Gravitational collapse and retrograde movements…is the Canadian regulatory system imploding?

OBSI, the ombudsman for securities and investments is looking to hand over the review of investment complaints involving segregated funds to the Insurance Ombudsman.

OBSI will refer the investigation and analysis of segregated funds to the Ombudservice for Life and Health Insurance (OLHI) even if they form a part of a larger portfolio that is the subject of a complaint to OBSI.

It is also looking to give up its mandate to investigate systematic issues, although the reasoning here is not exactly clear – something to the effect that because banking systematic issues need to be referred to the FCAC, in the interests of fairness investment related systematic issues should no longer be investigated.  This is an incredibly fudged and fobbed explanation.  Dealing with systematic issues was a major recommendation of an earlier Navigator report.

With regard to segregated funds:

I fail to see how you can properly assess the appropriateness of a portfolio if you exclude any significant asset, let alone a more complex insurance based investment vehicle.   To assume so is quackery.  Indeed how can either the insurance ombudsman or the investment ombudsman provide the type of necessary clear cut decision that investors deserve if they separate the allocation pie for separate analysis? 

I also wonder how so called professional organisations (Advocis) who should be preaching the importance of holistic advice (investment, pension and insurance needs should be considered in the same analytical space) would support such a juxtaposition. 

It is about time Canada moved towards centralised regulation of all components of the wealth management solution instead of hiving them off into product silos based on the assumption that investors seek transactions and not advice.   I can understand why some would like the sales process to be dumbed down, but I fail to see why those who oversee processes governing accountability would wish to do the same. 

Perhaps OBSI has had enough and has decided to avail themselves of their more onerous duties.  Working across the many different regulatory organisations and product lines without support from higher up has no doubt become impossible.   These two important developments look to me as if OBSI is hunkering down and putting the ball firmly in someone else’s camp.  

You might find it odd, though, that we have regulators supposedly looking to shake up mutual fund regulation and advisor standards in the securities world, yet at the same time allowing a big gaping back door for those who provide insurance based investment advice.  This not only compromises investor rights but is anti competitive in the market place.   In the light of this regulatory arbitrage though, one can see a rationale for OBSI’s relinquishing of seg funds: best interest standards would clearly conflict with current insurance suitability standards, which allow for a myriad of sins, making it theoretically impossible to both rule on a case and seek compensation.  I have noted at the end of this post an excerpt of a CLHIA document discussing suitability parameters for segregated fund recommendations – they are indeed very wide…

Issues regarding segregated funds

And just a short note on Canadian segregated fund issues:

These tend to be very high cost investment vehicles, especially those that look to guarantee 100% of the initial deposit and/or provide guaranteed lifetime withdrawals.  

These guarantees come at a price, lopping off the dividend return and often a good deal of the capital return, but most of the damage is done by the underlying costs of fund ownership.  The insurance riders, especially in lifetime withdrawal products, add insult to injury.  The guarantees, the costs and the opportunity costs tend to make them inflexible and illiquid investments, especially in low interest rate environments.  

A lower cost investment vehicle would be able to accumulate dividend and interest return even in a declining market, or distribute it, while the high costs of segregated funds prevent the benefit of either for segregated fund holders.  In other words, the crude risk management of these vehicles is to a very large extent obviated by the costs. 

If we were to regulate insurance under the same umbrella, allow insurance advisors to recommend a broader selection of products and raise the professional and regulatory standards, the suitability window for these products narrows significantly.   And this is why the OBSI decision is both facilitating and acknowledging regulatory arbitrage

If you have an ordinary portfolio and you have a significant seg fund component, allocating to this portfolio should be complex and, hence, why it is necessary for the review of the segregated component to be included in the overall review.  

You think you have an equity allocation but in reality you have a zero return illiquid investment at the lower bound and a high risk low return equity investment at the upper bound – the costs of these vehicles pretty much eat up the long term historical risk premium of equity investment. 

Most investors would be better off allocating to low cost fixed interest and equity investments, even during significant risk events, providing the portfolio is structured to manage significant risk events.  And this is the rub!   Advisors who use seg funds either do not know how to manage risk through portfolio structure and planning, and/or are not allowed to use other more appropriate securities and products.   

If you have an illiquid and significant segregated fund holding, and you are dependent on your assets for your financial needs, you will need more liquidity and  income from your other assets.  You may be forced to increase the allocation to lower risk fixed interest and cash based investments.  This leaves you with the worst of both worlds: lower return high risk equity investments that are unable to distribute and support the portfolio and a skewed allocation to lower risk assets to compensate for the short term income and liquidity deficiencies of the vehicle.

The even more complex guaranteed minimum withdrawal benefit plans further complicate the issue – these are investments that are effectively permanently illiquid once added to a portfolio.   They can cost up to 4% per annum a year, and, with their constraints on access to capital without penalty, are even more illiquid and inflexible.  They make many promises which cannot realistically be met by virtue of their cost structures, and the worse case scenarios they use as arguments for their rationale have already been shown to place the financial viability of life insurance companies at risk.     If a low risk guaranteed investment product that mitigates longevity risk is considered necessary then there are other options to consider.  

Asset and liability modelling and management is a complex area and one which would clearly benefit from higher standards and getting rid of transaction remuneration right across the Canadian product board.  

CLHIA parameters for segregated fund suitability

And finally, it is worthwhile looking at the parameters that the CLHIA consider for determining the suitability of this product, for indeed they are very wide:

Some markers that can be used in a preliminary assessment as indicators that an IVIC is a suitable product include:

• professional and/or entrepreneur: may indicate a need for creditor protection
• older: may indicate a need for probate by-pass
• conservative investment profile: may indicate a need for guarantees
• large estate: may indicate a need for privacy, probate bypass
• approaching retirement: may indicate a need for income guarantees

Sample Questions – This list is intended to stimulate effective fact finding strategies, not set out minimum areas of enquiry.
• Do you have life insurance?
• Do you need creditor protection?
• Do you have any dependents?
• Are they involved in your financial decisions?
• Do you have goals for your money after you die?
• Do you have a will?
• Are you concerned about the ability of your heirs to manage their finances?
• How much money will you need when you retire?
• Are you comfortable with market fluctuations?
• Are you comfortable with the risk that you could lose some of your original investment
• Do you like to make investment decisions?
• Do you want your beneficiaries to get their money quickly?
• How important is privacy to you?
• How long do you plan to hold the investment?
• What do you plan to do with the money in the future?

Other references

CLHIA Material for Financial Advisors

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