common minimum set of educational qualifications, where is the place for a product specific SRO like the proposed MF distribution SRO? Will the MF distribution SRO become a still-born initiative, to be substituted by an SRO with a much larger mandate? That would seem a logical conclusion. A single distribution SRO would mean that distribution associations like FIAI, FIFA and so on will have to work closely with manufacturer trade bodies like AMFI and Life Insurance Council and with all the three regulators, to co-create a genuinely independent distribution SRO that can fulfil the mandate that this committee envisages for this important institution.
Lower TERs, lower trail commissions for mutual funds
Here is an extract of the specific recommendations on costs and commissions on mutual funds:
The cost caps within an overall TER should not be fungible.
Upfronting of commissions should be totally removed. There is a current cap of 1 per cent that comes from the fund house capital or profits. This too should be removed.
Distribution commissions should only be paid as level or reducing AUM based trail. In the case of lumpsum investment, or upon termination of a systematic investment plan, the trail commission should be declining (or nil after a specified period of time).
The extra commission in B15 should be removed and a level playing field be created in the country. Manufacturers and distributors should on their own tap such unexplored markets to increase their sales and market share.
No category of mutual funds should be exempt from the zero upfront (when it is put in place).
Distributors should not be paid advance commissions by dipping into future expenses, their own profit or capital.
Competition has not reduced costs much below the expense ratio that was fixed when the AUM of the industry was much lower. The regulator should lower the cost caps as the AUM rises over time."
We have been arguing for some time that the end game for MF commissions is an all trail model and we clearly saw the 1% cap as a semi-final stage and not the end game. We now see recommendations that spell out the end game - which is elimination of upfronts of all sorts on all products. Since these recommendations cut across all financial products including insurance, at least there is a level playing field.
B-15 incentive removal will be welcomed by many industry participants (though not the B-15 distributors) since there were many complaints about abuse of B-15 addresses. Since SEBI has effectively been asked by the committee to reduce TERs, there will be a lot of pressure on SEBI to act. One simple way it could act is to decide that its steps to "energize distribution" which it took in August 2012, have worked and served their purpose, and therefore can now be withdrawn. That would mean end of the B-15 incentive and the additional TER as well as end of the 20 bps additional TER that AMCs were allowed to charge. This will restore TERs to pre Aug 2012 levels - which could be the first step towards a lower expense regime.
TERs of the largest equity funds in the country (regular plans) are presently in the 210 - 225 bps range and those of the smaller equity funds are closer to 300 bps. Before the Aug 2012 reforms, the largest equity funds TERs were in the 170-180 bps range. It is perhaps time that we went back to those days.
The recommendation to introduce a declining trail commission seems a slightly misguided one - as it bestows no benefit on the consumer, but increases propensity to churn. Distributor associations and AMFI will surely represent strongly against this move, and should have fairly convincing arguments to back their case.
To conclude
There are some far reaching recommendations that this committee has made which, if accepted, can significantly change financial products distribution in India. The biggest upheavals are likely in insurance distribution, with the fund industry likely to emerge as a key consequent beneficiary. Bank distributors will have to contend with sharply lower revenues across all third party products - which may result in sharper focus on CASA and own deposits and consequently lower focus on retail distribution of investment and insurance products. Lower costs and lower margins will accelerate growth of online distribution models to serve retail investors. IFAs who adopted a full trail model and who have focused on mutual funds and term plans, are the least impacted from these recommendations, as their distribution model is seen as the one that serves investor interests the best.
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