Guaranteed Investment Certificates – dull – but interesting!

For many investors, Canada’s most boring investment has to be a GIC (Guaranteed Investment Certificate). If you were thinking Canada Savings Bonds – they were eliminated in the 2017 federal budget. However, is GICs dull reputation truly deserved?

Lately, there has been renewed interest about this safe, dull-as-grass investment...

Question: What is a GIC?

Answer: A GIC is generally described to be a term deposit with a Canadian bank, trust company, credit union or caisse populaire. The term can be anywhere from a 30 day term to a term of 5 years. The “G” in GIC stands for “guaranteed” but guaranteed by whom? With one significant exception, in the case of an insolvency of a financial institution, almost all GICs in Canada have a government depositor protection program. For example, the Canadian Deposit Insurance Corporation (CDIC) is the federal government agency responsible for chartered banks and trust companies in Canada. In the case of insolvency/bankruptcy, the government agency ensures that eligible GIC investors are paid their full principle (up to certain maximum limits) along with any accrued interest owing. The one exception? In the Province of Manitoba, GICs issued by Manitoba-based credit unions have a depositor protection plan however it is not backed by government as there is no affiliation with any provincial government agency. However, here in the province of Ontario, GICs issued by credit unions are covered. As per DICO’s website: DICO’s (Deposit Insurance Corporation of Ontario) role is to protect depositors of Ontario credit unions and caisses populaires from loss of their deposits. Deposit insurance is part of a comprehensive depositor protection program for all Ontario credit unions which is backed by provincial legislation.”

In my view, if there is no comprehensive deposit protection program backed by federal or provincial legislation - then it is not a true GIC.

Question: How are deposit brokers and advisors paid? Are GIC finder’s fees a referral fee or a commission?

Answer:  Both! In speaking at great length with one of the founding fathers of the GIC deposit brokerage industry many years ago (sadly, now long gone) he described “agency agreements“as formal referral arrangements he personally made at each bank or trust company. I believe the first referral arrangement he made was with Morgan Trust in Toronto - late ‘70’s. The founder described mutual fund remuneration as commissions and GIC remuneration (to the dealer) were considered to be finder’s fees or referral fees. I believe that things haven’t changed since the 1970’s and banks and other financial institutions still pay finder’s fees or referral fees derived from GIC business to either the adviser’s head office or for smaller firms – directly to the deposit broker. Therefore an advisor can claim that he is earning GIC fees directly or is being paid a GIC commission from his head office. In the regulatory world it is said that there are very important differences between the definition of a commission versus the definition of a fee. GICs can have both fees or commissions. Sorry about that - apologies to securities lawyers everywhere!

Question: What is the history of the deposit brokerage business in Canada?

Answer: A thorough search on the internet did not reveal much information about the very early beginnings of the Canadian deposit brokerage industry. I believe that if it was written down, it may have been lost in the sands of time.

Therefore I have cobbled together some of the history that I’ve collected over the years by speaking to one of the early founders and I recall some of the stories from the “old-timer” deposit brokers now long retired.

In the 1970’s, 80’s and most of the 90’s there was no such term as a GIC dealer or mutual fund dealer in those early days - nor did the MFDA (Mutual Fund Dealers Association) even exist. By the late 1970’s there were at least three major deposit brokers. These deposit brokers offered both GICs and mutual funds to their clients and some offered deposit products from insurance companies as well. In the mid- 1990’s, both client held GICs and mutual funds co-existed on the same investment statement.

I became a GIC broker in 1992 but started my career in 1987 as a stockbroker. Although stockbrokers had mainframe computers back then, I got to see the installation of the very first personal computers - sporting huge 20 meg hard drives and monochrome (choice of green or amber!) screens in 1987 and 1988.

GIC brokers were far smaller operations and there were no mainframe computers or personal computers until the very early 1990’s. We still have our old GIC/mutual fund database going back to circa 1980 or so and they are on recipe cards! Yes, you heard right – recipe cards. If a client bought a GIC or a mutual fund, their advisor wrote it down on a recipe card. One card per client. More cards if you were a HNW (High Net Worth) client. The interesting thing about this multi-platform database is that it never required constant upgrading or updates, never crashed and never required any computer power whatsoever. Most importantly, it works just as well today as it did decades ago. The cards do tell me that client name GICs and mutual fund purchases did at one time appear on the same statement and on the same recipe card. If an investor requested a statement, we photocopied the recipe card and gave a copy to the client. [Note: now we know why many computed mutual fund book values do not accurately reflect investor’s true costs – they were never entered on the dealer’s computers!]

Fast forward to the late ‘90’s and my firm at the time, eagerly joined the newly created SRO (Self Regulatory Organization) for mutual fund dealers around 1998. There was a condition though – a big one. The brand new MFDA (Mutual Fund Dealers Association) made a request to the dealer to divest all client-held GICs (half of the dealer’s total assets). It was determined that GICs are not mutual funds and they would have to go. All GICs from all dealers had to be to be purged from the dealer’s mutual fund statements and computer systems. From now on, the dealer’s mutual fund operation had to be kept separate and distinct from the client name GIC business.

When the dust settled, the dealer separated out GICs from the mutual fund statements and put them on a separate client query and order entry platform and with the parting of ways from the newly formed MFDA created a separate GIC deposit operation based strictly on GIC trading. Deposit brokers were born (or reborn!) As it turned out, the dealer’s operation were eventually split into two or three separate operations: client name GICs (deposit broker), mutual funds (client name and nominee) and insurance.

Interestingly, client name GICs could not be mixed with client name mutual funds although mixing nominee GICs with nominee mutual funds was and still is even today, perfectly OK.

Note: the modern term is “nominee” type of account. In the 1980’s and 1990’s there was no such term – we used the term “self-directed” account to indicate that the securities are held with the broker in a trustee arrangement.

Although there was a predecessor association called the Federation of Canadian Independent Deposit Brokers going as far back at 1987, it is now known as the RDBA (Registered Deposit Brokers Association) which is the national professional standards association for deposit brokers.

Question: Do I have to pay a commission to buy a GIC?

Answer: The short and definitive answer is – absolutely not! Investors do not pay commissions to buy GICs because the advisor’s dealer1 is compensated by the bank issuing the GIC. Part of this compensation is paid to the advisor in the form of a commission. Deposit brokers are also compensated in a similar manner.

Note: For investors that buy their GICs through a securities dealer, starting in 2017, investors will receive new fee reports which will indicate the amount of GIC remuneration that the advisor’s dealer has received from the banks. Some GIC investors are misinterpreting this dollar number as commissions they have paid to buy GICs. That is not correct as there are no commissions to buy GICs.

 Question: Is it preferable to buy a GIC at a securities dealer?

Answer: Yes and no. Nominee GIC accounts can only be found at securities dealers or third party trustees but may not have the best interest rate.

Although deposit brokers had at one time, set up nominee (self-directed) GIC structures in-house in the mid 1990’s (pre-MFDA), today you would have to be affiliated with a securities dealer to set up a nominee GIC account. So today, all GIC deposit broker GICs are client-held meaning the GICs are held (by the investor) directly at the issuing financial institution. If you want a nominee type of account, you have to buy your GICs through a securities dealer, but not through deposit brokers. Yes, it is somewhat complicated behind the scenes. Since many deposit brokers are also financial advisors, it is easy to buy a GIC in either format, but you have to take off your deposit broker hat and put on your financial advisor hat to do a nominee GIC purchase with a securities dealer. Conversely, if you want to buy a client name GIC, you have to take off your financial adviser hat and put on your deposit broker hat to do the trade.

There are however, issues with credit union GICs in nominee accounts at securities dealers. Due to an interpretation of credit union regulations, most credit union GICs are generally not allowed to be held at a securities dealer which is most unfortunate because credit unions often have much higher interest rates than banks. Credit union GICs can however be easily obtained at a deposit broker.

 A nominee account is a lot less paperwork intensive than client name GICs. And nominee account structures have other advantages too – especially for estate planning reasons. But on the other hand, there is more choice of financial institutions for client-name GICs. More choice – a much greater chance of consistently obtaining higher interest rates for GIC investors. The choice often comes down to choosing between the conveniences of a nominee account versus the possibility of obtaining better interest rates with deposit brokers.

Question: Why do deposit brokers and financial advisers offer higher GIC interest rates than my bank?

Answer: This is the best keep secret in the entire investment industry. Interestingly, deposit broker GIC rates and financial advisor GIC interest rates are almost always higher than retail bank GIC interest rates. In other words, advisor compensation drives GIC yields higher for the same identical “no-cost” GIC in a bank branch. For example, a broker GIC rate is almost always quoted higher than the bank in-branch posted retail rates for the exact same GIC. See example of Bank ABC rates below. Even if the broker rate was the same as the retail rate, shopping the entire marketplace for the highest yield from all the available issuers would ensure a higher rate is obtained.

EXAMPLE

                                                                                          1yr         2yr       3yr       4yr    5yr

Bank ABC (retail in-branch GIC rate)                             0.55       0.65   0.85     1.05   1.25

Bank ABC (securities broker GIC rate)                           1.25       1.45   1.45     1.65   1.85

DEPOSIT BROKER (survey of top GIC rates)               2.30       2.45   2.50    2.60    2.75

Interest rates as of Aug 23, 2017, min $5,000

A GIC is an unusual type of investment where the existence of a commission or fee can result in a higher rate of return to the investor. Needless to say – never buy your GICs at your own bank without comparing and shopping for better interest rates. As you can see in the above example, the differences in rates can be mind-boggling! Contact your deposit broker or financial advisor who will show you how to obtain the best GIC interest rates.

Question: The rates you quoted are in some cases, more than triple my bank’s rate and have the same guarantee! How do securities dealers and deposit brokers offer such dramatically higher rates?

Answer: There are a couple of reasons. Banks, trust companies and credit unions are in the deposit taking and lending business. If the bank requires a large inflow of deposits to offset new mortgage obligations they will approach a deposit broker with a higher interest rate in order to attract new deposits. Deposit brokers can move a lot of money to a bank very quickly and efficiently. From the bank’s perspective, deposit brokers and stock brokers are inexpensive sources of capital. The bank doesn’t have to pay costs for brick and mortar operations to sell GICs at a deposit broker or at a securities dealer. It is a highly competitive business. Secondly, a deposit broker (or securities dealer) deals with dozens of banks – not just one. They can shop for the highest interest rate and obtain a much higher interest rate than the investor can usually obtain on their own.

Question: How can GICs be used in conjunction with mutual funds or other investments?

Answer: GICs should not be considered as a stand-alone investment. They can be used to reduce overall risk in any investment portfolio as GICs do not fluctuate in value and their rate of return is known ahead of time. You can reduce the risk of owning a stock based mutual fund (equity mutual fund) by investing the GIC interest income into equity mutual funds. In other words, you can reinvest your annual interest income into mutual funds; keeping your GIC principle intact.

For a bit more of a sophisticated way of mitigating equity mutual fund risk, you could buy a 5 yr term compound interest GIC and invest the expected compound interest immediately into mutual funds right now. If the mutual fund outperforms the GIC’s compounded interest rate 5 years from now, you are ahead. Worst case scenario - if the mutual fund drops to zero in 5 years (highly unlikely) at least you get your principle back.

Often overlooked too, is that GIC rates have recently handily beat Government of Canada bond yields (1 - 5 years) for the past several years. Bond purchases incur commission costs, driving down their yields even further. GICs have no commissions and yields have been much higher than bonds so GICs can be a superior investment and alternative to short term government bonds.

Question: Do GIC s have embedded commissions?

Answer: I think it depends where the GIC is sold. For the banks, some sort of commission element is likely wrapped into the pricing of GICs, especially those GICs that are sold at a bank branch to their customers. However for deposit brokers and financial advisors, I have come to the conclusion that GICs in fact, might not have embedded commissions at all.

The argument goes like this; Of course there must be commissions because like most investment products, the broker or adviser needs to be paid by charging a commission or fee or building in a commission into the product ( like a bond or mutual fund).

At first glance, this seems like a reasonable argument. However, GICs are unlike most investments and due to their unique nature they are sold in a different way than most investments. GICs investors are not charged a fee or commission to buy a GIC. It’s the advisor’s dealer (head office) that earns a referral fee from the bank and then the dealer pays part of the fee to the advisor as a GIC commission. The interest rate on the GIC is set by the bank not by the investment firm. Since neither the dealer nor the advisor sets the interest rate then the remuneration - can’t be embedded.

Question: Are GICs securities?

Answer: I first explored this question in the late 1990’s. At the time, some industry participants said yes, some said no. A GIC is merely a bank deposit – not that far off from the concept of a daily interest account – except with a fixed term.

In writing this article in 2017, if we ask the same question whether or not GICs are considered to be securities, we might get the same answer as we did in the 1990’s – some say yes, some say no.

Why is this question even important? If GIC were to be considered as securities, then securities regulations naturally, would apply but if the regulatory jurisdiction view is that a GIC is not a security, then certain securities regulations do not apply.

Here in Ontario, the provincial securities regulator is the Ontario Securities Commission (OSC). The OSC says that GICs are not securities. The national self-regulatory organization for Canadian mutual funds (MFDA) also says GICs are not securities. For the national self-regulatory organization for stockbrokers (IIROC) the definition has been less clear. However, on October 29, 2014, IIROC approved Dealer Member Rule 2800C – Transaction Reporting for Debt Securities (“Rule 2800C”) which clarified GICs status as non-securities. However, other provincial securities regulators outside of B.C., Alberta and Ontario, may treat GICs as securities. This question leads into another question; who nationally, regulates GICs?

Question: In Canada, who regulates GICs?

Answer: From a national viewpoint, we are not sure. The sale of GICs is governed by a number of organizations including the federal government under the DTIR (Deposit Type Instruments Regulations). Deposit brokers are recognized by the federal government as deposit-taking agents or mandataries. Deposit broker’s professional standards association is the RDBA (Registered Deposit Brokers Association) www.rdba.ca. There has been some debate about who precisely regulates the sale of GICs in Canada. I doubt there is any single entity that does. In my experience, the sale and regulation of GICs is governed depending where they are sold. If sold at a bank, then bank regulatory rules apply. If sold at a securities dealer, then securities rules apply. Deposit brokers have their own rules and guidelines to follow as set by the Registered Deposit Brokers Association. The late Finance Minister, Jim Flaherty best described Canada’s securities landscape as a “patchwork quilt” of different regulators. I think very few would argue the point.

Question: Are there any other interesting GIC tidbits?

Answer: Here is just a few more to consider...

-        GICs with a term exceeding 5 years (they do exist) are not insured by the CDIC (Canadian Deposit Insurance Corporation).

-        Non-redeemable GICs are generally not cashable before their maturity date (there are exceptions; depending on the issuer), and although there are some cashable or redeemable GICs, all GICs are generally cashable or transferable at death.

-        Credit union deposit protection programs vary from province-to-province. For instance, in British Columbia, it is unlimited for all plans. In Ontario it is a $100,0001 limit for regular GICs but unlimited for RRSPs, RRIFs, TFSA and other registered plans. In Nova Scotia, deposit protection programs are up to a $250,000 limit.

-        In some provinces, a credit union deposit protection program might also include foreign currency deposits – like U.S. dollars, something that the CDIC doesn’t cover.

1 Note: Ontario credit union deposit insurance will be increased to $250,000 on January 1, 2018

Question: With interest rates so low, and taking inflation and taxes in consideration, why bother at all with GICs?

Answer: Great question! It depends what you mean by low. In Japan and Germany, a 10 year government bond interest rate in recent years have gone negative - interest rates had actually gone below 0%. And that’s before commissions have to be paid which would have reduced the rate even more. Canada’s top GIC rates are staggeringly high by comparison.

The demand for GICs is generally inelastic meaning that demand does not change much regardless of the current level of interest rates. A typical GIC buyer is not interested in growth or risk – they are interested in safety, preservation of capital and certainty. Arguments about low after-tax rates of return and inflation will surely fall on deaf ears. There is no other widely held investment option that has such an iron-clad guarantee. Often times, an investor who has cashed in considerable amounts of stock-based investments will crystallize their gains by placing them in GICs. The same applies to business owners that have sold their family businesses – they’ve dealt with risk all their working lives so the security of GICs can be very appealing to them. Seniors too may be thinking about rebalancing their investments to more conservative GICs. And lastly, we can’t ever assume that interest rates will stay low forever. GICs by nature, are floating rate investments which will keep pace with higher interest rates should interest rates rise.

Are GICs as dull as grass? Yes certainly. And we are thankful they are!

Notes:

Referral or finder’s fees from the sale of GICs can be paid either to the advisor’s dealer or in the case of smaller deposit broker firms that hold contracts directly with the banks, can be paid directly to an advisor.

DICO (Deposit Corporation of Ontario): www.dico.com

Government of Canada Bond yields: http://www.bankofcanada.ca/rates/interest-rates/canadian-bonds/

Acknowledgement: Thanks to Brian Evans – Chair of the Board of Directors for the Registered Deposit Brokers Association (RDBA) for his discussion regarding GIC commissions and GIC fees.

DSC on death row –should we keep it alive?

BACKGROUND & HISTORY

Although mutual funds have been around in Canada for several decades, older investors may recall how mutual funds were sold in the early 1980s. There were no deferred sales charge (DSC) funds, low load funds or the various other permutations found today.

If you wanted to buy a mutual fund, you had to pay a commission called a front-end load. The front-end load could be as high as a 9%. The investor would receive a written confirmation detailing what the commission was (in dollars) what the price of the fund was, the name of the fund, purchase date, etc. Not much has changed today and if you choose to buy a mutual fund with front-end commission of 0%, you still receive the same confirmation details by mail shortly after the purchase date.

After the mid-1980s, the fund industry introduced a new way of buying mutual funds that neatly managed to side-step the lofty front-end commissions of the time. The deferred sales charge (DSC) was born. In this unique arrangement, an investor would pay 0% commission to buy a fund and 0% to sell a fund provided that he agrees to one condition: the investor promises not sell his fund within the first seven years of ownership. This is not to say that selling a fund is impossible but early redemption penalties could be severe (up to 6%) if you sold the fund soon after buying it. But if you kept it for the full seven years, you could sell all or part of your fund at no cost plus don’t forget, you didn’t pay any commissions when you bought it. At the same time, the fund companies introduced the concept of trailing commissions aka “trailers”. Trailing commissions are fixed annual compensation to the adviser for managing and servicing the account which provides the adviser annual compensation between 0.5% and 1% depending on the type of fund. Soon, the DSC way of purchasing a mutual fund became very popular.

The press thought this was wonderful – a win-win situation. The adviser gets paid, the investor escapes all commissions and the annual remuneration to the adviser (the trailer) would effectively kill the potential threat of “churning”. Trailing commissions changed the perception of mutual funds forever as advisors no longer had to make a trade in order to make a commission. From now on, mutual funds would not be traded as frequently as stocks.

By the late 1980s, Canada’s banks bought out most of the big stockbrokerage companies and the banks started creating no-load mutual funds of their own. No-load does not mean free as there is still a profit margin built into these products and there is an exchange of compensation from the fund management company to the retail bank side. However, from strictly the viewpoint of the bank customer – bank mutual funds are “free” and they were now in direct compensation with the independent, commission based adviser.

In a free market environment, competition is good and “free” is one of the most powerful marketing motivators of all. In the early 1990s the competitive marketplace became even more competitive as other no-load funds entered the fray. For instance, during that decade, one no-load firm, Altamira, became a juggernaut of the no-load world. Altamira ultimately, flamed out, crashed and burned during the “tech wreck” as legions of DIY (do-it-yourself) investors piled into their tech funds and then pulled it all out as the tech sector crashed. Altamira went from riches to rags literally, overnight.

In response to an increasingly competitive environment, by the 21st century,  advisors had to voluntarily cut their own commissions and front-end loads went from the high single digits to zero.

CONFLICT OF INTEREST

Some industry observers and regulators are targeting the DSC mutual fund indicating that the DSC has an inherent conflict of interest and should be banned.

Should DSC be banned? And does DSC represent a conflict of interest?

Back in the 1980’s and 1990’s we can make a pretty good argument that DSC was definitely not a conflict of interest. It eliminated churning (which is certainly a conflict of interest) and it saved clients from paying high commissions.

That was then but what about now? With front-end commissions at zero who would want to buy a DSC fund that could have a possible exit fee? As a result, DSC funds have greatly declined in popularity and for new mutual fund purchases, front-end mutual funds at 0% commission (set by the advisor) is by far, the most commonplace option to purchase a mutual fund today.

From a client viewpoint, the MER and performance of a DSC fund is the same as a FE fund ( at 0% commission) although one could argue that costs to set up the DSC limited partnership and legal structures to fund the up-front commission to advisers costs some additional incremental amount.

BEST INTEREST

The DSC practise of paying an advisor in advance seems to be the primary sticking point. One has to ask who it benefits. The answer is obvious -it benefits the advisor. A dollar received today is worth more than a dollar received later. Could DSC funds be seen as self-serving and not in the best interest of the client?

If there were no early redemption penalties, I might call it even but because there are, it is clear that giving client FE=0% commission is a better deal than DSC so if advisors claim they always work in the best interest of their client, one has to take a cold, hard look in the mirror.

It may be a moot discussion if regulators ban all commissions. If so, there would be no front-end loads, no DSC or low-load funds. Trailing commissions would be banned and replaced with fees. This would be unfortunate as the FE=0% commission model gets axed at the same time.

Although I disagree with the regulatory view that anything embedded is conflicted and must be banned, moving to a fee-based account presents its own set of conflicts of interest.

But that is another discussion.

In my view, DSC is very quickly dying a death of neglect. DSC once had its day - but that time is long gone.

Who will deliver the final coup de grace?

---

The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd.

Commissions, trailing commissions, management fees and expenses, may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the Fund Facts and consult your Assante Advisor before investing. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see a professional advisor for individual financial advice based on your personal circumstances.

The case for banning fee-based accounts

I was inspired to write this article based on an article that I read from a high profile investment councillor firm who advised their readers to avoid all F-class (fee-based) investment funds. I thought that advice was an extreme view.

However, if one could build a case that fee-based accounts are truly evil incarnate, what arguments could one use?

  • Fee-based accounts can be expensive. Traditionally, these were only used for high net worth (wealthy) investors. If embedded commission accounts are banned all investors would be forced to own more expensive nominee accounts and would be required to pay advice and service fees plus annual trustee fees, plus supplementary account fees plus partial transfer out fees plus unscheduled RRIF withdrawal fees, plus partial de-registrations fees, etc, etc. Fees on top of fees. Whether you are a small investor or a wealthy investor; one thing is certain - everyone hates fees.
  • I mentioned the article from the investment councillor firm. What was the issue? They claimed someone was overcharging an investor in a fee-based account. This is a nice segue into the differences between commissions or fees that investors pay to investment councillors or advisors for service and advice. Commissions for mutual funds are non-negotiable as they are set by the fund company. Regulations require that both fees and commissions must be fully disclosed. Essentially, commissions are fixed but fees for fee-based accounts are negotiable. If an investor is a bad negotiator your fee might be higher than your neighbour’s even though you own a similar size account with similar investments. You will definitely need to sharpen up those flea-market bargaining skills! Or perhaps the negotiable fee was negotiated for you by an investment councillor or financial advisor. In essence the supposedly negotiable fee turns out to be non-negotiable and you are paying perhaps too dearly? In the case brought up by the investment councillor, clearly the investor would have been better off in a low fixed embedded commission account than in a negotiable high fee account. Negotiability is a double edged sword –it can cut both ways.
  • Your accountant will learn to hate you. How do you pay your fees for your fee-based account? For most investors, this will likely be drawn from their investment accounts rather than from their bank account. If you have a regular non-registered account, you will see monthly fees being debited from your account – the money being generated by monthly redemptions from mutual funds. The problem is you may be generating capital gains each month. Who is going to calculate the total yearly gains (or losses) for tax purposes? That would be your accountant –if you have one. You might be thinking that you could keep cash (or a cash equivalent) in the account to pay for the monthly fees and not have to worry about tax calculations? Good thought however there’s a gotcha. If you set aside cash to pay for on-going fees you are creating cash drag on the account reducing potential performance in up markets. Admittedly, holding back 1% or so a year may not look like much but compounding over a long period of time –it will likely be a cash drag on performance. On the other hand, in an embedded commission investment fund, 100% of your money is being invested at all times.
  • Bad math. Some investors have gotten the idea that fees are better than non-deductible commissions just because they are tax deductible! This is completely incorrect. In fact, they can be exactly equivalent from a tax viewpoint. Be very careful in your comparisons here. A lower MER Class F investment fund may not be the best choice. [Please see references below, for more information] Remember too, that you pay HST on fees but not on embedded commissions. Tax-deductible fees are only deductible if you deduct them and report them properly. Otherwise you may be subject to CRA fines. Yes, your accountant will learn to hate fee-based accounts.
  • Conflicts of interest. I am astonished that even very smart people somehow have come to the conclusion that fee-based accounts do not have any conflicts of interest or worse, come to the conclusion that they eliminate all conflicts of interest. Not so according to U.S. regulators. Anytime there is an exchange of money for products or services there are always potential conflicts of interest. Here are a couple of potential conflicts of interest associated with fee-based accounts. There is a potential conflict of interest to charge higher fees –higher fees than ordinary commissions. This type of behavior would be described as self-serving –acting in the investment councillor’s or advisors best interest rather than the investor’s best interest. This is the same conflict of interest that our investment councillor brought to their readers attention – the overcharging of fees. Another well known possible conflict of interest is called “reverse churning” which is a conflict of interest where an advisor or investment councillor earns high annual fees but is potentially tempted to do little or no work on the account. Why risk the advisory fee income on volatile investments? Investors potentially wouldn’t be put into the appropriate investments.
  • Advice gap. If commission based investment funds are eliminated and only fee-based are left the choice of choosing an investment account becomes self evident. In other words, you can choose any type of account you want as long as it is a fee-based account. Will such a move create an “advice gap” where small or average sized investor accounts are left behind without an advisor? In thinking about this yes, I believe it is a possibility as clearly regulators are implying that there could be damages (advice gap?) and is currently asking the industry how best to mitigate damages to investors by moving solely to a fee-based model. I am sure the regulator is referring to collateral damages caused to small or average size accounts rather than to high net worth accounts. If the industry is faced with the scenario of only being allowed to offer fee-based accounts, securities dealers would have to eliminate minimum account sizes, eliminate minimum retainer fees and possibly even eliminate AUM (Assets Under Management) tiers. This would greatly increase accessibility for smaller investors but nominee fee-based accounts still have a lot of annual account fees which might make fee-based accounts uneconomic. There is no guarantee that all investment firms will get rid of minimums in order to serve smaller clients. In light of the regulatory environment in the U.K or Australia where embedded commissions are banned, the small investor is left to their own devices to find investment advice. Some industry observers say that given the proposed regulatory environment where most commissions would be banned, securities firms are changing their focus to wealthier investors –greatly expanding the current advice gap. Economically, many investors would be far better off using embedded commission funds rather than fee-based accounts and would still have access to an advisor.
  • The myth of dramatic and immediate cost savings. Proponents of fee-based accounts suggest that there will be a massive conversion of existing assets to “cheap” mutual funds should traditional embedded commissions be banned. In my observations over the last 10 years or so, this has not occurred or will not occur as advisors generally transfer their clients current mutual funds intact (an “in-kind” transfer) to the fee-based account. The same funds are kept. The best mechanism to lower costs is through natural market forces (competition!). Due to intense market competition, this is already happening as fund costs are declining rapidly.
  • Gradual creep of account fees and charges. If commissions are eliminated, most of the extensive reporting requirements will fall on the shoulders of the securities firms. This will require massive technology development costs in the millions of dollars. There will be continually rising costs to maintain these expensive systems part of which (like any other product or service) will be passed down to the end user.
  • The U.S. has far more experience with fee-based accounts than in Canada. Regulators in the U.S. have expressed concerns that fee-based accounts may not be appropriate for all investors and have concerns that advisors no longer have any incentive [in a fee-based account] to invest the time and effort required to help clients explore their financial needs, create an appropriate asset allocation strategy, design a portfolio, or provide ongoing oversight.

Summary and Conclusions

Fee-based accounts are not new. They were traditionally used strictly for wealthy investors who could afford the costs but if regulators ban commissions and all investors are forced to use fee-based accounts, small to average investors will likely see higher costs; higher costs for service and advice, higher on-going account fees to maintain and retain their fee-based accounts, higher compliance costs and higher accounting fees to hire a tax professional to properly deduct deductible fees on their personal tax returns plus endure even more accounting costs to calculate yearly capital gains/losses for non-registered accounts. Investing is becoming complicated.

Although I can whole heartedly recommend fee-based accounts for some investors, many other investors would be better off with embedded commission structures. They are simpler to understand, can be cheaper and are much simpler to handle with respect to taxation. And if U.S. reports are credible, represent fewer conflicts of interest.

Canadian regulators are proposing a single fee-based business model for all investors despite reports of significant U.S. regulatory concerns with that model. Based on the U.S experience, it is clear that no single investment model works best for everybody. Investors are unique and have different requirements depending on their personal circumstances. Let’s keep both models –perhaps making improvements to each.

More choice is better than less choice.

References:

Class “A” shares or Class “F” - which one is better?

After-tax considerations for fee-based accounts

Fee-Based Brokerage: Will They Work For You?

General disclaimer:

This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness.

Before acting on any of the above, please make sure to see a professional advisor for individual financial advice based on your personal circumstances.

Opinion disclaimer:

The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd.

Making sense of your new CRM2 charges and compensation report

Now that millions of Canadians have received their year-end statements and investment reports, they may have noticed a new report called the Charges and Compensation Report included with their statements.

The purpose of the charges and compensation report is to disclose all fees, commissions and charges paid by an investor, and to disclose all compensation and remuneration received by the dealer (the advisor’s head office).

It is important to note that the report does not disclose advisor compensation which is only a portion of the dealer compensation disclosed on the report. Therefore, typically an advisor receives a fraction of the amount indicated on the report.

The report is divided into a number of sections and the listing is extensive: general administrative costs, purchase, sale or other transactions, amounts received from fund managers, amounts received from third party referral fees, and amounts paid to other parties. One section details the fees that are paid by investors for their fee-based portfolios. You may also see a separate fee schedule which lists transfer-out fees, supplemental registered account fees, nominee fees, non-sufficient funds fees, etc. Depending on the fees you paid, you may not see all of these categories listed on your statement if they don’t apply to you.

For mutual fund investors, I recommend paying special attention to the important sections that detail trailers (monies paid from the fund companies to the advisor’s dealer) and advisory fees.

Any problems with the new report? GIC investors may assume that the GIC commission numbers listed is what they paid to buy GICs. However, there is no such thing as GIC commissions that investors have to pay for GICs! More on this later.

Again a reminder, the report discloses commissions and other compensation received by the advisor’s dealer (the advisor’s head office) – it does not detail the specific compensation received by the advisor.

Feel free though to ask your advisor what percentage he really makes – he shouldn’t hesitate to tell you.

Now that advisors and investors have had time to review the new reports in depth, it’s time to look at it with a more critical eye and see whether there is room for improvement.

Some believe that not enough information is disclosed. I was disappointed to see that there were no percentages listed in this new report as all amounts listed are dollars only. Upon seeing just dollar amounts for the commissions and fees they are paying, investors would generally ask themselves the question – In relation to what? For the fees and commissions I am paying, is that amount 0.5% of my account balance, 1.0%, or 1.5%? It doesn’t say.

In my view, the report could be improved by expressing the amount of money investors are paying in both dollars and in percent so that investors can make better comparisons with other financial institutions.

I think it would be useful to have GIC dealer remuneration listed separately along with a footnote explaining what this remuneration is.

Industry commentators may also like to see more than just dealer remuneration – they may be interested in seeing the costs of the mutual funds included in the report. Also they may like to see early redemption charges from the sale of deferred sales charge (DSC) funds prior to the DSC maturity date.

To improve things further, I would like to see more visuals - a pie chart of the mutual fund’s total MER can show how much the fund costs, what the taxes were, how much was paid to the advisor’s dealer, etc.

SUMMARY

Here are some suggestions that might help to improve readability:

I think the biggest challenge of this report is that there are no percentages included. Dollars by themselves can have little value. For comparing and evaluating investments – percentages should be included.

I think visuals could go a long way in breaking down the total cost of a mutual fund. Although pie charts are sometimes criticized for their overuse, I think they would be of great value to illustrate mutual fund costs. Seeing just one total dollar amount here may not necessarily be meaningful unless it is accompanied by a percentage.

Although the regulators specify what must be reported, there is no standard template that must be used. For a more consistent experience, I feel using an industry standard template for reporting purposes can improve consistency.

Due to the unique nature of GICs, investors do not pay commissions for GICs but securities dealers do receive compensation for the sale of GICs from the banks. Some GIC investors are assuming they are paying commissions to buy GICs. This is not correct. A footnote describing what this remuneration is can certainly go a long way. Additionally, GIC commissions should have its own category and not be lumped in with stock commissions or mutual fund commissions, or lumped into a somewhat ambiguous category called “Amounts received from others.”

In the meantime, I would encourage all investors to bring their Charges and Compensation Report to their next portfolio review so they can discuss it in more detail.

--

Glenn Szlagowski is a Financial Advisor at Assante Financial Management Ltd. in Kitchener, Ontario. The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see a professional advisor for individual financial advice based on your personal circumstances. Commissions, trailing commissions, management fees and expenses, may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the Fund Facts and consult your Assante Advisor before investing.

Pain of paying – the psychology of money (revisited)

I have been writing/blogging about the proposed regulatory changes regarding mutual funds and financial advisor remuneration since early 2013. Back then, regulators were telegraphing to the industry that commissions would be “targeted” for reforms. Although commissions were fully disclosed in writing, most times regulators were in favour of “direct pay” models that the UK and Australia were employing. In those countries, commissions were replaced by direct fees or bills that investors had to pay separately.

I objected to the proposal citing research about the possible “pain of paying” impacts on investors.

I recommended that we should retain what we have now - a two model system; embedded commissions and/or “direct pay” fee-based.

Years ago I bought Dr. Dan Ariely’s best seller book called “Predictably Irrational” and came across his videos on his website.

This video; http://danariely.com/2013/02/05/the-pain-of-paying/ inspired me to associate the “pain of paying” concept with the threat of unembedded commissions and replacing them with a “pay direct” model.

The regulator prefers to use the term “pay direct” or “direct pay” but I prefer to use the term most investors would immediately think of – “I have received a huge bill!”

This ties in very neatly with my hypothesis at the time that “pain of paying” behavioral concepts would apply directly to the possible banning of embedded commissions and that the unintentional consequences could be severe.

I have done some additional research lately because I think there is more to it than just embedded versus unembedded arguments.

Investment Counsellors often have no trouble whatsoever handing a High Net Worth (HNW) client a bill for say $10,000 a year on a million dollar account and their clients seem willing enough to pay. So if that is the case, why would mutual fund investors recoil in horror at the prospect of direct billing?

Good question.

Again Dr. Ariely’s video provided me with another clue when I bumped across some of his recent research on his “pain of paying” theory. Dr. Ariely goes on to explore an important part of the “pain of paying” equation that I had briefly touched upon in my 2013 article1 but didn’t realize how important it was at the time.

Dr. Ariely says the “pain of paying” is magnified to the nth degree by moving from a perception of free to something [painfully] quite higher.

Therefore raising a cost or price or fee of $0 to $1000 is infinitely more painful than raising costs from $1000 to $2000.

Although Investment Counsellors typically charge staggeringly high fees, why do their investors pay so willingly?

The answer is simple – those investors typically never had to deal with change. They’ve generally had to pay discreet fees right from the beginning.

I contacted Dr. Dan Ariely and asked him what the specific impacts on investors would be if investors in Canada were billed separately for their investments.

Dr. Ariely explained that if a client who has $1 million dollars invested in a savings account, for example, and pays 1% asset under management a year usually doesn’t express any concerns. However, Dr. Ariely argues that if a client had to directly pay $10,000 a year, they probably wouldn’t do it. The reason is that people may not seek advice if they have to pay for it directly.

Therefore, according to Dr. Ariely, if Canada bans embedded commissions and starts to bill investors directly, investors may refuse to pay, and if they do they will be upset. Investors may not seek advice, may stop investing or may not be put in the correct investments.

Up to this point, most references to unintended consequences refer to consequences that are relatively minor. Unfortunately, Dr. Ariely suggests otherwise.

---

1 Adviser fees – the pain of paying

Glenn Szlagowski is a Financial Advisor at Assante Financial Management Ltd. in Kitchener, Ontario. The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see a professional advisor for individual financial advice based on your personal circumstances. Commissions, trailing commissions, management fees and expenses, may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the Fund Facts and consult your Assante Advisor before investing.

 
Joomla Templates: by JoomlaShack