DSCs in seg funds risk poor consumer outcomes, say regulators

The Canadian Securities Administrators’ (CSA) decision to prohibit the use of deferred sales charges (DSCs) in mutual funds across all provinces by June 1, 2022 has been widely hailed as an important step forward. Still, that left an opening for some errant registrants to engage in regulatory arbitrage by selling segregated funds with DSCs, which are technically under the purview of insurance regulators.

But that appears to be changing after a joint declaration late last week from the Canadian Council of Insurance Regulators (CCIR) and the Canadian Insurance Services Regulatory Organizations (CISRO).

“Segregated fund contracts and mutual funds are products with certain similar characteristics, including some compensation and fee structures,” the two said in a joint statement last Thursday. “The CCIR and CISRO are of the view that there is a high risk of poor consumer outcomes associated with DSCs in segregated fund sales and this form of sales charge is not consistent with treating customers fairly.”

‘We were pleasantly surprised’

While the CCIR and CISRO acknowledged the risks of potential conflicts of interests and misalignments of costs and services provided in using DSCs for seg funds, as well as regulatory arbitrage, they didn’t say they’re banning the practice yet. Instead, the insurance regulators “[urged] insurers to refrain from new DSC sales in segregated fund contracts in line with the June 1, 2022 ban in securities,” adding that they expect a transition to stopping such sales by June 1, 2023.

For Ken Kivenko, President of investor advocacy group Kenmar Associates, the ban couldn’t come soon enough.

“We were pleasantly surprised to hear the announcement,” Kivenko says. “We submitted, letters, analyses, research, and anonymized cases showing the harmful effects of DSC seg funds. I don’t know if that’s what prompted the announcement, but we have to compliment the regulators for acknowledging they’re unsuitable, and saying they’ll take care of it.”

Kivenko notes that while the DSC ban for mutual funds is set to take full effect on June 1, the products will still cast a six-year-long shadow for investors. Investors who buy funds sold before that deadline will be subject to the normal DSC schedule for those products, he says, which means unless they wait until 2028 to make redemptions on those products, they run the risk of paying charges unknowingly.

While he anticipates some firms will follow the CCIR and CISRO’s guidance and stop issuing DSC seg funds on their own, Kivenko expects the insurance industry will get a fair runway before a hard prohibition is enforced, similar to how securities dealers were given a lengthy transition period between the CSA’s adoption and the full effectivity date of the ban for mutual fund DSCs.

That’s a reality also acknowledged by FAIR Canada as it expressed its own approval of the CCIR and CISRO’s announcement.

“FAIR Canada is very pleased to learn that insurance regulators are addressing this important investor protection issue and doing their best to sync up their ban with the CSA’s ban on mutual funds,” Jean-Paul Bureaud, Executive Director at FAIR Canada, said in a statement emailed to Wealth Professional. “Understandably, the insurance industry will need time to transition, but it is a significant development for financial consumers in Canada.”

FAIR Canada has not seen data on the number of guaranteed investment funds (GIFs) offered with DSC sales options, how the sale of such products has changed over the pandemic, nor how much Canadians have paid in DSCs for seg funds. But Bureaud believes those who purchased those types of GIFs during the pandemic may have thought they were buying products without sales charges, only to discover later on that charges would kick in if they sell before their schedule is up.

“Given the income squeeze on many Canadians caused by the economic slowdown during the pandemic, it is likely that many Canadians got a rude awakening when they tried to get their money out,” he said.

Is the writing on the wall?

The CCIR and CISRO announced plans to launch a joint consultation later this year on upfront commissions in sales of segregated funds. Aside from understanding the impacts of a complete ban of upfront commissions or other measures that could be adopted to improve consumer outcomes, the regulators hope to assess the potential impacts on all stakeholders including consumers, intermediaries, and insurers, and what would be a reasonable timeline for the industry to adjust to any other changes.

“[The consultation] will also serve as a checkpoint for the industry to provide a progress update with regard to ending the use of DSCs for new segregated fund contract sales,” the two regulators said. Until then, they said they’re open to engaging informally with stakeholders on both DSCs and other upfront commissions as they relate to segregated fund contracts.

For Kivenko, the announcement was a good sign that Canadian insurance regulators are starting to work closely with their counterparts in the securities space. But beyond that, he sees a need for more cooperation to protect investors, specifically between Canada’s Ombudsman of Banking Services and Investment (OBSI) and the Ombudsman for Life and Health Insurance (OLHI).

“Until about five years ago, OBSI and the OLHI were able to cooperate with each other closely on complaints. But now, if a consumer submits a complaint related to an investment account with a seg fund in it, OBSI has to send the seg-fund portion of it to the OLHI,” he says. “It’s a complete violation of modern portfolio theory. You can’t look at a portfolio in pieces. You have to see it as a holistic view.”