Real Returns. Ask the right questions on commissions

While choosing between financial products, most investors pay attention to their returns, safety, taxes and exit options. But there’s one critical element that you must not leave out of the equation — commission structures.

Often, it is the commission structure that decides which product gets sold to you and which does not. Commissions also tell you if a product is designed to earn you a good return or for the company selling it! Therefore, before signing up for any investment product that is being pitched to you, here are three specific questions to ask.

Despite competing for the same investor’s wallet, Indian financial products operate on widely different commission structures. On traditional insurance plans (all policies that are not market-linked), agent commissions can go up to 40 per cent in the first year, 7.5 per cent in the second and third years and 5 per cent in subsequent years. This commission is calculated on the premium you pay. On unit linked insurance plans, first year commissions can go upto 10 per cent with 1-3 per cent paid each year on renewal. While traditional plans are not subject to any regulatory cap on total expenses, the regulator limits the total cost on ULIPs at 3 per cent for 10-year plans and 2.25 per cent for longer term plans.

Mutual funds usually function on a combination of an upfront commission and an annual trail fee. The trail fee, calculated on the NAV, accrues to the agent as long as you stay with a fund. Whether a scheme pays higher upfront commission or higher trail fees depends on the category of the scheme and the policies of each fund house. But note that SEBI bans upfront commissions on mutual funds paid out of the investor’s money. Therefore, upfront commissions in MFs are paid by the fund house and do not come out of your pocket. Equity funds typically pay anywhere between 1 and 6.5 per cent as upfront commission, with trail fees ranging from 0 to 2.5 per cent (of the NAV). Debt funds pay upfronts of up to 3 per cent and trail fees of 0.75 to 1.25 per cent. But the overall expenses for MFs are capped by SEBI at 2.5 per cent annually; so no matter how a fund structures its commissions, they cannot be higher than this limit.

What about commission structures on fixed income products? Well, commissions on post-office products are at 0.5 per cent of the amount invested. Of the suite of post office products, the Public Provident Fund and Senior Citizens Savings Scheme alone earn no commission. Corporate fixed deposits pay 1-3 per cent upfront with riskier firms paying more.

All this tells that even products meeting the same need can have vastly different commission structures. A pension plan from an insurance company may pay the agent up to 40 per cent of the first year’s premium as commission. But the National Pension System (NPS) allows only 0.25 per cent of the investment. A close-end NFO may earn the agent a 6 per cent upfront commission, but an old open end fund may earn him nothing — the entire fee may even be a trail fee.

This should tell you why banks or other distributors are so keen to sell you NFOs over older funds, traditional plans over ULIPs or insurance pension plans over the NPS.

The quantum apart, structuring of the commission is also critical. The structure can decide whether the distributor’s interest is aligned with the investors’. It also has a bearing on the returns you ultimately earn. There are two aspects to consider here.

One, for the investor, an upfront model may lead to churn. If a distributor earns all his commissions upfront, his interest is best served by making you buy new products frequently.

A full-upfront commission may also prompt the agent to stop servicing you once the product is sold.

Two, if the commission is upfront, a part of your cheque is not even getting invested in the first place. Therefore, you lose out the power of compounding.

It is the 35-40 per cent upfront commissions in traditional insurance plans, for instance, that contribute to such poor returns from them.

If the commission is reckoned on the NAV or value of the portfolio (as with ULIPs and MFs), a part of your final returns on the investment are shared with your advisor. Thus, if the product creates considerable wealth, the commission you end up paying can be larger with a trail fee than with an upfront fee.

But your advisor getting rich right along with you may be quite a good thing, because it guarantees you the right advice.

Of course, from an investor’s point of view, the best commission structure is the one used by post-office schemes or the NPS. You pay 0.50 or 0.25 per cent on your initial investment and then forget about it.

A final question you must ask, once you have understood a product’s commission structure, is whether there is a plan that allows you not to pay it.

Mutual funds offer direct plans under all of their schemes, where you do not incur any commission payout. Insurance companies sell online plans where the commission component is cut out. Here, the choice must depend on the kind of product you are looking for and your own level of financial awareness.

In the case of standardised products such as term insurance or liquid mutual funds, the choice of plan may not make a big difference to returns. In such cases, you may as well go direct.

But in equity funds, if you aren’t financially savvy, product choice may make all the difference to your returns. Here, go direct only if you know exactly which fund to invest in.

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