What Difference Will CRM II Really Make?

On July 15, 2016, the latest round of regulatory reform in Canada came into effect. Although it took over a decade to come to fruition, we can at least feel comforted that, contrary to popular opinion, regulators in Canada sometimes actually do something once in a while. Perhaps very little, perhaps very late… but something. Earlier iterations of a more ambitious reform package called the Fair Dealing Model were initiated by the Ontario Securities Commission long ago. This being Canada, the only industrialized country on earth without a national securities regulator, the Ontario initiative went on to be watered down repeatedly in an effort to gain a national consensus via the Canadian Securities Administrators (CSA).

The CSA is simply the sum of all provincial and territorial Securities Commissions. In the case of CRM II, this structure is not so much an example of too many cooks spoiling the broth as it is of too many cooks adding so much water to the offering that over a decade of tinkering, the former soup has been converted to a rather thin broth. Some might say that the whole is less than the sum of the parts since the only things groups like the CSA ever seem to agree on are lowest common denominators. Nonetheless, I’ll take a “glass is half full” approach and acknowledge that oftentimes, something is better than nothing – even if so much more could have been done. In fairness, I should also note that there are those who feel that the initial reforms, while laudable in intent, are impractical from an implementation perspective.

Effective immediately, certain information is to be disclosed to clients on their statements. While much of the information required to be provided relates to annual costs, the practical upshot is that most of what follows will not be available until December 31, 2016. Monthly statements are expected to remain much the same until then. Nonetheless, some people will see the new format of statements in October.

For most people, the first actual statements that will record the “annual report of charges and other compensation” and “annual report on investment performance” will be sent out in January, 2017 and will reflect information as at December 31, 2016. In other words, in the coming months, investors will finally see in simple terms exactly how much they are paying their advisor’s firm (the advisor only receives a portion of this money) as well as how well they have been performing over the last little while.

It should be noted that this information will be old news for some people. Investors working with fee based advisors already get an annual statement verifying total fees paid and those working with Portfolio Managers (i.e. those using Discretionary Accounts) also get quarterly performance reports. For most people, however, this will be totally new.

The $64,000 Question Is:

ìWhat Will Change?î

It seems everyone has an opinion. To be sure, more transparency and accountability is a step in the right direction. Just how big of a step are we talking about? In my opinion, the improved disclosure of performance will likely be more impactful than the improved disclosure regarding the cost of advice. Ironically, most people are expecting fallout regarding advisor compensation. Perhaps the real trouble will arise when people connect dots if they perceive questionable value along with considerable cost.

Various studies have shown that a large percentage of people are still of the misguided impression that financial advice is free. Even among those who know that they’re paying, there are those who cannot do a reputable job of explaining how or how much their advisor is being paid.

While the amount paid varies from advisor to advisor, the primary variables are the advisor’s business model, the client’s asset allocation and the client’s account size (usually as measured on a household basis). One thing that some people might not have thought of is that there may have been at least a few DSC (deferred sales charge) mutual fund purchases that were deliberately made in late 2015, In a hypothetical scenario like that, DSC purchases would generate an up-front payment to the advisor the week that the purchase is made. If that purchase was made in 2015, the big up front amount would not be reported on as part of the 2016 payments made to the advisor.   For the advisors who did this, there are three potential benefits:

• Getting a big payday in 2015 without registering any remarkable payments in 2016.
• Having a lower stated income in 2016 relative to placing money into front end versions (trailers on DSC equity funds are typically 0.5%, whereas trailers on front end funds are typically 1.0%).
• The client who bought the DSC fund would be locked in for a further 7 years or so for those funds that were purchased on a DSC basis.

In short, even as the industry moves toward greater transparency, there will always be opportunities to skirt good intentions in order to look more virtuous than they might actually be. Note that there is nothing illegal about this tactic.   The only concern I’m trying to draw to peoples’ attention to is one of professional ethics.

My guess is that there will be a modest to moderate amount of shock and dislocation as a result of the statements going out in early 2017. What remains to be seen is just how violently investors react when they see how much their advisors are paid. Most should expect a number in the vicinity somewhere above 1% of total assets invested. Smaller accounts might be surprised to see that they’re likely paying more. While the numbers may vary, here’s my guess of what most people will see:

For those people who thought that their advisor was the second coming of Mother Teresa (i.e. that their advisor was working as an act of charity), this will be a rude awakening. They may also have to remove those pesky “I brake for unicorns” bumper stickers they’ve been sporting all these years. There may likely be some anger, but I believe cooler heads will ultimately prevail and people will get over it.

To my mind, the bigger issue will likely be performance. In the post global financial crisis world of 2016, there are far too many ‘I brake for unicorns’ type investors out there still. Polls and studies delving into investor expectations show that many people are living in a fantasyland. The Financial Planning Standards Council recently released their long-term planning projection assumptions for CFPs. Those numbers are modest, but realistic – unlike most investors. Specifically, the FPSC recommends that planners aim for about a 4% return on a balanced portfolio after fees. Assuming a 2% inflation rate, that’s a total ‘real’ return of only 2% above inflation. Of course, that is the sort of return that many people have been getting in the past half-decade already. We now have the most reputable financial planning organization in the country saying we should expect more of the same for years to come. Just because we should expect it doesn’t mean that people do expect it. Is there any consolation in knowing it would have been (and in the future might yet be) a 5% nominal (3% real) return once the advisor’s fee is backed out?

So far, we’ve been talking about what CRM II does do. We haven’t discussed what it doesn’t do. There is absolutely no mention of product costs in the new CRM II disclosures.

Some cost-related rules and regulations have been implemented previously, including point of sale disclosure and a statutory pre-purchase requirement for both the mutual fund facts and ETF facts documents. The concern that I have is that uneven cost reporting will effectively have the unintended consequence of misleading investors. Why disclose one (the cost of products) at a point of sale and another (the cost of advice) on client statements?

Imagine getting your car repaired and having the mechanic give you a bill for the labour while requesting a blank cheque for parts. As it stands, investors will soon be told how much they are paying for labour (financial advice), while disclosures about how much their parts (mutual funds, exchange traded funds, etc.) cost will appear on a separate invoice. How’s that for encouraging meaningful price shopping?

Many people, myself included, had high hopes for what improved disclosure might mean for the public. The original idea was to manage costs and conflicts through a more transparent relationship. What has emerged is a reduced attempt to move forward on this front. The good news is that positive change is coming. In my view, however, we’re more than a decade behind where we could (and should) be if meaningful, client-centred reforms had been put forward when they were needed.

John J. De Goey, CFP, CIM, FELLOW OF FPSC is a Portfolio Manager with iA Securities. The views expressed are not necessarily shared by iA Securities.