We keep hearing about financial literacy from regulators, media and policy makers. But does it actually affect our lives or impact the way our money is managed? We try to find out the answers to some of these questions using the consultation paper released by the PFRDA.
Some of the startling facts from the report include:
- 90.2% of working Indians with cash incomes were unaware of a mutual fund as a vehicle of investment
- Less than 5% could give an accurate description of the mutual fund concept
- No New Fund Offers (NFOs) from AMCs would enter the market in the past without the promise of a 7-8% commission to the large distribution chains
- More than 20% customers of 8 insurance companies (out of 16) have allowed their insurance policies to lapse
Well, we cannot attribute specific reasons for these facts. However, familiarising the retail investor with the product features, ensuring a clear understanding of the risk-reward trade-off and the fees charged to the clients will create a fair ground for extending financial services in the country.
India has a rapidly expanding High-Net worth-Individual (HNI) and middle class population which requires comprehensive financial planning. The gross domestic savings are at a healthy rate of 37.7%. Mutual fund investing by households has more than doubled from 3.7% in 2006 to 7.80% in 2008. This shows that people are moving away from traditional options like fixed deposits to mutual funds in order to earn a better return.
The report discusses how a poorly counselled product can cause consumers to lose faith and prevent them from reaping its benefits. Poor practices and a lack of proper advice will ultimately hamper the financial services industry and the people who provide these services. Over 3 million insurance agents, mutual fund advisers and bank officers (selling non-banking investment and credit products) reach out to 188 million people. The number is not enough to support the financial planning needs of HNIs and retail consumers. Distributors need to go beyond the mere sale of products and consider holistic investment planning. Bringing in a professional approach will enhance the client-adviser relationship and enable advisers to charge a reasonable fee for their efforts.
The report highlights the practice of charging the consumers very high fees during the initial years of investment for long-term products like insurance and pension. Typically, the investment horizon of an insurance policy spans over 10 to 20 years. High front-loading of commissions is allowed by The Insurance Act, 1938 whereby commission for the first year can be a maximum of 40% of the premium. Suppose the first-year expense for the policy is 40% and your policy gets lapsed. In order to make some gains, your plan must surpass the 40% returns within the first few years. So, when the policy gets lapsed, the consumers fail to recover even their initial expenses, let alone their capital.
The entire issue of transparency between the provider of financial products, the intermediary distributing the product and the end-consumer is very well explained through an example in this report.
There are three participants in a transaction –
- A (manufacturer)
- B (agent) of A
- C (customer)
When B gets paid by A for services offered to C, B will be prone to take into consideration the interests of A, instead of C. This tendency can be averted if B benefits by rendering services to C rather than A. Hence, SEBI has come up with the recent regulation for no-load mutual funds from 1 August 2009. The move was followed by IRDA mandating a 300 basis cost cap between gross and net yield. Though, the report states that the primary issue of charging the customer heavy fees at entry point, called as front-loading, still persists.
IOSCO (the International Organisation of Securities Commissions) focuses on the guidelines and the code of conduct of insurance associations and regulators:
- A set of compliance exams
- A system of continuing education
- A process of registration
- A process of regulatory filings
- An ongoing system of monitoring
- A system of compliance that the adviser will follow
- Well-defined enforcement procedures
- Punitive action
Another way to bring in accountability is to make C well aware of the pros and cons of the products. Unless C completely understands asset classes, markets and products with regards to C’s earnings, expenses, savings and liabilities, then the problems arising out of mis-selling cannot be avoided. According to an OECD research report titled ‘Improving Financial Literacy: Analysis of Issues and Policies’ released in 2005, “A financially literate population promotes economic growth and well-being by expanding the quality of available financial services, and by enhancing the ability of individuals to more effectively use the services in their best interests.”
The report speaks about setting up of Financial Well-Being Board of India (FINWEB), which will have order and literacy as its twin mandates:
- Common minimum standard of regulation for retail financial advisers that cuts across regulators, products and markets
- A state-led, national-level effort in financial education
The committee recommends a Self Regulatory Organisation (SRO) system for agents, advisers, banks, post offices, financial planners and retail chains. Plus, all financial products should have a no-load structure by April 2010. Further, suggestions include documenting the entire sales process, customer profile and reasons for product selection. The committee also mentions punitive action and redress system. Another interesting aspect is the work proposed through the financial literacy cell.
The mutual fund industry has witnessed exponential growth (see Chart 1) in assets in the last decade.
source: AMFI, 31 March 2009
source: AMFI, 31 March 2009
However, this growth has seen limited retail participation (see Chart 2) unlike developed countries like the US where the household share in mutual funds is around 45%. Also, saving for retirement was one of the household’s financial goals for 95% of mutual fund–owning households in US. In addition, more than 75% households indicated that retirement saving was their primary financial goal (source: Investment Company InstituteFebruary 2009). This trend has yet to catch up in India. The recommendations offered by the committee will definitely streamline the intermediary business in India. On the other hand, the availability of financial products to the retail investor will speedily occur only through the various distribution channels. Although, the recommendations seem to improve the way financial products are being sold, it does not lay down the roadmap for reaching out to the public and generating financial awareness. Thus, the industry and the regulator need to evaluate how effectively and simultaneously the twin goals of regulation and financial education can be achieved.