Financial Services Consumer Alliance
May 27, 20165160
5160 Yonge Street,
Box 85 17th Floor Toronto,
Ontario M2N 6L9
Reference: Segregated Funds Working Group Issues Paper May 2016
The Financial Services Consumer Alliance is an informal alliance of consumers and experts in the financial industry who are dedicated to protecting consumers in any transactions involving the financial industry. Our structure and access to unprecedented expertise allows us to comment on the commercial practices used by the financial industry with objectivity and without fear of censorship or reprisal. As you will see in our recommendations below, we will be providing a viewpoint on segregated funds that will be unique and maybe controversial.
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1) Missing guarantee in the CCIR Paper
After reading the CCIR paper on segregated funds, we discovered an IMPORTANT oversight in relation to the guarantees of segregated funds. The CCIR paper lists 2 exiting guarantees for segregated funds; the death benefit guarantee and the capital guarantee. There are in fact 3 types of guarantees offered by segregated funds. The missing guarantee which is becoming the most important is the income guarantee whereby you can annuitize a segregated fund to receive a guaranteed payment usually over 20 years and usually being a payment equaled to 5% of the value of the guarantee per year.
CCIR should recognize that as a consumer approaches retirement, for most Canadian consumers, they are NOT looking to protect their capital but are in fact looking at protecting their future retirement income. Some consumers may decide to forsake their capital in exchange for a source of guaranteed income. This is what happens when a consumer buys an annuity.
We believe that the segregated fund with the income guarantee, because of the complexity of this guarantee, is where more regulations and a lot more disclosure are particularly needed. As a result, it should be included in the CCIR paper.
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What are segregated funds? Why are consumers buying them? Why are licensed representatives selling them? These are complex questions. However, they should be answered simply from a consumer point of view.
Segregated fund is an insurance contract. It is amazing how many people working in the financial industry do not understand this fact. When I was at Maritime Life, at the beginning of my career, I was working in the consumer service department, and a large amount of my time was dedicated explaining to financial institutions why we could not proceed with a transfer of the segregated fund to a self directed RRSP…
A segregated fund is an insurance contract offering an investment vehicle and an insurance component linked/insuring that investment. The insurance component is required by law with the obligation on the insurer of offering a minimum of 75% guarantee for the segregated fund contract to be considered a contract of insurance instead of a securities contract.
As consumers, we expect the regulations, supervision and disclosure applying to the investment vehicle of the segregated fund to be aligned with mutual funds. In addition, we expect to have a separate set of regulations, supervision and disclosure applying to the insurance component of segregated fund. The set of regulations, supervision and disclosure will have to vary by type of guarantees.
Segregated funds are complex products and there is no way possible that the regulations, supervision and disclosure associated with this product be simpler than mutual funds.
Why are people buying a segregated fund? The answer should be obvious. It is because they want to insure a risk they are not willing to take.
For example, a financial planner prepares a retirement plan. Based on the savings of his client, the client must achieve a minimum rate of return of 6% to achieve his retirement goals. When you add the average MER of a mutual fund, the gross return that must be achieved is between 8.5 to 9%. Most advisors would therefore recommend that a lot of risk be taken by investing fully in an equity investment. What if the consumer can’t because his risk profile is conservative and he does not want to lose some of his capital? Based on the risk profile, the advisor would have to recommend a less risky investment such as a balanced fund which would provide potentially less return (in a bull market) but more return (in a bear market).
This would mean not achieving the retirement plan objectives. The other alternative would be to insure the risk on the capital that the client is unwilling to take in the hope that the additional potential return provided by a bull equity market would be worth more than the cost of the insurance/guarantee on the capital.
Comment 1: The existence of the guarantee under a segregated fund modifies the risk profile of the client allowing him to take more risk that what he would usually be allowed to take. Segregated Funds should therefore have a 2 steps KYC. The first step is a KYC aligned with a KYC for a mutual fund and the second step is a KYC annex providing an insurance need analysis with a disclosure statement stating that the client understands he could be taking additional risk by selling this risk to an insurer.
This principle is recognized in other financial products such as mortgages. You have conventional mortgages and insured mortgages. Both products are mortgages. However the insured mortgage, having insurance against default, allows the lender and borrower to borrow above the 75% threshold. As a result, if a borrower puts a 25% down payment on a property he is deemed to self-insure the risk of default. However he could decide to instead use that down payment in his business by borrowing 95%. He would have to buy insurance to do this. His mortgage would be more expensive. Does this mean the insured mortgage is less valuable than a conventional mortgage because of cost? No, it depends to the objective and circumstances involved. The client would have to analyze the cost and benefits of the 2 options and decide what is best for him.
This is what a consumer should be able to do with a segregated fund but is unable to do. Guarantees have their cost embedded in the MER and are seen as an investment cost. When compared with the MER of a mutual fund, the MER of the segregated fund seems noncompetitive. This is wrong. It is time that this practice is stopped. Apples should be compared with apples; oranges with oranges…
This is why we believe full and separate disclosure for each component of segregated funds is very important. Currently, because of lack of disclosure on segregated funds, consumers are unable to determine what they are insuring and the value of the insurance they are buying. This is because of lack of disclosure with a) Cost of the guarantees and b) Amount of the guarantees.
Adding disclosure, we believe, would in fact allow consumers to judge fairly the value of segregated funds offered by insurers. It would foster the right competitive environment bringing more competitive segregated funds to the marketplace. If consumer understands the value of segregated funds, they will be willing to pay for it. If they are willing to pay for it, insurers will be willing to offer them. We believe that the right disclosure environment would foster a very competitive marketplace and would in fact influence insurers in reintroducing segregated funds with a 100% capital guarantee which is a product and a guarantee that consumers want, need and should have access to.
1 What enhanced disclosure of charges and other compensation for IVICs would encourage intermediaries and consumers to examine more closely the products recommended and purchased?
Comment 2: We believe that a segregated fund with a 75% guarantee (not taking into account the death benefit guarantee) is the investment equivalent of a mutual fund. But how can consumers see this?
We believe that the charges for the various types of guarantees should not be embedded and hidden in the MER of the investment. The process has already started when Manulife introduced the income guarantee in its product INCOME PLUS where the cost of the guarantee of .75% was separate of the MER. We should not give too much credit to Manulife for this change, since it was not done for the sake of proper disclosure, but was done because the .75% applies to the value of the guarantee and not the value of the investment, and therefore the .75% could not be embedded in the MER. However we believe this type of disclosure is a good change and it should be applied to all guarantees.
As a result, the cost of the death benefit guarantee and cost of the capital guarantee should be listed separately allowing the consumer to see how much each guarantee will cost. Knowing the cost, the consumer would be able to judge this cost against the potential risk insured; deriving the value of the guarantee which would allow the consumer, with the help of an advisor, to compare the value offered by the guarantees of the segregated funds against other alternative strategies to mitigate risk.
For example, the death benefit guarantee cost is .25% and the cost of the 75% capital guarantee is .1%. If the MER of the equity investment offered by the segregated fund is 3%, currently, the consumer would not know what he is paying for as everything is embedded in the MER. He only knows about the 3% MER. He does not know what part of the 3% MER applies to the investment and what part applies to the guarantees.
With the new changes to the disclosure, the insurer would have to disclose the death benefit guarantee cost of .25% and capital guarantee cost of .1% separately which would mean the insurer would have to disclose an MER of 2.65% for the investment. This would allow the consumer to fairly compare the investment cost of the segregated fund against the mutual fund. If the Mutual Fund MER is 2.25%, the insurer and its representative would have to explain to the consumer why its investment is more expensive by .4%
After looking at the cost of the investment, then the consumer would be able to review the cost of the guarantees of .35% and the value offered by these guarantees while comparing this cost against other self insured strategies available under mutual funds.
Comment 3: Disclosure of the investment of segregated whether it is commission or charges should be aligned with mutual funds. Disclosure on guarantees of segregated funds should be separate and designed to allow the consumer to decide between insuring a risk or not insuring a risk.
- How else might better disclosure and transparency be achieved by the IVICs industry?
We believe that disclosure and transparency are directly related to how segregated funds are distributed. Currently a mutual fund representative can only be attached to one dealer. In the insurance industry, the insurance representative can be attached or contracted through multiple intermediaries called MGAs or distribution channels (i.e dealing with an MGA and signing a contract directly with a specific insurer).
We see this practice as going against consumer interest. There are NO positives for the consumer for this state of affairs. This leads to reduced compliance and supervision. The advisor must become knowledgeable with multiple operational systems and processes which is impossible to achieve; leading to increased errors or omissions.
Finally it increases the chances of conflicts of interest and the impact of soft dollar arrangement since the commission of the insurance representative offered by each MGA will be dependent on the sales made with each MGA. Managing 2 sales quotas will result automatically in a conflict of interest.
- What would be the most effective method of ensuring that IVIC consumers were aware of soft dollar arrangements and other sales incentives?
We believe that an advisor who chooses to be remunerated on a commission basis versus fee basis has a responsibility to disclose all sales incentives in addition to commission. A fee based advisor would be prohibited to accept sales incentives.
The problem is that unlike mutual fund, the distribution of IVIC varies a lot.
The manufacturer/insurer can directly contract the insurance representative even if the representative is autonomous. The insurance representative can also deal through an intermediary and in fact select multiple intermediaries. Finally the representative can be captive and not independent. Sales incentives will vary greatly by distribution channel. We believe however that the representative who represents himself as being independent should be held to a higher standard when disclosing or avoiding conflict of interest. It would be the responsibility of the independent agent to make such disclosure or avoid such situations.
For a captive agent, who is a commissioned employee of the insurer, where the block of business is ultimately owned by the insurer, the duty of disclosure would fall under the responsibility of the insurer. Such disclosure would have to include any arrangements where the insurer allows the captive representative to sell the product of another insurer through an MGA owned by the insurer of the captive agent while compensating the captive agent negatively and on an arbitrary basis if he sells the product of another insurer. Under this type of arrangement, the captive is heavily influenced monetarily in selling the segregated fund of his insurer versus the segregated fund of other insurers.
- How should insurers make sure that soft dollar arrangements and other sales incentives do not create conflicts of interest for intermediaries?
Sales incentives and soft dollar arrangements are intended to drive sales and thereby by definition create a conflict of interest.
For captive agents, the responsibility is clear and it is the responsibility of the insurer or its branch to ensure that no conflicts of interest exist or such conflicts of interest are disclosed.
If the representative is independent, then the question is whether it is the insurer who should be responsible or whether it should be the MGA. We believe it should the MGA as it is closest to the representative. However the MGA should be offered an environment where it can succeed by forcing a representative to contract only with one MGA.
When an independent representative contracts directly with an insurer then it would be the responsibility of the insurer to limit conflict of interest. I was not at all impressed with Manulife Direct Channel when it started to offer Manulife shares incentives to its independent representatives contracted directly with the company. Such sales incentives should never be allowed.
- How should account performance reports for IVIC contract holders be harmonized with those on the mutual fund side? What adjustments could be made to take into consideration IVICs’ guaranteed protections?
As stated before investment performance excluding the cost of guarantees should be harmonized with the mutual fund side. Cost of all guarantees should be disclosed separately from the MER.
We believe this would be the first step in protecting consumers when a segregated fund is replaced with a mutual fund. Currently we have witnessed that such replacement are strictly done based on the disclosure of the MER capitalizing on the fact that segregated funds are more expensive. There is no disclosure on the value of the guarantees. This leads to the replacement of segregated with consumers losing guarantees/insurance when they are “in the money” and when they paid a lot of money for these guarantees.
The principle behind replacing any insurance is clear. It is based on full disclosure. A replacement form should be created and standardized and should be required to be signed by a consumer prior the replacement of a segregated fund.
- Are IVICs generally considered to be held as a long-term investment compared to other types of investment products?
IVIC’s are considered a long term investments because of the guarantee of capital or income. We have seen many consumers keeping a segregated fund longer because they were “in the money” in regards to the value of the capital guarantee. If they had held a mutual fund they would have liquidated that investment.
Again disclosure is very important prior a segregated fund being replaced.
- To what extent should the enhanced investment performance data requirements be harmonized with mutual fund rules?
As stated above!
- What additional data would be of value to IVIC contract holders?
Taxation of segregated funds is important as many advisors still don’t understand the difference. Please note that this is not surprising as different insurers have applied the Income Tax Act differently. This even became a Court case (reference civil case Audet against Thibault)
Any decreases to the guarantees because of a withdrawal should be clearly disclosed on the annual report with the information showing how such decrease was calculated.
The way guarantees are reduced should be clearly disclosed and representatives informed and educated by the insurer. There are two ways guarantees are reduced by withdrawals; a prorate decrease or a full reset.
- What differences could be made to take into account the guaranteed protections in an IVIC?
It is important that the consumer is aware whether the guarantee is reset automatically or it has to be done manually. If it is done manually then the advisor should have a process in place to ensure that he can advise his client whether or not a reset should be done.
- Are there any reasons why segregated fund investors should not receive Fund Facts upon subsequent investment in the same fund? Please explain.
We don’t see any reasons why not.
- What risk classification methodology do you believe is most appropriate for segregated funds and how should this be disclosed?
Again there should be a risk classification for the investment component of the segregated based on the same methodology used for mutual funds. However a way should be used to integrate the guarantee of the segregated fund. The risk of an equity fund under a segregated fund with a 75% guarantee or the same investment under a mutual fund does not represent the same risk as the same fund with a 100% guarantee. While volatility is the same for each product, the end result will differ greatly.
- What should be the responsibilities of life insurance companies with respect to oversight of IVIC sales and their distribution? What factors affect the ability of life insurance companies to oversee IVIC sales?
We believe that the primary role of insurers should be the education of representatives (all distribution channels) contracted with them. Insurers should be required to spend and provide this education for free. Judges in civil cases have been clear on this issue. It is the responsibility of the insurer to educate representatives on their tools and products.
Oversight of IVIC sales should the responsibility of the organization closest to the advisor. For captive representative this would be the insurer through its branches. For the independent representative, this would be the MGA who has contracted the representative. For the independent representative who has signed a contract directly with the insurer, this should be the insurer.
- What should be the responsibilities of intermediaries with respect to IVIC sales?
The definition of an intermediary is quite large as defined in the paper. As a result we don’t see how we can answer this question
- What could the industry do to address issues with insurer and intermediary supervision of the distribution and suitability assessment of IVICs?
One of the major issues with IVICS is the service provided. This is very important as IVIC are long term investment contracts. However unlike mutual funds it is possible for unlicensed representatives to receive servicing commission on segregated funds.
First let’s deal with licensed representatives. Under the law, a licensed representative can offer financial advice on any products whether or not he is contracted with an insurer. It is also important to note an important difference between the distribution of mutual funds and distribution of insurance products. In the mutual fund industry, we don’t believe that the representative signs a contract with the mutual fund manufacturer. He signs a contract with his dealer and is able to automatically sell all funds offered by the dealer. This is not the case for insurance. Representative must sign an insurance contract with each individual insurer.
In insurance, the representative has to sign a contract with the insurer.
Let’s assume that representative A signs a contract with Insurer B. For a reason such as lack of sales, Insurer B decides to cancel the contract of representative A. Currently; insurer B has the option of not giving a servicing contract to representative A. This means that while representative A will still be able to collect servicing commission on segregated fund he sold and while still being able to provide advice (since he is still licensed), the insurer B can deny representative A access to its online platform and can deny access to any documents related to the service of the segregated fund. The client will not be informed that his representative has lost his contract with Insurer B and that such representative is unable to monitor his investment anymore. This is unacceptable.
If an insurer has signed a contract with a representative and decide to cancel such contract, this insurer should be obligated to offer a servicing contract to the representative if he still licensed and in good standing with the regulator.
Under segregated fund, unlike mutual fund, it is possible for a representative that is no longer licensed to continue receiving servicing commission of a segregated fund he sold. These segregated funds, which do not have any longer a licensed representative, become orphan policies. This is unacceptable. The industry should adopt the Quebec position which states that the existence of orphan policies is illegal. When a representative ceased to be licensed, the insurer or MGA should be required to inform the client of this fact. The non licensed representative should be given 60 days to arrange for a licensed representative to provide service for his block of insurance policies including segregated funds or the insurer or MGA will have to step in and force the sale of the block of insurance policies to a licensed representative.
- To what standard of care should individuals who advise on and sell IVICs be held? Please explain.
How can this answer be answered when consumer are still unable to determine who they are dealing with because sales representatives are promoting themselves as financial advisors? In Quebec, where this is illegal, 12,000 of 32,000 licensed representatives are breaking the law. An advisor automatically should be held to higher degree of care and standards. Nobody should be able to call themselves a financial advisor unless their conduct falls under a strong code of ethics such as the code of ethics for the Certified Financial Planner. As a consumer, I strongly criticize Advocis for a weak and useless code of ethics.
A sale representative only has to worry about the suitability of the sale he or she is making. However when you act as an advisor, automatically you are acting in a fiduciary capacity. Conflict of interest and disclosure become very material and relevant to the conduct of the advisor.
- Should the “know your client” / “know your product” standards as used in the securities sector apply to the sale of IVICs?
KYC should be required for segregated fund in conjunction with a need analysis for the insurance component of the segregated fund.
- What requirements for updating client information should apply to IVICs intermediaries?
Twice a year or if a major change occurs.
- In addition to the potential gaps discussed above, do you believe that there are other areas in which IVICs and mutual funds regulation may achieve a more harmonized outcome with respect to the fair treatment of customers?
There are many other areas which need to be harmonized:
Rebating DSC charges under segregated fund should not be an infraction meaning that it should not be an infraction for an advisor to choose to pay the DSC fees through his commission if it is necessary for the client to move to another investment. Rebating DSC fees on mutual funds is not illegal. In fact, in Quebec the situation is even more ridiculous. Not only an insurance representative is committing an infraction when rebating DSC fees but the client is also committing a penal infraction by accepting the rebated commission.
Standard of care for illustrations. It is important to note that any illustrations in regards to the results of investing into a mutual fund or segregated is wrong right from the start since these illustrations are based on a constant rate of return. It is proven mathematically that a constant rate of return which excludes volatility is not the same as the same average rate of return which includes volatility.
As a result, in most cases, illustrations using a constant rate of return overstate the illustrated results. Representatives when doing such illustrations should use a very conservative rate of return excluding MER. Basically we believe that a representative is overstating the possible returns of the investment if a rate of return is higher than 5%.
STATEMENT AGAINST the selling of segregated fund with an income guarantee which is registered under the Income Tax Act as an RRSP or RRIF.
We have become aware of a serious problem with the new type of segregated fund that have an income guarantee. When such segregated funds are converted into a RRIF, it raises the question of how the income guarantee will be impacted by the RRIF withdrawal.
There are two types of products each treating withdrawals from RRIF differently. For the first product type, the income guarantee remains the same and unchanged if the minimum RRIF withdrawal is taken. If more than the minimum is taken out, the guarantee will be decreased on a prorata or on a reset basis.
We have no problems with this type of product.
The second type of product is where the income guarantee is reduced by any withdrawals made from a RRIF whether or not the client is taking the minimum withdrawal. Please note that the client has no choice. He must at least withdraw the minimum RRIF amount under the law. After modeling this product, it has become clear that the income guarantee is worthless and can never be used when the product is registered as a RRIF.
For example, the client has a RRIF with a value of $100,000 and a income guarantee of $100,000 which means that his income guarantee is 5% of 100,000 ($5,000). His RRIF minimum rate is 10% and the client must take out $10,000. First problem is that the RRIF withdrawal is made at the end year of the previous year. Withdrawals will be made in the current year. Let’s assume the client makes the withdrawal at the end of the current year and the RRIF value is now $80,000. The client will still have to withdraw $10,000. However the prorata decrease of the guarantee will be based on the $80,000. This means the guarantee will be reduced by 12.5% and the new guaranteed amount will be based on 87,500 and the income guarantee will be 5% of this. This is quite a loss for one year only. After a few years, the guarantee is gone and totally worthless. The client has paid a .75% MER for something that could never provide any value. The insurer is committing fraud when promoting this type of product when it is registered as a RRIF.
We ask that regulators step in to protect the public and prohibit insurers to provide segregated funds with an income guarantee under a RRSP or RRIF format unless the contract states that the guarantee will not be reduced by minimum RRIF withdrawals.
- Are there other disclosures or requirements that have not been considered in this Issues Paper that would help achieve such a harmonized outcome?
We believe that regulators need to address the problem of Universal Life policies in addition to IVIC. Whatever regulations are adopted for IVIC, these regulations should apply to Universal Life where the funds are invested into an Index linked investment or linked to a mutual fund. Currently the use of Universal Life as an investment is totally unregulated with no KYC required or delivery of prospectus required…
- Please provide any other information that you believe regulators should consider regarding IVICs.
Financial Services Consumer Alliance