How Do You Pay for Your Investment Advice?

Many individual investors have no concept of the fees they are paying for the advice they are given. It would surprise many if they were told their Advisor could earn five times as much recommending mutual funds over guaranteed investments such as Bonds, GICs or Savings Bonds. These inherent conflicts have given way to new programs that provide an alternative method of charging for services that will allow for unbiased investment advice. First a review of the standard practices in the investment world.

There are currently three main ways of paying for investment advice:

Hidden Fees

Mutual funds charge an average fee of over 2.6% . This charge is hidden and is a combination of sales charges, management fees and other costs of running the fund. If you purchased a “load” fund on a deferred sales charge (DSC) basis and you sell it before seven years, an extra charge on top of the 2.6% will be charged.

Commissions

A commission-based relationship is structured in away so that you pay for every transaction. Mutual funds are in a sense commissioned-based as some funds pay a large (hidden) fee to the advisor when you buy the fund, but here we are referring to stock or bond trading where you pay for each sales/buys transaction.

Fee-based Programs

There are many types of fee-based programs with the simplest definition being a program in which the client can see the fees being charged. Fees vary, usually depending on the size of the investment portfolio and in most cases are based on a percentage of the assets under management. There are fee-based planners who charge an hourly fee for service, but they generally provide a specific Financial Plan or service, and leave the actual purchasing of the investments to another individual/company.

What is Best For You?

There are two main points to consider when deciding what is best for you:

1) Total cost and

2) Potential conflicts of interest (asset bias).

Consider a 2.6% fee over 20 years will eat up 40% of your potential returns and you know you should focus on lower fees. The second point is a big one. Is there an asset bias in your relationship where your advisor gets paid significantly more for investing you in more volatile equities than safe fixed income? This is not to say that commissioned-based advisor should not be trusted but just that you should be aware that this could be the case.

Mutual funds were designed so smaller investors could gain access to diversified, managed portfolio. The reality is until you build your portfolio to a larger size, $100,000 , you are probably going to be using the commission-based relationship with mutual funds. There are programs that are fee-based for less than $100,000 but they tend to be a variation on buying individual mutual funds and the fees are not reduced.

Once your portfolio grows, you should look at the benefits of a fee-based relationship, listed below.

• Fees are visible, and more flexible i.e. can be reduced

• If a flat percentage fees is charged on all the investments, the asset bias is removed and the only way the advisor makes more money is to grow your portfolio.

• Improved tax-efficiency. Fees for non-registered assets are typically deductible against income, which can result in significant savings for high-income clients.

• Different strategies can be implemented such as indexing and the use of “F-Class” mutual funds. “F-Class” mutual funds remove the sales charge and trailer fees from the mutual fund to reduce the overall cost of the fund.

• Generally included the development of a retirement plan at no addition cost.

• Other charges and services may be provided at no cost i.e. no-charge cash management accounts and fees waived on RRSP account.

• Fee-based products basically have no up-front or deferred sales charges, which allow more flexibility for both the client and the advisor, in terms of making strategic investment decisions and rebalancing.

• You have retained a professional for questions other than just transaction-oriented conversations.

The drawbacks of fee-based relationships are:

• Fees are visible. Okay, it’s a benefit, but consider over the years that equity markets and your portfolio value drop, you will keep seeing these fees coming out of your account. In some cases ignorance is bliss, but consider if you owned mutual funds, where you don’t see the fees, you would probably be paying more in fees and you do not have a chance to deduct the fees charged on your non-registered accounts.

• Some clients assume they will have less contact from their advisor since they get paid whether they call or not. This assumes that the service/contact you were getting in the first place was good. Warren Buffet, one of the wisest investors I know of, was quoted in the 1996 Annual report of Berkshire Hathaway as saying “Inactivity strikes us as intelligent behaviour”. Too much activity usually means the portfolio was set-up incorrectly or it is active for the sake of activity. Regularly scheduled meetings solve this contact concern.

• Clients may end up paying more in fees than they currently are in commissions. If you traded stocks infrequently and do not have a portfolio approach to investing, paying a fee on assets will probably increase your total cost, so this may not be in your best interest. But be aware that an un-diversified portfolio may be more costly than any reasonable fee charged by an Advisor so weigh the advantages on the whole program not just the trading cost.

Fee-based relationships continue to grow at an extremely high rate. Why such growth? By tying compensation to the asset base, this product sends a clear message to the investor that the Advisor is on their side. More disclosure of the total cost charged to an Investor just makes sense and it allows for fair comparisons to different types of investment programs.

To contact Mark Williams, visit his professional profile page at this link