Only in extremely rare cases can moving clients from a mutual fund with a management expense ratio (MER) of about 2 per cent to a segregated fund with an MER closer to 3 per cent be justified, one expert says.STANDRETT/iStockPhoto / Getty Images
Are you a professional financial advisor? Register for Globe Advisor and then sign up for the new weekly newsletter on our newsletter sign-up page. Get exclusive investment industry news and insights, the week’s top headlines, and what you and your clients need to know.
Pledges from regulators to ban sales of segregated funds with early withdrawal penalties next year are not enough because the delay in matching a similar ban on mutual funds that comes into effect in June leaves a large window of opportunity for foul play, according to some investment industry insiders.
Earlier this month, the Canadian Council of Insurance Regulators (CCIR) and the Canadian Insurance Services Regulatory Organization (CISRO) issued a statement calling on insurers to stop selling seg funds with deferred sales charges (DSCs). Sales of those financial products should cease by June 1, 2023, exactly one year after mutual funds with DSCs become banned in Canada.
However, because of that 12-month delay, there will be “bad advisors” who move money from mutual funds into seg funds and lock clients in for another five years to earn another commission, says Maria Flores, chief compliance officer at Carte Wealth Management Inc. in Mississauga.
“We’re talking about the same money that six or seven years ago was already given to the advisor. There’s a huge problem here,” she says. “Until [regulators] decide to put a stop to it, it’s going to continue to happen.”
Mark Kent, chief executive officer of Portfolio Strategies Corp. in Calgary, says he has “absolutely” seen cases of regulatory arbitrage in which advisors have redeemed some clients’ mutual fund assets to buy seg funds.
“That has been an issue for years and it has been accelerating this past year,” he says, as the ban on DSCs for mutual funds has loomed.
Only in extremely rare cases can moving clients from a mutual fund with a management expense ratio (MER) of about 2 per cent to a seg fund with an MER closer to 3 per cent be justified, Mr. Kent says, noting that some advisors who made such moves for their clients pointed to niche benefits such as the probate bypass or creditor protection that seg funds provide.
“I think it has just been a smoke and mirrors job to justify more seg fund sales,” says Mr. Kent, adding that he has even seen it happen in his own firm.
“We asked one of our advisors – this was about a year ago – for proof of disclosure and client sign-off on fees [related to moving that client from a mutual fund to a seg fund] after one of our branch managers caught it,” he says. “We ended up terminating the advisor for cause because we had no evidence she had been disclosing fees and charges properly.”
In response to questions seeking to clarify the timeline to harmonize rules for seg funds with DSCs to those of mutual funds, the CCIR and CISRO said their Feb. 10 joint statement was “clear.”
“Insurance regulators believe it is time to end deferred sales charges in segregated funds as this form of sales charge is not consistent with treating customers fairly,” the organizations stated in a response sent by e-mail. “As of June 1, 2022, insurance regulators across Canada urge insurers to refrain from new DSC sales in segregated fund contracts, in line with the June 1, 2022 ban in securities [and] on June 1, 2023, insurance regulators across Canada expect insurers to stop new DSC sales.”
Yet, even those within the industry who argued against banning DSCs now believe the risk of arbitrage during that year-long gap is real.
Greg Pollock, CEO of Advocis, the Financial Advisors Association of Canada, says the organization hasn’t conducted any research to conclude regulatory arbitrage is taking place, “but it wouldn’t surprise” him if it was happening.
“That’s why we have argued all along that like products should be harmonized to the greatest extent possible,” he says.
Insurers have made efforts to address regulatory arbitrage concerns in recent years, including by adding a clawback feature to some seg funds that requires advisors to repay their commission if a client ends up making an early redemption. However, Ms. Flores and Mr. Kent say it’s possible for advisors to avoid that outcome and potentially even leave clients on the hook.
“Let’s say you’re an advisor with a client who redeems a seg fund with a [clawback] and you have to pay back the commission,” Ms. Flores explains, “the insurer will give you time to repay that debt, and if you sell products from that insurer from that point on, you will still make a commission but it will go against any debt you have until it’s settled.”
However, what some advisors do is if they have a debt with one insurer, they establish a new relationship with another managing general agency (MGA), which wouldn’t know about their debt with that insurer. Then, those advisors’ businesses go on as usual.
“Once the advisor leaves that debt with [the insurer] and is out of the picture, that debt counts against the original MGA,” she says. “It’s now fully responsible for that debt. And we are talking about big debts, where $500,000 could happen easily.”
In that scenario, Mr. Kent says he doesn’t think the MGA is necessarily going to “pick up the ball,” and, ultimately, there’s a risk clients could have to pay up.
“I don’t think a lot of people have really thought that through very well,” he says.
For more from Globe Advisor, visit our homepage.