Total Cost Reporting Is Coming
There’s plenty of evidence that Canadian investors are unaware of, or are insensitive to, investing costs. For example, DIY (Do-it-Yourself) investors purchased mutual funds through discount brokers with embedded trailing commissions intended to compensate dealers for providing clients advice. But discount brokers are not permitted to provide personalized advice. As of 1 June 2022, discount brokerages were banned from selling mutual funds that have charged investors billions of dollars in fees for advice they did not receive. An estimated $250M anually in excess fees were paid for over a decade resulting in material harm to retirement savings.
Current annual cost reporting includes, but is not limited to, trading commissions, advisory fees, account fees, Registered Retirement Savings Plans (RRSP) or Tax-Free Savings Account (TFSA) account fees, front loads, trailing commissions, cost of borrowed money and the like. Investment funds attract special attention because they contain certain fees that are not apparent to fund unitholders. Total cost reporting will include all the costs of ownership. Empirical research has demonstrated that mutual fund embedded commissions can lead to conflicts of interest and poor cost disclosure, resulting in more expensive funds being sold to clients.
Regulators are now trying to increase fee transparency and competition by implementing a Total Cost Reporting program.
The Regulatory Initiative
After much consumer prodding and pioneering work by the Mutual Fund Dealers Association of Canada (MFDA), the Canadian Securities Administrators (CSA) and the Canadian Council of Insurance Regulators (CCIR) have finally published proposals [https://www.osc.ca/en/securities-law/instruments-rules-policies/3/31-103/csa-and-ccir-joint-notice-and-request-comment-proposed-amendments-national-instrument-31-103] that would enhance Total Cost Reporting (TCR) for investment funds and segregated funds. The proposal attempts to capture all direct and indirect costs incurred by a client in their accounts. TCR will capture a number of costs not currently reported in the annual cost report.
The proposals are part of the Canadian securities and insurance regulators’ harmonized response to concerns relating to current cost reporting requirements for investment funds and segregated funds, whereby several product fees are not included in the current annual report on fees and expenses sent to investors. They seek to enhance investor protection by improving both investors’ and policyholders’ understanding and awareness of the ongoing, embedded costs and other costs of owning investment funds and segregated funds. This coordinated work should help cut down on regulatory arbitrage between insurance and investment sectors.
The proposals would include periodic reporting to clients showing the ongoing costs of owning segregated funds and investment funds. Monthly/quarterly account statements would be expanded to include the fund expense ratio for each of the investment funds that the client owns, expressed as a percentage. For securities investors, annual cost and compensation reports would be expanded to include the total dollar cost of owning investment funds over the past year. This should open people’s eyes. For segregated fund holders, comprehensive reporting of this information would be included in a new annual report.
The current annual report on costs includes the fees paid directly to the dealer, such as trading commissions and indirect payments received by the dealer from fund companies, such as trailing commissions. Total Cost Reporting will include the fund’s management fee, short-term trading fees, early redemption penalty fees paid to the fund company and the trading expenses incurred (Trading Expense Ratio) by the fund in managing the fund. Other expenses such as performance fees related to Alternative funds may also be included. These costs add significantly to the cost of investing, depending, of course, on the number of investment funds in your portfolio.
The reports will be easy to read and comprehend and will include definitions of key terms. Investor testing will be employed to ensure Main Street will understand the information provided and be enabled to act on it. All text will meet plain language standards.
The reporting presentation and format follow behavioural finance ground rules (sample reporting formats are included with the consultation paper). Investors, consumer advocates and the wealth management industry have been invited to submit comments and suggestions. We also expect the regulators to simultaneously launch enhanced investor education and tools to assist investors to use the reported cost information for better decision-making.
The annual cost report and performance reports will be delivered together so that investors can see the relationship between cost and performance.
The regulators are proposing that both sectors move forward in lockstep, with final amendments coming into effect at the same time in September 2024, if final publication would occur, and ministerial approvals are obtained during the second quarter of 2023. Dealers and insurers would be required to deliver statements and reports compliant with the Proposals as of the first reporting periods that fall entirely after this date.
Why Total Cost Reporting Is Important
With the decline of Defined Benefit pension plans, more Canadians than ever now depend on their own investments for their retirement. Increased longevity makes retirement income security especially important. This regulatory initiative should help reduce the chances of retirement portfolio erosion due to excessive investing costs.
The longer the time horizon, the bigger the bite that fees take. As the time horizon increases, the proportion of returns consumed by fees increases. Over long time periods like 20 or 25 years, even small differences in compounding rates have a huge impact on returns. Read Decompounding-the tyranny of fees. [http://www.canadianfundwatch.com/search?q=decompounding]
The adverse impact of fees is two-fold: The investor pays an ever-increasing amount in fees as account balances grow because many fees are based on a percentage of assets in the account. Every dollar extracted to cover management /advice costs is one less dollar left to invest in the portfolio to experience the magic of compounding.
In addition to paying potentially tens of thousands of dollars in avoidable fees, analysis shows that an investor gives up many times that amount in lost portfolio returns over time. Try out the Ontario Securities Commission fund fee impact calculator [https://www.getsmarteraboutmoney.ca/calculators/mutual-fund-fee/] to see the outsized impact fees have on long-term returns.
In Canada, the mutual fund industry is heavily vertically integrated, with many of the largest firms also restricting the product shelf to proprietary products. This situation makes the value of Total cost reporting especially important for Main Street.
It’s also important to note that one key finding of the CSA-sponsored Cumming Report on embedded fund fees was that affiliated dealer flows showed no flow-performance sensitivity at all, which was found to be relatively more detrimental to investors relative to all trailing commission-paying purchase options for non-affiliated dealer flows. See A Dissection of Mutual Fund Fees, Flows and Performance. [https://www.osc.ca/en/securities-law/instruments-rules-policies/8/81-407/dissection-mutual-fund-fees-flows-and-performance]
Several economic forecasts project that market returns may be lower in the future, so the impact of fees on returns and savings will be even larger. Fees are the silent killers of investment returns when amplified by decompounding over time. Don’t think even 0.25% doesn’t matter; in the long term, the impact can be significant.
What Can You Do To Control Your Costs?
Once armed with total costs, investors will know the all-in costs to maintain the account and an estimate of the percentage of these costs of the value of the portfolio. This information can be used to assess whether the costs incurred are providing good value for money and how big a drag these costs are related to the pre-tax returns derived from the account.
You can then start exploring alternatives to actively-managed mutual funds and different account types. A friendly chat with your advisor can help identify cost reduction options. Be aware that your advisor is exposed to conflicts of interest and is most likely not a fiduciary, so some independent spade work is required if you’re serious about reducing account costs.
Don’t assume that a higher price means higher performance or lower risk. Research on mutual funds has shown that higher-cost funds generally underperform lower-cost funds because the fund managers have difficulty creating sufficient value to mitigate the additional expenses.
First, check if the type of account you have is suitable for you. A fee-based account is not suitable for everyone. Ensure you are not paying trailing commissions and an advice fee. Mutual funds held in a fee-based account should be F-class (trailing commissions stripped out).
Second, check if the dealer can sell you a range of competitive securities or is licensed to sell only proprietary in-house mutual funds. If only proprietary mutual funds, your portfolio will not have the optimum portfolio holdings due to the restricted product fund shelf and investment strategy options like shorting and limit orders will not be available unless the dealer is licensed to sell all types of securities.
Third, seek out lower-cost mutual funds and ensure they are in the series that is the best one for you. Mutual funds are frequently offered in different series/share classes. The funds’ objectives, management, and underlying investments are identical across all classes, but each series may have different expense ratios, minimums, or both. Typically, the larger the amount invested, the lower the fee.
Next, consider alternative securities such as low-cost Exchange-Traded Funds (ETFs) or direct indexing to meet your portfolio needs. Direct indexing can help optimize after-tax returns. An Index mutual fund is cheaper than an actively-managed fund.
Finally, consider changing dealers to one that better matches your needs and objectives. You can choose between full service, discount, Robo advisors, fee-for- service and mutual fund dealers. You may want to engage with a financial planner who will treat your financial needs holistically, including insurance and taxation.
Bottom Line
Stock markets are unpredictable and volatile. You can’t control the markets, but you can control the impact of costs (and taxes) on your portfolio. The lower the costs of investing, the greater proportion of an investment’s return an investor can retain.
The Total Cost Reporting initiative will provide a very useful tool to help investors better manage their accounts and portfolios.
Ken Kivenko, PEng (retired), President , Kenmar Associates,
kenkiv@sympatico.ca, www.canadianfundwatch.com