Is scrapping DSCs from segregated funds the right path forward?

While some defend upfront charges, DSCs 'difficult to justify' from best-interest perspective, says financial advisor

Is scrapping DSCs from segregated funds the right path forward?

Canada’s insurance regulators have yet to officially ban deferred sales charges (DSCs) for segregated funds. But for one financial advisor, scrapping the option would make sense.

“When we look at it from the from the perspective of what's in the client's best interest, it's very difficult to justify how a DSC, or any kind of upfront charge has a place in the marketplace,” says Mehul Gandhi, managing director and senior insurance advisor at Westmount Wealth Planning in BC.

DSC seg funds under the microscope

In a statement published February last year, the Canadian Council of Insurance Regulators (CCIR) and the Canadian Insurance Services Regulatory Organizations (CISRO) said that DSC options in segregated fund contracts are “not consistent with treating customers fairly.” They urged insurers to stop selling DSC options in segregated fund contracts in line with the June 1, 2022 ban on DSCs in mutual funds, and said they expect all such sales to end by June 1 this year.

In September, the CCIR and CISRO launched a consultation on upfront commissions in sales of segregated funds, including DSCs. Some members and representatives of the industry came out in defence of DSC options.

In its comment letter, the Financial Advisors Association of Canada (Advocis) argued that because segregated funds possess different features and have different compensation structures compared to mutual funds, the evidence against DSC mutual funds can’t be applied to seg funds.

“Instead of a complete prohibition, regulators should explore measures, such as additional monitoring, to address the risks arising from the sale of these products,” it said.

Many of those in favour of DSC seg funds also maintained that taking away DSCs risks widening the advice gap. Prohibiting DSCS, the argument goes, could discourage advisors from offering segregated funds to smaller clients – households with modest savings or younger Canadians, for example – which could reduce the range of options those consumer groups can choose from.

Similar to mutual funds, DSCs in seg funds can also be useful for newer advisors to get a decent amount of compensation as they build up their expertise. While that might not be as much of a concern for salaried greenhorns, the story is very different for those trying to build up their own business from scratch in the independent space.

“There are some cases where advisors may feel the DSC option will not end up hurting their client,” Gandhi adds. “If the DSC segregated fund is in a locked-in account like a LIRA, the client is typically not going to redeem the funds for the foreseeable future until they reach a particular age. If they’re a long time away from that age, then potentially the DSCs might not seem harmful for them.”

An irreparable conflict?

For some stakeholders, a ban on DSC seg funds couldn’t come soon enough. In its comment letter, FAIR Canada recommended that DSCs in segregated funds be implemented as soon as possible.

“Research on commission structures demonstrates that DSCs distort the advice process and skew advice towards products that pay these fees, as opposed to products that best serve consumers,” it said.

The Canadian Advocacy Council of CFA Societies Canada (CAC) took the same view, arguing that the DSC option incentivizes insurance representatives to sell products and offer advice that maximize their compensation, rather than what’s best for the consumer. In its own comments, the Financial Planning Association of Canada (FPAC) took the view that no compensation structure should incentivize the sale of one investment product over another.

“To that end, it is our position that all upfront compensation, including deferred sales charges and advisor chargebacks, should be banned,” the FPAC said.

Closing a regulatory gap

Ken Kivenko, president at Kenmar Associates told Wealth Professional: “The DSC option for seg funds suffers from same mis-selling conflicts as for mutual funds. … There is no identifiable benefit to the financial consumer from a DSC segregated fund.”

With client-focused reforms and a prohibition on mutual funds already in place, Kivenko says DSCs in seg funds should also be disallowed to curtail the possibility of regulatory arbitrage.

“These days especially, any contract provision that constrains liquidity is not sound investing,” Kivenko says. “Churning could also raise its ugly head as it did with mutual funds.”

Some may argue that DSCs can help clients stay invested for the long term, as the potential pain of being charged for redeeming before the DSC period is up will make them think twice. Still, Gandhi isn’t convinced.

“Are DSCs an advantage for clients? Is it in their best interest? It's very hard to make a case that it is,” Gandhi says. “I think this is a reasonable legislation for what the regulators are trying to instil here.”

Mehul Gandhi is a Senior Insurance Advisor and Managing Director for Westmount Wealth Planning Inc. Westmount Wealth Planning Inc. is a subsidiary of Westmount Wealth Management Inc. Westmount Wealth Management Inc. is registered as a Portfolio Manager in British Columbia, Alberta, and Ontario. Mr. Gandhi’s comments are solely intended to refer to products sold under a life insurance license.