On 03-Jul-20, SEBI amended the Investment Adviser Regulations. A few progressive amendments included were (i) disallowing individual Registered Investment Advisers (RIAs) from distribution (ii) reserving the name Investment Adviser only to those registered with SEBI as RIA (iii) instituting client level segregation for advisory and distribution services for non-individual RIAs (iv) banning relatives of individual RIAs from distribution (v) explicitly allowing RIAs to execute orders (without direct or indirect compensation) for clients. Further under clause 15(2) of the RIA regulations it is mentioned that ALL compensation to the Investment Adviser must be received DIRECTLY from the customer who is being advised and no compensation can be received from any other party with regards to the products being advised upon. In other previous orders/circulars SEBI has steadily reduced the commissions payable on mutual funds over the years. SEBI has also mandated that mutual funds create the DIRECT route for investing – thereby providing an avenue for eliminating commissions in mutual funds. Clearly SEBI is serious about a gradual but definite shift towards a fiduciary standard in ADVICE. We hope in the years to come SEBI will deign that we are ready for a complete abolishing of all commission based products in India and mandate that AIFs and PMS’s also have a DIRECT route for investing.
The down side of the continual squeezing out of commissions by SEBI is that intermediaries/agents/brokers are being driven to products that do not fall under the ambit of SEBI – namely life insurance products. Insurance products are problematic in India for a few reasons. The agency problem (conflict of interest) is rife within the industry. Investors are clueless that the insurance products they buy have massive inbuilt commissions embedded within them. These commissions incentivise agents/insurance advisers/brokers to push insurance products that are clearly not in the interest of the investor. Let us provide a simple real life example – in which we have personally been called to advise upon. A 73 year old man is sold a policy (of 24 year term) that requires him to pay 3.28 lakh per annum for the next 12 years. After the 12 year payment term he will receive a cumulative pay-out of 74.50 lakhs over the subsequent 12 years. The policy is sold based on the following “sound” advice – Pitch 1: Over the first 12 years the total premium paid would be about 39 lakhs. In return the investor is receiving close to 75 lakhs – which is nearly double his investment. Pitch 2: The premium contribution can be claimed under Income Tax section 80C and the proceeds of 74.50 lakhs are completely tax free under section 10(10D) of the Income Tax act. Pitch 3: The pay-out is guaranteed.
Peeling the onion reveals the hard truth in this wealth destroying product. First and foremost, look at the payment term of the policy – 12 years against the current age of the investor who is 73 years – which 73 year old would expect to pay premiums well into his mid-eighties – even if the policy proceeds are intended for the next generation? Second - a straightforward IRR calculation on the cash flows of this product indicate a paltry post tax return of 4.28% over the 24 year term of this product!! Clearly when the investor has a time horizon of at-least 12 years – why should he settle for such a meagre post tax return. Even if the investor is very risk averse, the simplest of debt products such as the Bharat Bond ETF will generate a 6% post tax return over a 10 year period. Third – the policy gives very little liquidity unlike simple products such as Bharat Bond ETFs or Index funds which can easily be liquidated in the secondary markets at any point in time. An equally valid point to note is that in this case the investor was unaware that he in had already maxed out his tax deductible contributions under section 80C. Section 80C has a ceiling of 1.50 lakhs upto which premium contributions can be used to reduce taxable income.
When the investor was advised that this product is prohibitively expensive and likely involved very high pay-outs to other intermediaries – he was puzzled. He said he was only paying the insurance company premiums and no-one else. He was simply unaware that a non-trivial amount was also lining the pockets of the agent/broker selling this product from the insurance company. When the simplest of debt products - can generate a post tax return of 6% why should any product generate just 4.28% return over a 24 year period ? A Bharat Bond ETF over a similar time frame would have given a pay-out of close to 1.10 cr Rs against the total policy pay-out of 74.50 lakh Rs. A nearly 50% increase in total pay-out – that too when investing in a simple cost effective and highly liquid product such as the Bharat Bond ETF against a complicated illiquid insurance product such as this. Where do we suppose the difference in returns between the Bharat Bond ETF and a typical insurance product (such as the type described here) disappears ? The answers lies in the lining of the pockets of commission agents (north of 2% commission on an annual basis), the insurance company (mortality charges, fund management charges, administration charges, premium allocation charges) and the Government of India (Service Tax on all of the charges levied by the insurance company).
With commissions in products under the mandate of SEBI being significantly reduced, it is ironic that good regulation from SEBI is now incentivising financial intermediaries to recommend higher commission products not falling under the ambit of SEBI – namely insurance products. Section 80C and Section 10(10D) of the Income Tax act give significant concessions to certain insurance products. Ideally these insurance products should have delivered higher post tax returns to investors. However the reverse is true. All the tax benefits of most such insurance products are essentially nullified through the high commission structure of insurance products – very little benefit actually accrues to the investor. The result is that insurance products have become an aggressive sell. Clueless investors are pushed towards more complicated, expensive, illiquid , low return products – when far simpler alternatives, significantly cheaper, with more liquidity are clearly available.
The down side of the continual squeezing out of commissions by SEBI is that intermediaries/agents/brokers are being driven to products that do not fall under the ambit of SEBI – namely life insurance products. Insurance products are problematic in India for a few reasons. The agency problem (conflict of interest) is rife within the industry. Investors are clueless that the insurance products they buy have massive inbuilt commissions embedded within them. These commissions incentivise agents/insurance advisers/brokers to push insurance products that are clearly not in the interest of the investor. Let us provide a simple real life example – in which we have personally been called to advise upon. A 73 year old man is sold a policy (of 24 year term) that requires him to pay 3.28 lakh per annum for the next 12 years. After the 12 year payment term he will receive a cumulative pay-out of 74.50 lakhs over the subsequent 12 years. The policy is sold based on the following “sound” advice – Pitch 1: Over the first 12 years the total premium paid would be about 39 lakhs. In return the investor is receiving close to 75 lakhs – which is nearly double his investment. Pitch 2: The premium contribution can be claimed under Income Tax section 80C and the proceeds of 74.50 lakhs are completely tax free under section 10(10D) of the Income Tax act. Pitch 3: The pay-out is guaranteed.
Peeling the onion reveals the hard truth in this wealth destroying product. First and foremost, look at the payment term of the policy – 12 years against the current age of the investor who is 73 years – which 73 year old would expect to pay premiums well into his mid-eighties – even if the policy proceeds are intended for the next generation? Second - a straightforward IRR calculation on the cash flows of this product indicate a paltry post tax return of 4.28% over the 24 year term of this product!! Clearly when the investor has a time horizon of at-least 12 years – why should he settle for such a meagre post tax return. Even if the investor is very risk averse, the simplest of debt products such as the Bharat Bond ETF will generate a 6% post tax return over a 10 year period. Third – the policy gives very little liquidity unlike simple products such as Bharat Bond ETFs or Index funds which can easily be liquidated in the secondary markets at any point in time. An equally valid point to note is that in this case the investor was unaware that he in had already maxed out his tax deductible contributions under section 80C. Section 80C has a ceiling of 1.50 lakhs upto which premium contributions can be used to reduce taxable income.
When the investor was advised that this product is prohibitively expensive and likely involved very high pay-outs to other intermediaries – he was puzzled. He said he was only paying the insurance company premiums and no-one else. He was simply unaware that a non-trivial amount was also lining the pockets of the agent/broker selling this product from the insurance company. When the simplest of debt products - can generate a post tax return of 6% why should any product generate just 4.28% return over a 24 year period ? A Bharat Bond ETF over a similar time frame would have given a pay-out of close to 1.10 cr Rs against the total policy pay-out of 74.50 lakh Rs. A nearly 50% increase in total pay-out – that too when investing in a simple cost effective and highly liquid product such as the Bharat Bond ETF against a complicated illiquid insurance product such as this. Where do we suppose the difference in returns between the Bharat Bond ETF and a typical insurance product (such as the type described here) disappears ? The answers lies in the lining of the pockets of commission agents (north of 2% commission on an annual basis), the insurance company (mortality charges, fund management charges, administration charges, premium allocation charges) and the Government of India (Service Tax on all of the charges levied by the insurance company).
With commissions in products under the mandate of SEBI being significantly reduced, it is ironic that good regulation from SEBI is now incentivising financial intermediaries to recommend higher commission products not falling under the ambit of SEBI – namely insurance products. Section 80C and Section 10(10D) of the Income Tax act give significant concessions to certain insurance products. Ideally these insurance products should have delivered higher post tax returns to investors. However the reverse is true. All the tax benefits of most such insurance products are essentially nullified through the high commission structure of insurance products – very little benefit actually accrues to the investor. The result is that insurance products have become an aggressive sell. Clueless investors are pushed towards more complicated, expensive, illiquid , low return products – when far simpler alternatives, significantly cheaper, with more liquidity are clearly available.