Fees or commissions – which one is better?
Sorry for the cop-out, but today’s raging controversy about whether we should ban commissions and move entirely to a fee-based system (like in the U.K and Australia) has become a tug of war pitting one system versus the other.
The anti-commission, pro-fee crowd firmly believes that commission of any sort skews investment recommendations and that mutual fund commissions should be banned permanently. I disagree with the conjecture by some that commissions skew investment recommendations.
The pro-fee crowd believes that handing a bill to a client for managing mutual funds on a quarterly or monthly basis is the one and only path to enlightenment.
The annual fee is usually a percentage of assets under administration (AUM). A typical fee for a $250,000 mutual fund account might be 1% annually. One percent of $250,000 is $2,500 which means you will be billed $625 every few months. The fee collected does not all go to your adviser. The adviser typically might be on a 50% “payout”. At this 50% payout level she earns $1,250 but has to pay head office expenses, licensing fees, client statement fees, regulatory fees, etc. She might only get a portion of those total proceeds as the remuneration is split out to the adviser’s firm and the branch she works for.
Unfortunately, the adviser’s costs and expenses are not disclosed and this is a shame as most investors should know where all this money really goes to.
From the client’s perspective, you still have to pay the amount even though in previous years this 1% or $2,500 was built into the price of the product. In other words, the 1% was all inclusive. The regulators are proposing that the 1% built-in fee should be replaced by a bill of the same amount to the client.
So which system is better? Build the 1% into the cost of the product or charge 1% less for the product and then send the client a bill for 1%? (Assume all costs for either model are fully disclosed.)
From a mathematical perspective, reducing the product’s price and then adding the same amount back is a wash.
To the client not much changes; you are still paying the 1% in either model whether it is separated out from the product price or not.
The regulators are favouring the 1% bill model as they feel it is better for all clients.
I say –not so fast!
As an adviser, I am currently earning annual remuneration anywhere between 0%, 0.25%, 0.50%, 1.00% and 1.25% depending on the type of fund in the portfolio. The breakdown is this:
I earn 0% annual remuneration for GICs and money market mutual funds, for bond funds I would earn 0.25%. For balanced funds, I would earn 0.50% and for equity mutual funds I would earn 1.00% to 1.25%. Depending on the adviser’s asset allocation, the average compensation (excluding GICs) might be 0.80% or it could be a great deal less, especially if you do not have much in the way of equity mutual funds or do a lot of GIC business.
Do you see what the problem is? If the regulators ban commissions, I get an instant pay raise of at least 25% or more! And the regulators will force clients to pay the increased fees.
There’s nothing wrong with getting a pay raise if you deserve it but here is my point; I will be doing the same amount of work but I will be getting a 25% pay increase. Ironically, the pay raise will come courtesy of the regulators!
Reducing choices and increasing costs at the same time should be raising some eyebrows and certainly should be raising some questions. Not everyone has $250,000 to qualify to have an adviser and be charged a fee. What about new investors just starting out in life – recent graduates or young families? Will that market segment have $250,000 just to have the privilege of paying a new fee?
Commissions have the advantage of being transaction based and are not dependent on account size. In most cases, today’s commissions will be lower than the proposed higher fees in the fee-based accounts that the regulators seem to be favouring.
My vote is to keep the current two-tier system and let the client choose the appropriate model. I am all for reform, but limiting choice, inflicting monetary pain and excluding many thousands of Canadians from financial advice is not my idea of reform.
Instead, I would simply propose that commissions be capped by the regulators. If the renumeration is the same for everyone, then “skewing” or even the faintest temptation to skew investment recommendations would be completely eliminated.