To fee or not to fee? That is the question

October 12 2010 by Ellen Roseman

After the financial crisis of 2008-09, governments around the world started looking at ways to make the investment business more ethical and transparent to consumers.

Some countries are changing the compensation system for financial intermediaries. Instead of allowing product providers to pay commissions to product sellers, they want consumers to pay sellers directly for their services.

Embedded commissions are hidden from consumers and represent a conflict of interest that makes financial advice less reliable.

Suppose you’re buying mutual funds and don’t know which ones to choose. Your advisers may urge you to buy funds that pay them better commissions. Stock funds, for example, are more lucrative than bond funds.

Mutual fund sellers may push their own house-brand funds at the expense of other equally good funds. Or they may push you to borrow money to invest, thus increasing the assets they manage and their commissions.

Life insurance sellers also earn commissions from product sellers. They can make more money on cash-value and universal life policies than on term life policies. So, guess which ones they prefer to sell?

The compensation structure for financial advisers is not yet an issue in Canada. But it’s a high-profile trend elsewhere. Britain and Australia are both moving to ban commissions in the next couple of years.

I recently moderated a panel discussion on fees versus commissions, which included British and Australian industry representatives. They both said that financial advice would be more objective if consumers paid for it out of their own pockets. See story here.

What about better disclosure of conflicts? That’s the Canadian approach. Right now, securities regulators are planning to make a short document available by law to all mutual fund buyers at the point of sale.

Disclosure doesn’t work, the two foreign reps agreed. People just don’t read the documents they’re handed and often don’t understand them anyway.

Canada should start talking about fees and commissions, since the issue is not going away. Consumers will want to follow other countries’ examples.

Financial advisers can’t call themselves professionals and accept payments from product providers — without betraying the trust of clients who rely on them for unbiased advice.

P.S. There’s something wrong with the comment link in the post below this one (“Looking for your Responses”). So, please post your comments here.

13 comments

  1. bylo

    Oct 12 2010

    Re Gary Gorr’s analysis:

    These days, few advisors charge any load, let alone 2%, on front end load funds.

    That’s because under the front end (FE) model, they get paid a trailer of 1% per year rather than the 0.5% they get under deferred sales charge (DSC).

    In Gorr’s example, with a $250k portfolio, that means the
    advisor gets $2,500/year and more as the size of the portfolio grows.

    Using Gorr’s numbers, after 20 years the advisor is earning an “annuity” of $10k/year!

    Another way to look at it, at an average of $5k/year after
    20 years, the advisor has made $100k off the client, or nearly 10% of their portfolio. And that’s without any front end load.

    If an advisor proposes to charge a FE load on top of the higher trailer, especially on a sizable portfolio, I’d recommend that the client run, not walk, to another advisor.

  2. EB

    Oct 13 2010

    Thank you for writing the article “To fee or not to fee?”,

    I am an advisor and strongly feel that the fee based model you wrote about is the best way to provide truly impartial advise.

    I hope that over time, articles like yours will help educate people so that they can make better, more informed choices.

    I thought it was both ironic and sad that it was an Investors Group rep (Mr. Regan) that defended the old way so strongly.

    You were kind enough to not point out that Investors Group advisors are notorious for pushing their in house DSC funds or the fact that Investors Group funds are very pricy.

    So again I say bravo.

  3. MDB

    Oct 13 2010

    Hi Ellen, just read your article on the fees associates with investing.

    The commissions paid on the sale of mutual funds in Canada is not the issue at hand. The big problem is with the MER.

    Take it from someone with 30 years in the industry, Canadian simply are not capable (or refuse to believe) of grasping just how MERs work.

    This I can tell you from having sat across the table from not only my own clients, but also from potential clients, whom I was trying to win over.

    Just to set the record straight, a mutual fund investor loses 60-80% of their total lifetime return because of MERs.

    The MER, remember, does not include many other costs associated with the management of a fund. The biggest omission is the stock and bond trading fees.

    On a typical equity fund, the stock trading fees will take another 1-2% away from the investor.

    John Bogle, over at Vanguard, also makes a valid point with regard to the lost cost opportunity of money because of the fees associated with mutual fund investing.

    On a Canadian equity fund with an MER of 2%, you can add on another 3% premised on the aforementioned. So in total the investor is on the hook for 5% up front on Canadian equity funds and in the range of 6-7% on international funds.

    Let us not forget segregated funds, where the investor is losing in the range of 8-10% in fees.

    When you compare that to the fact that the NYSE has returned around 7% on average since inception, one can see the problem at hand.

    Now, back to my original point. I would pull out a prospectus and show the investor the MER and explain how it was applied.

    My clients would glaze over, not wanting to understand this issue. If everyone they knew invested in mutual funds, that made it okay with them.

    Some perceived that a regulated product sold by a licensed broker could do no harm.

    Others just had a complete lack of wanting to comprehend the dynamics of investing (this despite the hour and hours I spent with them, just like when they were in school, they chose to not pay attention).

    I could never understand how such an easy product feature was incomprehensible to investors.

    When it came to investors from other brokerages coming in, I truly believed that despite the prospectus in hand, they thought I was misleading them in order to discredit their advisor.

    They would look me in the eye and say that they were not charged the fee (MER). The only fee they would ever comment on was their annual RRSP trustee fee.

    Mutual funds, here we go, are a marketing ploy. They were designed from the ground up to meet the pre-existing mindset of a human being.

    Physiological studies of how an individual’s mind works when it comes to investing resulted in the birth of the mutual fund.

    Just look at the name, “mutual fund,” which implies that there is something warm, community based, generally accepted by the masses at work here.

    There is no such thing as a mutual fund, it is a stock portfolio, a bond portfolio, or some combination thereof.

    Individuals bought mutual funds because they didn’t want to directly own stocks. But in reality that is what they did. They bought a basket of stocks.

    Because the TSX is so thinly traded, the funds these individuals bought were only able to invest in a handful of companies, those with a large enough market cap to withstand their buying power.

    The act of buying 2 or 3 funds to diversify only resulted in a duplication of holdings.

    It is impossible over the long run for a mutual fund to outperform the return of the stock of the company that offers the fund for sale.

    Thus, if there is an investment opportunity at hand, it is in the ownership of mutual fund company stocks.

    What other business is allowed to levy massive fees to the owners of its products, regardless of performance, each and every quarter of the year?

    There is no tightening of the belt during times of recession, but only this massive block of consumer equity sitting being billed year after year after year.

    Other brokers would say, “I wonder how much money Michael Lee Chin makes every year.” I would open the AIC annual report and point to the management fees, which were in the hundreds of millions of dollars.

    Mike became a billionaire from the selling of mutual funds. He didn’t invest in mutual funds, he owned them.

    Warren Buffett has been quoted on many occasions showing his disdain for mutual funds. Yet many mutual fund salesman use him as an example of the buy and hold dogma out there today.

    Warren Buffett buys companies and only when the existing management team agrees to stay on board to run day to day operations. Up until the recent fire sale in the equity markets, he hadn’t bought a stock in over 20 years.

    In closing, may I state that mutual funds are a zero sum game for the investor for the reasons which I have stated and a number of which I haven’t.

    The only winner here is the salesman. Even if you have small book of business of $10 million, it will generate $100,000 per year in trailer fees.

  4. bylo

    Oct 13 2010

    While we’re on this issue, two more egregious industry practices:

    1. Under the DSC model 0.5% of the MER is used to repay the fundco for the 5% sales commission they paid the advisor up-front. Once that commission has been amortized, i.e. when the DSC penalty period runs out after several years, there’s no longer any need to charge the client that extra 0.5% MER. What happens now is that many advisors convince their client to convert their shares from DSC to FE so that the advisor can pocket that extra 0.5% for themselves (because the trailer on FE is 1%.) What the client doesn’t realize is that there’s no justification for this. If the advisor could deliver their services for 0.5% during the DSC period they should be able to do so afterwards, especially on a now-larger portfolio. The fundcos should instead rebate that 0.5% back to the investor. After all it’s the investor’s money that’s collected via MER; it’s not the advisor’s or the fundco’s. Why aren’t regulators, who claim to represent the best interests of investors, not forcing the fundcos to stop this practice?

    2. Discount brokers offer mutual funds under the FE model so they earn 1% per year in trailers. Fundcos also offer so-called F-class shares with about 1% lower MERs because they don’t pay trailers. But fundcos won’t let discount brokers offer these shares to retail investors. Trailers are intended to pay an advisor for the investment advice they offer their clients. But discount brokers don’t offer advice. Indeed they’re prohibited by securities regulators from offering such advice in the first place. So why must investors pay this extra 1% per year embedded into their MERs when they get nothing in return? And again, why aren’t regulators, who claim to represent the best interests of investors, not forcing the fundcos to stop this practice?

  5. Gary Gorr

    Oct 13 2010

    I have some factual concerns with this article and also re some of the comments.

    Re the article:
    “Suppose you’re buying mutual funds and don’t know which ones to choose. Your advisers may urge you to buy funds that pay them better commissions. Stock funds, for example, are more lucrative than bond funds.”

    My compensation is the same no matter what fund I recommend, conservative, middle of the road or aggressive.

    I have no incentive to move clients into Equity funds because I get paid better.

    What matters most is the client’s risk tolerance and then recommending the appropriate solution tied to that level of risk.

    “Mutual fund sellers may push their own house-brand funds at the expense of other equally good funds.”

    I concur.

    “Or they may push you to borrow money to invest, thus increasing the assets they manage and their commissions.”

    This is true but borrowing has advantages for some people and makes it easier for them to accomplish their goals. It also has risks and clients should understand that too.

    However leveraging has been done by wealthy individuals and companies for years, why shouldn’t the average guy benefit too?

    Just know this: I am not a three eyed monster out to steal your kids. I have spent over 13 years in educational courses to acquire my profession’s highest designations and annually invest over 50 hours a year in professional development to stay current and serve my clients better.

  6. second opinion mike

    Oct 13 2010

    While I agree with MDB’s general comments, I am not sure about the math on total costs or the percent of value siphoned off by advisor/salespeople.

    Both commenters are very correct on the fact that the industry benefits fund co’s and sales people in a very obvious way, while benefits to investors are lagging far behind.

    Most commissioned salespeople revert to discussing their need to make a living for theiir family as a justification for the commission model, which is a way of saying they need to get theirs first and investors can have anything that’s left.

    There are good salespeople, but the industry still prevents them from being efficient and effective for clients.

  7. DIY Investor

    Oct 15 2010

    The world doesn’t understand percentages and the financial services industry has taken advantage.
    People do pay more attention however in down markets. I’ve seen people perfectly satisfied to have their portfolio up 26% when the market is up 30%! They look me in the eye and tell me their advisor did a great job!
    The tsunami wave of retirees is coming in and they want to retire but they can’t – there nest eggs have been confiscated.

  8. Bruce Loeppky

    Oct 21 2010

    I don’t understand why so many writers like Ellen Roseman who are usually NOT financial advisors continue to say embedded commissions represent a conflict of interest.

    We all see our doctors whose fees are hidden to us. The gov’t has a program where doctors charge back depending on the service rendered, but as consumers, we are mostly unaware of this.

    As long as the advisor explains how they are paid so their clients understand the system, what’s the problem?

    Canada has one of the best & most regulated security systems in the world. We do need to bring some of those organizations together to make the whole network run better, but the system is very good overall & has served consumers well.

  9. Dan Hallett

    Oct 21 2010

    Ellen – always a hot topic. And lots of good and interesting comments here – including some fair criticism of the industry.

    While the prevailing method of remuneration isn’t perfect, I’d argue that no method is. What matters is not the system but how advisors within the system conduct themselves and treat their clients.

    As to the level of costs, I note that regulatory costs continue to rise and many of them are charged on a % of asset basis. Otherwise, I’ll point to two recent articles that address a number of issues discussed above.

    http://thewealthsteward.com/2010/06/advisor-compensation-no-fee-model-is-free-from-potential-conflicts/

    http://thewealthsteward.com/2010/10/canadian-regulators-unlikely-to-ban-commissions/

  10. Bruce Loeppky

    Oct 24 2010

    I am a financial advsior & I don’t understand why writers like Ellen & even other advisors like EB try & link the giving of advice & bias or impartiality.Fund companies don’t pay me any more or less to offer Fund A or B to a client & my firm couldn’t care either,as long as the product is suitable for the client.I offer the best funds to meet a need.I don’t care if it’s Fidelity,Trimark,Mackenzie or RBC.
    EB was corect that Investors Group charges very high fees & also push leverage as one of their key ‘concepts’.The leverage concept is more about raising assets for Investors Group & the advisor than helping clients with a finacial need.

  11. bylo

    Oct 25 2010

    “I don’t understand why. … Fund companies don’t pay me any more or less to offer Fund A or B to a client & my firm couldn’t care either,as long as the product is suitable for the client.”

    There lies the rub. Some investments pay higher commissions and/or trailers than others. Most equity mutual funds pay 5% up front plus 0.5% per year under the DSC model. GICs on the other hand typically pay only 0.25% per year.

    For example, an elderly recent widow in less than good health goes to an advisor for advice about a large inheritance. If the advisor recommends equities over GICs, then they stand to make more in commissions and trailers even though for most elderly widows a high percentage of equities is inappropriate.

    Another example. A young couple goes to an advisor for help with an inheritance. They reveal that they’re way over their heads in credit card and mortgage debt. If the advisor recommends that they use their inheritance to pay off their debt, the advisor earns nothing in commissions. Yet paying off debt, especially high interest credit card debt, is likely to be the most appropriate thing for the couple to do. But the commission system provides a strong incentive (temptation) for the advisor to recommend mutual funds over debt repayment.

    No one argues that advisors don’t deserve to be compensated for the work they do. The argument is that the commission model creates conflicts-of-interest that don’t exist in other remuneration models.

  12. Dan Hallett

    Oct 25 2010

    Bylo,

    <>

    This is true but it’s true of virtually every licensed financial advisor in the country. Many financial advisors who are licensed to sell or advise on investments (and earn fees tied to the value of investments) offer pure financial planning advice for a fee by the hour.

    While not every advisor does this, many do. Accordingly, suggesting that advisors make nothing by advising to pay down debt isn’t quite correct.

    Advising clients to invest cash instead of paying down debt will also have negative longer-term consequences for the advisor, so anyone who has a longer-term perspective (and is not ethically challenged) will advise debt-ridden clients to clean up their balance sheets first.

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