Why is it so difficult for regulators to build an incentive structure that's fair to all?
What role do incentives play in directing the flow of financial products into household portfolios? One way to answer this question is to look at data on retail financial products that have seen incentives change over the past 10 years and look at the direction of the flow of money. We can do this for two sets of investment products—pure asset management products such as mutual funds, and insurance-embedded investment products in the form of life insurance policies. There are now several data points that we can map given that privatization in mutual funds is more than 20 years old and that in insurance is 15 years old, and there have been regulatory changes in incentive structures in both products over the past decade.
Let’s look at mutual funds first. Up until 2006, mutual funds could charge investors money up to 6% of the money collected in a new fund offer (NFO). If an NFO collected ₹ 1,000 crore, the mutual fund could deduct ₹ 60 crore from investors’ money over the next five years. In 2005-06, the NFO charge netted the industry ₹ 2,281 crore (this would be recovered over five years). This was in addition to the 2.25% of the invested amount as a front load and the expense ratio of around 2%. The fat front fee in an NFO sale and rising markets combined to cause the great NFO rush from 2005 to 2008 with over 73% of the inflows in mutual funds in 2005-06 coming from NFOs. But fat front-end commissions end up in churning of investors, or the practice of sellers of retail financial products to move investors in and out of products with the sole aim of harvesting the commissions on each transaction.
Rising markets usually make investors blind to the real cost of churning, but an alert capital markets regulator clamped down on churning by banning the 6% charge on open-ended funds on 4 April 2006. The industry quickly ramped up manufacture and sale of closed-end funds, which were still allowed to charge 6%. The number of closed-end NFOs more than doubled to 24 in 2006-07 while open-end NFOs fell from 44 to 35. It took another two years for the regulator to turn off the tap on closed-end costs as well and these were banned on 31 January 2008. Closed-end NFOs have now dropped to five and open-ended continued to drop to 30 and NFO-related sales dropped to 8% of total inflow compared with 73% of inflows that were NFO-linked. Clearly, commissions were driving sales.
Next let’s look at the behaviour of life insurance products. There are two kinds of products in the market—traditional plans and unit-linked insurance plans (Ulips). Both had similar incentives structures from 2006 to 2010—an upfront commission of 40% for the first-year premium and a 100% loss of money on all premiums paid if the investor discontinued the policy in the first three years. The incentive for agents to hard sell and for companies to encourage policy lapses in the first three years were there. Investors were hard sold Ulips as money-doubling products in a rising market and then churned to harvest the entire value. The public outcry caused the insurance regulator to change incentives in Ulips, but traditional plans were largely left untouched. Front commissions in Ulips dropped to 6-8% due to the cost caps in place and the maximum the company could penalize investors for discontinuing policies in the first five years became ₹ 6,000 on 1 September 2010. But traditional plans continue with a 40% front commission and a total loss of value on early surrenders.
Now let’s look at firm behaviour. Ulips accounted for 42% of the total business in 2005-06. This increased to a peak of 70% in 2008-09, with 90% of the private company business and 62% of Life Insurance Corp. of India’s business coming from Ulips. 2011-12 was the first year after the commission structure change that saw Ulips lose market share to traditional plans—they fell to 42% of total business. The number was 7% for Ulips and 93% for traditional plans in 2012-13. LIC has moved its business back to almost 100% from traditional plans and the private sector now does more than 70% of its business selling the opaque and high-cost traditional plan that returns no more than 4% a year to the investor. That the insurance industry is manufacturing and selling a very high-cost product while there exists a cheaper and cleaner product—the Ulip—only points to the fact that incentives are driving both production and sales behaviour with little regard to investor interest. We can see this by looking at total commissions paid out by the industry, which has remained between ₹ 15,000 and ₹ 19,500 crore per year from 2008-09 till 2013-14, no matter what product was being sold.
While we can argue about savvy investors shifting between products as markets change, the data clearly shows that incentives drive manufacturing and sales behaviour. This becomes a very serious issue when the product is financial. Financial products are invisible; they are created while being described by the seller to the buyer. The moment of truth is far away, unlike a biscuit or a car or even a telecom service.
Why is it so difficult for regulators to build an incentive structure that’s fair to all three parts of this market—manufacturers, agents and investors? The capital markets regulator has kept pace with events and proactively looked at incentives to nudge firm behaviour. The insurance regulator needs to do the same. It must end arbitrage within the industry between Ulips and traditional plans, and make both transparent and comparable in costs.
Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at firstname.lastname@example.org