Industry Trends 31st October 2014
How about introducing a growth commission?
Vijay Venkatram, Managing Director, Wealth Forum

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Large sections of the distribution fraternity are very concerned about AMFI's proposal to do away with upfront commissions. Such a move is seen as a death blow for small IFAs and a huge entry barrier for new entrants - both of which are anti-growth. Wealth Forum delves into the background of AMFI's proposal to understand the likely shape of things to come and attempts to define the potential problems of eliminating upfront commissions a little more accurately rather than making sweeping statements. From this problem definition comes a potential solution that can hopefully achieve both the objectives that the regulator has in mind : reduce churn and mis-selling on the one hand while fostering growth on the other hand. Read on, consider our proposal to introduce a growth commission and share your thoughts on whether this concept or any version of it is worth taking forward.


AMFI's discussion paper on eliminating/reducing upfront commissions has created quite a flutter within the distribution community. Representations have been made to AMFI by distributor associations and we are witnessing a lot of discussions and debates on the merits or otherwise of discontinuing upfront commissions.

From what we understand, this move is not entirely initiated by AMFI. It appears that SEBI has done some plain talking with AMFI's top brass in a recent meeting and expressed in no uncertain terms its displeasure on escalating upfront commissions and potential rise in mis-selling as a consequence. AMFI, we understand, has been advised to either take action as a trade body, or see regulatory intervention, if it fails to do something on its own.

An indication of just how serious SEBI is about this is the fact that AMFI, we understand, was gently reminded that upfront commissions are anyway not payable by AMCs vide SEBI's June 2009 circular. So, what does the June 2009 circular actually say? Here is an extract from SEBI circular dated 30-Jun-2009:

"4. In order to empower the investors in deciding the commission paid to distributors in accordance with the level of service received, to bring about more transparency in payment of commissions and to incentivise long term investment,

it has been decided that:

a) There shall be no entry load for all mutual fund schemes.

b) The scheme application forms shall carry a suitable disclosure to the effect that the upfront commission to distributors will be paid by the investor directly to the distributor, based on his assessment of various factors including the service rendered by the distributor."

http://www.sebi.gov.in/cms/sebi_data/commondocs/imd_cir_3009_p.pdf

Going down memory lane

Most of us in the industry remember this circular as the one that ended entry loads. Many have perhaps forgotten that the same circular also specified that upfront commissions, if any, will be payable only by investors directly to distributors, based on their own assessment of service rendered. AMCs were not supposed to pay upfront commissions from 1st July 2009. There is no specific circular that rolled this back - hence the position for the last 5 years has remained that AMCs cannot pay upfront commissions. Since the circular is silent on trail, trail commissions can continue.

In the immediate aftermath of this circular, upfront commissions stopped for a while. Then we had an "informal arrangement" guided by SEBI under its erstwhile Chairman, where 1st year commissions were capped at 1.25% (any combination of trail + upfront, so long as total 1st year commission did not exceed 1.25%). With a change of guard at SEBI 3 years ago, this informal arrangement effectively got scrapped and market forces took over. After SEBI put more money into AMCs pockets through its August 2012 reforms, upfront commissions in recent times have gone back to levels that prevailed when entry loads existed.

When we go overboard, we invite regulatory intervention

As always happens, when things get stretched beyond reasonable levels, we invite regulatory attention, and this is what has perhaps happened now. The sword of a ban on upfront commissions has always hung over the industry's head over the last 5 years. It appears that this sword is now being brandished, and the leeway that was tacitly available, is now being shut.

Given this background, it would be surprising if AMFI finally decides to continue with the current commission structures. Changes are inevitable, especially since the industry has been rapped on its knuckles for going overboard on upfront commissions, upfronting of trail and any other nomenclature which effectively puts substantial commissions into the hands of distributors immediately on concluding a sale. Whatever be the confabulations within the industry, one thing looks quite certain : the yawning gap between 1st year commissions and subsequent year commissions will become much narrower. Under the "informal arrangement" of a 1.25% cap on 1st year commissions which was guided by the previous SEBI Chairman, the gap between 1st year and subsequent year commissions was 0.5%, since most fund houses opted for a 0.5% upfront and a 0.75% trail structure. A gap of 0.5% is perhaps not large enough to induce churn. But a gap of 2% or more - which is where we currently are - is surely quite lucrative to induce churn. If we got ourselves back into the pre 2009 era in terms of upfront commissions, and expected no regulatory intervention - despite a circular which explicitly bans payment of upfront commissions by AMCs, perhaps we were getting a little too ambitious.

High upfronts will most likely go - time to align with this eventuality

High upfronts look like an endangered species right now - doomed to become extinct in the near future. Whether this will be replaced by low upfronts capped at a level found acceptable to the regulator or an outright ban on upfronts - we will know shortly. Shrinkage in upfront commissions will almost certainly happen, and distribution will need to realign to this emerging reality. One way of looking at this is that we had a few years unofficial window that was opened despite the 2009 circular - which should have been utilized by distributors to realign their business models. Those who used this window and realigned, are well positioned when this unofficial window closes. Those who haven't, will need to go through a painful adjustment process now. The silver lining, if one were to look for one, is that business volumes are improving - higher volumes can compensate to some extent the pain of lower 1st year margins.

2 main objections against ban on upfront commissions

There are two main objections that have been raised against any move to cut / eliminate upfront commissions.

  1. That it will be a death-blow to small IFAs who depend on upfront commissions to fund their expenses, and

  2. That it will prevent new IFAs from coming into this business, as income in the initial years will be too low to make it an attractive business proposition.

Reality is perhaps a little different

The reality perhaps is a little different. More than size, the impact really is a function of how large your gross sales is as a percentage to your existing AuM. The larger this percentage, the higher is the negative impact of a shift to an all trail model. Here is a simplistic set of numbers, as an illustration:

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In all five cases A to E, we have assumed an existing AuM of Rs. 10 crores (you can make it 1 crore or 100 crores - the mathematics won't change - only the absolute numbers will vary based on size). We have assumed a current brokerage structure of 2% upfront and 0.6% trail from 1st year onwards. In other words, 1st year brokerage of 2.6% and subsequent years at 0.6%. In the all trail alternative, we have assumed a 1% trail and no upfront commission.

The difference between the 5 alternatives lies in the New sales % to AuM - gross sales of full commission products as a percentage of your existing AuM. If this figure is at 40%, you lose a lot of money in a switch over to an all trail model. If the figure is 10% - ie gross sales in a year at Rs. 1 crore on a total book of Rs.10 crores, you stand to gain from a switch to an all trail model. As mentioned before, the mathematics remains the same irrespective of size. If you had a 1 cr AuM and gross sales of 40 lakhs, you are a loser in a switch to an all trail model (total income will reduce from Rs. 164,000 to Rs.100,000). If on the other hand you had gross sales of 10 lakhs on an AuM of 1 crore, you will benefit from a switch to an all trail model (total income will increase from Rs.86,000 to Rs.100,000).

A caveat - this is a simplistic model, meant only as an illustration. In reality, there will be another income stream which has not been factored in - some 1st year trail on new business - the quantum of which will depend on whether the new business is fresh assets or rotation of existing assets and how many months in the present year these assets have earned 1st year trail. We have not included this in the above table, as it will needlessly complicate the illustration, as the variables are too many.

So, who is the real loser in an all trail model?

If this is the math, who really stands to lose and who stands to gain in a shift to an all trail model?

  1. Distributors who are on a high growth path - who are adding significant AuM each year through substantial net sales, will receive lower remuneration in the initial years. So long as they are growing rapidly, they will earn lower commissions in these high growth years if they shift to an all trail model. Once their high growth phase slows down - as it inevitably will - they will earn substantially higher income in subsequent years through a larger trail on an enhanced book. A shift to an all trail model would in some form be a growth tax that is paid at present, which gets reimbursed to you, with interest, in subsequent years. This growth tax is an issue - as we clearly want many more distributors to be on a high growth path - for the sake of rapid growth of the industry. Ideally, we should be incentivizing growth, not punishing it.

  2. Distributors - big or small - who have a high gross sales as % to AuM and whose AuM is not growing appreciably (loosely referred to as the churners), will be big losers in a shift to an all trail model. If they are not really adding net new assets into the industry, perhaps they won't find too many sympathizers for their cause.

  3. Distributors - big or small - who have low gross sales relative to existing assets will be beneficiaries of a shift to an all trail model. While this means that distributors who don't churn will be beneficiaries - which is a good thing - it also perhaps means that distributors who are not growing much will stand to benefit more than those who are growing rapidly - at least in the short run. That's not a very positive message to put out into the distribution fraternity.

Can we consider a growth commission?

So, what can we do to blunt the impact of this growth tax - which is an unintended consequence of a shift to an all trail model? A simple suggestion is for all fund houses to agree on providing an AuM growth incentive that is paid out based on a distributor's net sales performance in the previous year at an industry level. Lets call this a growth commission. While a scientific model will need to be evolved after careful thought, the principle could be that a tiered structure of growth commissions can be created based on net sales performance at an industry level in the previous financial year.

A distributor whose net sales of equity and hybrid products (full fee products) was say above 40% of AuM (this could be a high growth player or a new entrant) can get upto 2% growth commission in the present financial year on all new sales of such products. Going down the scale, you can have say 1.5% for somebody whose net sales as % of AuM was above 30%, 1% for the 20% tier and 0.5% at the 10% tier. A distributor who was at 2% growth commission for a year can slip to 0% in the next year - if his net sales numbers were poor. You get growth commissions only when you help the industry grow - not when you only rotate existing assets. The slabs can be fixed at an industry level as caps - upto 2%, upto 1.5% etc - and AMCs can either pay out the max rate permitted within the cap or a lower level, based on business economics. Keeping a cap will however prevent excesses, which is necessary to prevent abuse.

A small distributor who is growing well (net sales above say 20% of existing AuM) will get a healthy growth commission so long as he grows. Likewise, a new entrant can in the initial years aspire to hit the top slab every year (net sales > 40% of existing AuM) and take home a growth commission of 2% in addition to the higher trail of the all trail model. As his business grows, he is likely to slip down the tiers of growth commission - but by then, he would have built up some AuM that earns him a healthy trail under the all trail model.

The structure and the numbers will need careful consideration - but the idea is that growth champions and new entrants (who are also growth contributors to the industry) get some form of a growth commission which blunts the adverse impact of the growth tax we spoke about. Mature businesses will anyway benefit from a shift to an all trail model. The only segment which therefore stands to lose is the churners - which is perhaps the way it ought to be.

Is this nothing but upfront commission under a new name?

Is this re-introduction of upfront commissions in another name? I don't think so. Upfront commissions that induce churn and mis-selling is what the regulator is against - and rightly so. Growth commissions that incentivize those who have established a track record of bringing in net new money into the system is fundamentally different from upfront commissions on gross sales for distributors of all types - growth champions or churners. Its time to reward one category and disincentivize the other. Upfront commissions don't do this - growth commissions can potentially do this. A growth commission that is a top up on a higher trail of the all trail model should surely motivate the right thinking distributors to strive harder to grow. Is this too much of a cost for the fund industry to pay? Perhaps not, considering that it has been paying vast amounts as upfront commissions - and not growing anywhere commensurate to its payouts.

If the fund industry sees merit in this thought process, it can refine it, plug loopholes, make it water-tight - and then present this as an alternative to the regulator. The regulator is clearly pro-growth - and therefore should logically be open to considering such a thought process, if presented properly.

What do you think?

Do you think this though process of a growth commission is a step in the right direction? Can it adequately address the unintended consequences of a shift to an all trail model? Will it motivate you to grow your assets? Will growth focused small IFAs find this as an attractive and fair proposition? Will new entrants get sufficient cashflows in their initial high growth years to make this an attractive business proposition? How should this thought process be refined further to make it more effective? Share your thoughts with the industry by posting your comments in the box below - its YOUR forum!


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