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