We believe that deferred sales charges products, or DSCs, should be banned. These predatory products are bad for investors for many reasons. For example, there are the high upfront costs, or when the fund performs poorly or no longer meets its needs, investors may be deterred from redeeming. There's also the temptation on the part of unethical dealers to churn accounts, generating a fresh upfront 5% payout by switching the investor to another fund once the redemption-fee period is over.
The good news is that on December 19th, 2019, the Canadian Securities Administrators announced that in most provinces, the use of DSCs will be banned in 2020, with a phase-out period estimated to be about 2 years. The bad news is that the Ontario Securities Commission (OSC) didn’t follow suit after the Ontario government opposed the ban, ostensibly for investor safety and protection. Investor advocates have long believed that the reason was more political than any real desire to protect the investor.
With the government more or less tying the OSC’s hands by not allowing a ban on DSCs, the OSC had to work out a compromise. And this February, right before the COVID-19 shutdown, the OSC released a list of restrictions on the sale of DSC products, effective June 1, 2022. Here are some of the proposed changes:
Investment Fund Manager Restrictions
- A maximum term of 3 years for redemption schedule, down from the current 7-year maximum
- 10% annual redemption of units without redemption charge to be cumulative
- Separate series of units for DSCs
Dealer Restrictions
- No sales of DSC products to clients aged 60 years and older
- Maximum client account size of $50k
- No sales of DSC products to clients with a time horizon shorter than redemption schedule
- Clients cannot use borrowed money to purchase mutual funds with a DSC option
- Upfront commissions paid only for new contributions to the account
- No up-front commissions on reinvested distributions
- No redemption fees applicable to investor redemptions upon the death of a client, involuntary loss of employment, permanent disability or critical illness
The OSC has invited comments on these restrictions. As of June 24th, the OSC received 18 comment letters on the topic. 17 of them called for an outright ban on DSCs.
We will discuss the merits of these restrictions next week, but today, we want to address how in the face of protests against institutional and systemic racism and inequality, both in the U.S. and Canada, some of these restrictions can only work to further marginalize small investors, especially minority investors. Investors with the least money have the most to lose, especially since the deck might be stacked against them to begin with.
Race and Financial Inequality
The Canadian Centre for Policy Alternatives released a report titled ‘Canada’s Colour Coded Income Inequality’, that identifies a wealth gap between racialized and non-racialized populations in Canada.
“These aspects of income inequality, from both employment and wealth, are also visible in the inequality in family incomes. The data show that racialized individuals are more likely to be in families in the bottom half of the income distribution (60%) than non-racialized individuals are (47%). Investment income shows a similar pattern: 25.1% of the racialized population over the age of 15 reported investment income, compared to 30.8% of the non-racialized population. The average investment income for the non-racialized population ($11,428) is 47% higher than the average for the racialized population ($7,774). The racialized gap in capital gains is clear: 8.3% of the racialized population over the age of 15 reported capital gains, compared to 11.9% of the non-racialized population. And the average amount of capital gains of non-racialized Canadians ($13,974) is 29% higher than the average amount for racialized Canadians ($10,828),” the report finds.
It also notes that in 2015, racialized men earned 78 cents for every dollar that non-racialized men earned. This earnings gap remained unchanged since 2005. Racialized women earned 59 cents for every dollar that non-racialized men earned, while non-racialized women earned 67 cents for every dollar that non-racialized men earned. Little progress was made in reducing this gap over the 10-year period.
Racialized people, on average, have lower incomes, lower savings, and therefore, lower investable assets than non-racialized populations.
Client Account Size up to $50k Allowed
The main point of contention is that DSCs can only be sold to clients with a maximum account size of $50,000. This is most harmful to clients who do not have much money to invest at all – and therefore need their assets to be protected.
In July 2019, the OSC’s Investor Advisory Panel released a report titled, ‘A Measure of Advice: How much of it do investors with small and medium portfolios receive?’ The report found, among other things, that 43% of advised investors did not agree that their advisor had provided them with educational advice about financial concepts, 31% were unable to say their advisor had ever spoken to them about planning for financial goals such as retirement, education or buying a home, and only a small minority reported they’d received advice about budgeting or debt management (20%), tax and estate planning (28%), or planning for the future needs of a family member (23%). It also found that 60% of mass-market investors reported that their advisor communicated with them in the past year only “once or twice” or not at all, and 49% of mass-market investors said their advisor spent less than an hour, in total, communicating with them during the past year.
This goes to show that on average, investors with small and medium portfolios receive very little communication from advisors, and arguably, not enough advice. Several investors in general are also less sound in areas of financial literacy. Morningstar’s head of sustainability research Jon Hale points out that having wealth means having a personal safety net to deal with life’s emergencies, eases the path to a college education and homeownership, both of which are also significant wealth creators. And, of course, having wealth provides the ability to build more of it through investing. It is appalling that it is these small investors who will be targeted by predatory DSCs.
Several of the comment letters to the OSC call this out specifically. Neil Gross, chair of the Investor Advisory Panel says in his letter, “We agree with the Canadian Securities Administrators (CSA) that deferred sales charges (DSCs) are harmful to investors… We are concerned that the proposal extends protection to some but not all investors. For example, while it safeguards investors with large accounts from the harm of DSCs, it does not extend the same protection to smaller investors, who may well be more vulnerable as they tend to receive less robust investment advice. Similarly, we are unable to support an option that is deemed too detrimental for older investors yet would still be marketable to young ones, including those who are the least experienced investors.”
Harold Geller of MBC Law Professional Corporation’s Financial Loss Advisory Group says in his letter that, “The present Ontario does not treat all Ontarians equally. Ontarians with large accounts will be protected but accounts of smaller investors will be open to further DSC victimization. Older Ontarians will receive some protections, but our youth will not be protected from this predatory advisor recommended DSC.” He also calls DSCs concrete handcuffs.
The Small Investor Protection Association points out in its letter that in effect, the OSC has chosen to define a client of modest income as one with $50K or less to invest. “Therefore, it seems that the OSC explicitly expects clients with higher amounts to invest to be sold less onerous products as the commissions earned would be sufficiently high to attract dealer interest. In other words, only non-DSC products are suitable for more affluent clients while DSC products can be suitable for clients of modest means (and potentially of less financial literacy). Ironically, it is often those clients with the lowest amount of money who can’t afford to have fees impacting their returns. They also may require access to the funds at unexpected times and will be unduly penalized for early redemption. Simple, low cost investing is most appropriate for such investors.”
Investor Isaac Glick says in his letter, “The conflict-of-interest is impossible to mitigate and leads to very skewed recommendations that leave a mass-market client locked in for 7 years in an expensive mutual fund. In fact, the proposals limit sales to investors with accounts less than $50K; people who need low-cost products, trustworthy advice and liquidity in case of an emergency expense. I cannot see a professional advisor even thinking of selling a DSC fund to such people with so many better choices readily available.”
Investor advocate Ken Kivenko’s Kenmar Associates asks that in addition to the protection of clients over 60 years old, there should be restrictions on the type of clients to whom a DSC fund can be sold. The letter outlines these as vulnerable clients as defined by the U.K. Financial Conduct Authority, retirees, recent immigrants and veterans and clients with a large debt load, among others. “DSC sold funds are generally more expensive than mutual funds that do not carry a provision for the recovery of the 5% upfront pay-out to salespersons embedded in the management fee. This suggests that investors of modest means based in Ontario could have their life savings impaired by fund salespersons recommending DSC mutual funds,” Kenmar Associates’ letter says.
Sole Voice of Dissent
The sole voice of dissent so far in the call for a ban on DSCs came from Advocis, who said in its letter:
“We support the OSC’s efforts to preserve consumer choice by permitting the DSC option to continue with new restrictions that will address key investor protection concerns associated with its use. While DSC is generally becoming less prevalent in the marketplace, it is a suitable sales option for some clients who would not otherwise be able to access the capital markets and benefit from the value of advice.”
The letter then proceeds to provide feedback on the restrictions, and opposes the $50,000 maximum, asking instead that it be increased.
“Our greatest concern with the Proposal has to do with the maximum client account size. With a proposed maximum of $50,000, the Proposal will render the DSC option not economically viable and the effect will be nearly the same as if Ontario had banned DSCs. With the new maximum three-year redemption schedule, the upfront commission paid by the investment fund for the DSC option is likely to be 3%. This means the maximum commission will be $50,000 x 3% = $1,500. This commission is split between the dealer and the advisor, with 50- 50 or 60-40 ratios being quite common. Therefore, the maximum commission the advisor might earn under this option would be about $750 for three years of service. If these accounts utilized the DSC option, the average advisor commission would only amount to $195 for three years of service. This is plainly uneconomical,” the Advocis letter says, asking that the limit be extended to $100,000.
We disagree with this point of view. Although the commission calculation is accurate from the perspective of an advisor, it does not change the fact that a retail investor can seek a lower cost option elsewhere. This is a common counterargument, that low balance investors may lose access to advice without DSCs, but Canadian investors now have access to automated and robo-advice platforms from large reputable firms, as well as fee-only financial advisors.
Financial plans should never be based solely on commissions that the salesperson earns – that is a clear conflict of interest. Plans should be tailored to each individual investor, keeping risk appetite, financial goals, liabilities, and yes, time horizons in mind. We believe fees are subtractive to an investor’s long-term success, and deferred sales charges are an extreme example of this.
How Can Investors Protect Themselves?
Ask questions. Ask LOTS of questions.
In terms of your chances of running into a DSC fund, Morningstar’s database shows that 1625 of 24,000 Canadian mutual funds give the option of a deferred sales charge. Net assets on these funds total $117 billion, or less than 10% relative to the $1.6 trillion of assets invested in all mutual funds, notes Morningstar Canada’s director of investment research Ian Tam.
“In general, the main way you can protect yourself is to always ask questions. Ask your advisor what you’re paying in total. How much are you paying for advice? How much are you paying in charges? Ask for cost breakdowns. It’s your money, you have to protect it,” says Tam.
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