Fees and Commissions - how your investment advisor is paid (updated)
Guaranteed Investment Certificates (GICs)
A significant amount of my income is derived from bank deposits and GICs.
I find the best interest rates from dozens of banks and trust companies. I get paid a finder's fee from the issuing financial institution for placing the deposit with them. The client pays no fees or commissions for buying GICs. Please note that the finder's fee is not deducted off the client's interest rate. The client gets the full interest rate each and every time.
The funds that I offer can be sold on either a front-end basis, back-end basis or low-load basis. The "low-load" option is similar to a back-end fund except it has a shorter time duration. A front-end load refers to an upfront commission paid by the client to the investment advisor for the purchase of mutual fund.
The front-end load, is a percentage of the amount purchased. Although a fund's prospectus allows for front-end loads of 4% or more, the fee is actually negotiable between you and your advisor. The current trend for the last decade or so has been to not charge any commissions at all for these fund purchases. Why is that? Why would an adviser not want to earn a commission? The reason is straightforward. Most advisers are quite happy to reduce costs to their clients and are quite happy to just earn the trailing commission they receive from the fund company to service your account. Also, I should mention that if you buy a mutual fund on a front-end basis, unlike selling a stock, you do not pay a commission or fee when you sell your fund.
In most cases, you can also buy the same fund on a back-end load basis. In this method you do not pay any fee or commission to acquire the investment. Although you do not pay any commissions to buy a fund on a back-end load basis, if you decide to sell your fund within seven years or less, you will have to pay the fund company a declining exit fee. You do not incur any exit fees after this seven year period is up. In other words if you stay with the same fund company for a full seven years there are no fees to buy or sell. Most fund companies will also allow you to withdraw 10% of your investment annually without any exit fees. If you sell your fund within the seven year time period, the fee that is charged depends on the length of time the fund was held. The exit fee declines typically from 6% in the first year to 0.5% or 1.0% in the last year. Back-end funds were very popular in the late 1980's and the 1990's as they enabled investors to avoid a front-end commission. However over the years, many advisers have gradually reduced their front-end commissions to zero which has reduced the popularity of the back-end option.
If a fund is purchased on a back-end load basis, the advisor commission is paid by the fund company - usually around 5% but his annual service fee compensation is less. A back-end load (DSC) trailer fee is 0.5% annually versus 1% on a front-end load fund.. The advisor does not keep all of these commissions. The commission is split between the advisor and the company he works for. For example, an adviser might only keep one-half of the commission and the company keeps the other half providing the adviser with an office, staff, computing, telephone, office supplies, etc. or the adviser might get a higher payout but be obliged to pay for his (or her) own staff, pay office rent, office supplies, etc.
It is very important to understand that you will obtain the same rate of return whether the fund is purchased front-end or back-end. Provided that is - you have held your back-end load fund for the whole seven years. Otherwise you will incur an early redemption fee (DSC fee) as mentioned above which will reduce your rate of return.
For a new purchase in a new fund, I would generally recommend the purchase of a front-end fund ( with the commission set at 0%) as these funds do not have any early redemption(DSC) fees.
In order to ensure that all mutual fund fees are open, disclosed and transparent, the fees and their descriptions are detailed in the mutual fund's prospectus. Additionally, your adviser is obliged to review these fees with you before you make a fund purchase and advise you if there any fees if you sell.
Advisors are paid an annual service fee often referred to as "trailers" which is used to provide ongoing service and advice to the client after the sale. Back-end trailers are typically 0.50% and front-end trailers are usually 1.00% annually.
You are allowed to switch your fund within the fund company's family of mutual funds. Although there can be a switch fee each time you switch from one fund to another, very few advisers would charge a switch fee. I do not charge switch fees.
These types of accounts are becoming more popular with higher net worth clients. These accounts are usually larger in size. Most banks, trust companies and private money managers have been using fee style accounts for their high net worth clients for many decades.
In this type of account the investor pays a flat fee or percentage of assets to the advisor for managing the portfolio. A typical fee would be 1% of the market value of the portfolio charged annually. The adviser must give up all other commissions or service fees (trailers) for the account. In a fee-for-service account, the fees charged to manage the account may be tax deductible. Not all investments are subject to fees. GICs are exempted.
The current embedded structure of fees and commissions in the securities industry may in the future be replaced with something else. The U.K. and Australia have already moved in that direction. Although doing away with the traditional commission structure in North America has undergone much internal debate, I believe that the industry will eventually go with some sort of AUM (asset under management) type of model. See fee-for-service accounts (above) for an example of how this might work.
Which system is better? I think this is debatable. I have used both types of accounts and from the client's perspective, one may not be necessarily better than the other. If for instance the MER of the mutual fund drops by 1% only to be replaced by a separate bill to the client of 1% then what has the client gained? Nothing really. The wild card here is the tax deductibility question. Right now, fees (under certain conditions) could be tax deductible but commissions are not. If the industry decides to replace commissions with something else, there is no assurance that the CRA (Canada Revenue Agency) will stand aside and allow millions in additional tax deductions. For instance, nominee (self-directed) trustee fees were tax deductible at one time but today they are not. Also, investors should be aware that fees are not deductible for any registered accounts like RRSPs and RRIFs.
In the proposed new fee-for-service alternative, the fees could range as high as 1.75%( or more) for smaller size accounts. Replacing the traditional embedded 1% advisor commission with a separate 1.75% fee doesn't sound like a good deal for the client. Bottom line, if the new proposed fee structure proves to be more expensive than the traditional commission structure, regulators should exercise some caution before implementing these changes.
Unfortunately, the business media has not done a very good job in their coverage of mutual fund fees in general. I hope the above explanation about fees and commission gives a bit more clarity regarding these issues. I respond to all inquiries and if you have a question about mutual fund fees, I can be reached at firstname.lastname@example.org.