The Norwegian fund market was rocked to its foundations when Sbanken, an internet retail bank, announced that it would return all retrocessions (kickbacks) to its customers.

The typical retail investor is not well versed in the dark arts of financial advice. Most likely he is unaware that his adviser makes ten times more money by recommending the most expensive fund versus the least expensive. This type of conflicted advice is the norm rather than the exception in most of Europe. Alas, unlike other product categories an expensive price tag seldom translates into higher quality. In fact, in the world of investments, it usually works the other way: the more you pay, the less you earn.

Read our report: Ban Kickbacks for an in depth analysis.

The ultimate conflict of interest

The key driver behind the disconnect between the adviser’s and customer’s financial well-being is called retrocessions, or kickbacks as it is more commonly known. They are the same thing as commissions or inducements: the customer pays the fund provider who passes on roughly half of the fee (the retrocession) to the adviser or distributor. In other words, advisers get an incentive, in the form of cash, for recommending a particular  fund or particular product to a consumer which is given to him by the fund manager as a reward.

Credit: Finance Watch

Both the UK and the Netherlands have banned them. Unsurprisingly, customers there now enjoy the lowest fund charges in Europe. In spite of the Anglo-Dutch  success story, Europe’s other regulatory bodies seem inclined to let the free movement of kickbacks continue.  

The fund providers are the chief beneficiary of this conflicted advice model.

An industry which delivers such poor returns to investors continues to function the way it does in large part because of the kickbacks on offer for advisors. It is therefore probably naïve to expect market forces to step in where the authorities won`t. 

To be fair, MiFID II (the Markets in Financial Instruments Directive) has made it difficult for advisers to pretend to be independent and receive kickbacks at the same time. Now only non-independent advisers can receive third-party payments. In addition, advisers need to justify the kickbacks by explaining how the consumer gets a better service as a result. These are usually loosely-defined, quality enhancing services. Most, but not all, players seem to interpret this as a licence to carry on as if nothing has changed. However, in Norway cracks are beginning to show in the walls of the industry fortress.

The battle of Norway

After the introduction of MiFID II, DNB (Norway’s largest bank and fund provider) was the first player to make a move on the industry’s pricing model. The bank’s interpretation of the new EU regulation was that the current structure and level of retrocessions could not comply with the new rules. The kickbacks impaired the ability to act in the best interest of customers and did not match what could be explained by “enhanced quality.”  

In February 2019, DNB therefore tried to get the rest of the industry to accept and create a new class of funds with a uniform retrocession level of only 0.15 percent. This modest fee was designed to cover what DNB believed was its true cost of distribution. The industry reception was dismal and the proposal was more or less dead on arrival.

While DNB was regrouping to figure out another way to move forward, Sbanken struck at the heart of the industry model.

Sbanken is an internet bank with a history of challenging the established players. In 2009 it was the first Norwegian distributor to stop charging entry and exit fees on funds.  After some initial resistance the rest of the industry followed suit.

In August 2019 Sbanken shocked the industry again by handing back all retrocessions to the customers. Instead it charged a flat fee of 0.3 percent on actively managed funds. The bank explicitly stated that it wanted to contribute to a price war on funds and compared its competitors to vultures.

©Sbanken fund advertisement

Overnight almost all of the 400 funds distributed by the bank became significantly less expensive. Customers who previously paid two percent in annual fees suddenly got away with one percent plus the 0.3 percent distribution charge.

As could be expected this move created strong resistance, especially from fund providers with a significant chunk of the volume in direct sales to retail investors. Convincing customers to buy something which is more expensive than the same product which is a few clicks away is always going to be a hard sell.

Thus, the price cuts by Sbanken have presented the competition with a rather unwelcome damned if you do, damned if you don’t predicament. Either accept that a distributor sells an identical fund at a lower price or cut the price themselves. If they continue to sell their funds at their old price they will lose customers. If they cut prices to stay competitive they lose revenue from the “loyal” customers (or more likely customers not paying attention).

The Empire Strikes Back

Of course, a third option is to create contractual or other obstacles to prevent the distributor from undercutting their prices. There are indications in Norway that fund providers are reducing the level of kickbacks. This increases their own margins at the expense of the distributor, but leaves crumbs in terms of lower prices for the consumers.

This illustration shows how the Norwegian pricing model may evolve if unchecked. Fund providers with a significant share of direct sales are offering distributors lower commissions in order to prevent them from undercutting their direct sales channel. The result may end up in squeezing out independent distributors and ending up with only vertically integrated fund providers.

We believe that Sbanken is moving in the right direction, but find that their new model at best is an intermediate step towards a ban on retrocessions and the emergence of clean share classes with no embedded retrocessions.

The resistance to change from a large part of the competition shows that a ban is required to end conflicted advice across the board.

Consumers who take the time to understand the market may migrate to new pricing models and enjoy lower prices. However, in our opinion a sizable number of customers will remain within the current pricing model and continue to overpay for tainted advice and distribution.

Retrocessions are an unnecessary evil and should be banned across Europe.

Read our report: Ban Kickbacks for an in depth analysis.

This is how it works: the adviser recommends a fund to the customer who invests 10.000 euro. The customer pays the fund provider an annual fee of let`s say two percent. The fund provider typically splits the fee in half and pays the advisor one percent (100 euro) of the amount the customers invested. If, on the other hand, the adviser instead recommends an index fund with 0.2 percent annual fee he will receive a retrocession of a paltry 0.1 percent (10 euro). It is fair to assume that an adviser who routinely chooses to prioritise his customer’s well-being over his employer’s soon will find himself out of a job.

Arne Thommessen works at Forbrukerrådet, the Norwegian Consumer Council, on financial issues.

Posted by Arne Thommessen