A radical, far reaching prescription for financial services
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It is no secret that financial awareness is low in our country, and many issues can be traced to this. One of this is mis-selling, which is fairly widespread because of financial illiteracy and also due to customers’ own apathy towards personal finances.
There has been some regulatory tightening to ensure that mis-selling is reduced and that customers are not taken for a ride. Now, there is a new initiative to curb mis-selling and rationalisation of incentives in financial products in the form of the Sumit Bose Committee report. The report primarily focuses on mutual funds and insurance.
If some of its provisions are implemented, it will greatly benefit the investing public. Consumers at large have been bearing the brunt of mis-selling and have lost huge sums of money in the bargain. Many people have been sold low yielding insurance policies, for every conceivable goal.
The committee report specifically dwells on what is mis-selling (which is selling a product not suitable to the customer in terms of financial situation, risk tolerance, investment objective and so on), as well as its causes. It correctly flags remuneration and how it is offered, as a cause for mis-selling. Remuneration on products alters the distributor’s behaviour in favour of pushing the one that offers the most commissions. The timing of remuneration (front-loaded or back-ended) also significantly influences distributor behaviour on product selling.
Incentive structures can also be a factor in mis-selling. The report observes that this needs to be aligned with goals and their tenors. If products offer upfront incentive for long tenored products, mis-selling can happen. Availability of multiple products with diverse incentive structures allows agents to choose one that gives them the highest commissions upfront. To modify the behaviour of agents, incentive structures and their timings needs to dovetail with customer requirements. It also specifically prohibits companies dipping into future expenses or their profit/capital.
Banks are one of the main participants of mis-selling, the report pointed out. The main problem is that banks use their clients’ privileged banking information to pitch products. This is gross misuse of information. Banks should only perform banking functions. All their product sales should be done through a completely different entity which cannot access data of banking clients. This will address the problem of misuse of privileged client information and will create a level playing field for other product sellers. The report, however, does not address this point.
The suggestions are radical in certain ways—they focus on function rather than form. Functions defined are: insurance, investment and annuity. The report suggests that the lead regulator should fix the rules of the game—the Securities and Exchange Board of India (Sebi) for investment components, Pension Fund Regulatory and Development Authority for annuities, and so on. This will ensure that there is no regulatory overlap and there is uniformity across products in terms of costs and commissions. It will also remove any future altercations on jurisdiction. This is a good way to remove regulatory arbitrage and bring the focus back to customer needs.
Another major suggestion is that the investment portion would have no upfront commissions and would follow an assets under management (AUM)-based trail model across products. Upfront commissions would stay only on the pure risk components in insurance products. This is another radical suggestion that tries to remove distributor-behaviour-distorting commissions. This would mean that insurance products will become a lot cheaper.
Flexible exit options with limited costs, too, have been suggested. Lapsation or exit costs are not to accrue to product providers. All these are lacunae in existing products the report is trying to plug.
A big problem customers face is on return expectations. The committee report suggests that returns on investment should be disclosed at the point-of-sale as a function of amount invested (as opposed to based on sum assured or premium). Also, many times, customers do not have access to important information—product costs, returns, benefits and holding period—which are usually a part of long, convoluted documents. This study, hence, suggests disclosures in a crisp form that could be understood by customers.
The importance of documenting the sale process was stressed upon. Proper documentation needs to be maintained to ensure that client goals, financial situation and risk tolerance have all been taken into account, before suggesting a suitable product. Merely taking a signature on benefit illustration does not ensure the product being aligned with the client’s requirements.
The report calls for no upfront, and a level or reducing trail in mutual funds. This can induce churning. In fact, it should be the other way round. It should gradually increase till, say, five years and stay at that level from then on, to disincentivise churning. Also, mutual fund expenses have crept up. There is a proposal to do away with the incentive for beyond top 15 (B-15) cities. Association of Mutual Funds in India has also proposed a phased withdrawal of this, which is good for the consumer and the industry. Fund houses and distributors should increase the pie dramatically and earn more, rather than earn higher commissions per unit of sale.
The report recommends upfront commissions in insurance just on the mortality portion and trail commissions on investments, which it suggests should be level or declining. Though this is a good suggestion, in my opinion, the trail here too should start small and increase over the years and stabilize at a higher level for the rest of the period, to naturally wean away distributors from churning.
The Sumit Bose Committee report has the potential to radically transform the landscape of financial product distribution. It will make the financial services landscape far more responsive to needs of customers, curtail mis-selling, increase transparency and even bring down costs for customers. Overall, this is a very transformative effort. Let us hope it sees the light of the day.
Suresh Sadagopan, founder, Ladder7 Financial Advisories.