Intermediation in the distribution of financial products

When it comes to investing or buying a stock or a mutual fund or an insurance product, most of us tend to rely on our financial advisors, brokers, agents etc. These are all referred to as ‘intermediaries’ – persons or entities that ‘intermediate’ or provide a link between ourselves and the providers of the financial products – i.e. banks, mutual funds, insurance companies etc. All such intermediaries are, naturally, required to be compensated for the services they render.

Have you ever wondered who pays for the compensation to such intermediaries? And how? How is the level of compensation set? Can you avoid paying for such a compensation? Is it advisable for you to do it?

This article discusses the various aspects related to this area.

What are the different ways of compensating the intermediaries?

There are different types of intermediaries who are involved in the distribution of financial products. These include web-aggregators, agents, brokers, financial advisors, employee sales force etc.

Various financial institutions may refer to each of these intermediaries by different names. However, at the very basic level, the functions performed by these intermediaries are the similar – i.e. to reach out to prospective customers; analyse the customer needs; provide the right product that meets the customer needs; and provide help in completing the paperwork required to sell the product.

These are important services that are rendered by the intermediaries because they help you decide on the ‘right’ product to be purchased / invested in and also help generate business for the financial entity. For such valuable services provided, these intermediaries are compensated. Their compensation is ultimately borne by you as the investor – either directly or indirectly. For example:

What is the ‘right’ level of compensation and who sets it?

This is a difficult question to answer. As a principle, the ‘right’ level of compensation is something that is commensurate with the efforts put in and costs incurred by the concerned intermediary.

For example, a web-aggregator may need to be compensated for the IT infrastructure created by him, enabling you as the investor to compare products of different providers, and making an informed decision.

Similarly, an individual insurance agent may need to be compensated for his time in reaching out to the customers, performing a need-based analysis and providing a door-step service to the customers in issuing and servicing of his / her policy.

However, as you can imagine, each individual intermediary may be different and therefore it would be impossible to arrive at the compensation that is exactly commensurate with the time / effort involved and the costs that may be incurred by the intermediary.

Given this, it is typically the provider of financial products who decide on the level of compensation to be paid to the intermediaries. This, in turn, also considers the limits placed on such compensation by the various regulators in the financial services industry. Consequently, there may be some uniformity in the level of compensation offered to the intermediaries of providers of a given type of financial product.

Can you avoid paying for such a compensation to the intermediaries?

The short answer is – yes!

Almost all providers of financial products now also offer customers the ability to buy various products ‘directly’ – without going through any intermediary. For example:

Life insurance

• You can buy life insurance products online – on the website of the insurance company itself. This would avoid you incurring any costs associated with any intermediary.
• However, there may be a restriction on which products can be bought directly as not all products may be suitable to be bought online – for which, one has to go through one of the intermediaries.
• There may also be restrictions on size of the policy that can be purchased online. Policies with sums assured beyond a certain level might require medical tests and as such can’t really be issued online.

Mutual funds

• You can invest in a mutual fund through a ‘direct’ mode. This would allow you to maximise your returns.
• It may be noted, however, that going through a bank or an entity specifically set up to provide online / direct investment access to investors would not amount to you having invested directly! For example, investing in ‘ICICI Prudential Mutual Fund’, by going through ‘ICICI Bank’ or through ‘ICICI Direct’ does not amount to you having bought the mutual funds directly. You may need to buy them directly only by going to the website of ICICI Prudential Mutual Fund itself.

In case of investment in equity shares / stocks, however, one has to necessarily go through an intermediary. Although there are online portals claiming to provide you services at ‘zero’ intermediation costs, there may be other features of such a model which mean that their intermediation costs are indeed recovered from you - indirectly. Again, there can never be a free lunch!

Pros and cons of going ‘direct’

It is tempting for an investor to avoid going through an intermediary and buy the financial product ‘directly’ instead. And why not? Afterall, this would mean that the investor may save on the intermediation fees, which in turn, would result in a higher return on his / her investment.

However, before jumping into buying the product directly, one may need to consider the following:

However, if one is convinced of having the necessary knowledge, skills and the time to analyse the financial product concerned, it may be worthwhile going ‘direct’ instead of going through an intermediary.

Conclusion

A vast majority of us do not possess detailed understanding of various financial products. Until we develop this, one may need to rely upon the intermediaries for their advice. Of course, this does not mean that one should blindly trust such intermediaries – you may need to ask various questions to make sure that you understand the nuances of the product you are investing in!

However, for those who do wish to avoid the intermediation costs, the providers of financial products make available facilities to invest directly. This, if done with full knowledge of the underlying product and its risks, may help enhance the overall return on your investment.