Adviser fees - the pain of paying

I don't know about you, but I am rarely overjoyed when I go to the mailbox and return with a handful of bills that I have to pay. I am even less enthused when I am forced to pay a new fee where there were none previously.

If the press have any say (they do), our regulators may do exactly that. Investors could soon be receiving bills for the mutual funds they own.

Shortly, regulators for Canada's mutual fund industry will likely announce big changes to the way we buy or hold mutual funds which in my view, could be detrimental to the average investor's best interests.

Under the current traditional commission structure for mutual funds, very few investors pay any up-front commissions to buy mutual funds.

If there are no commissions or if funds are purchased at 0% commission, are mutual funds free? No, of course not. Adviser funds have the adviser's remuneration built into the price of the product. What this means to the investor is that the mutual fund company collects the commission at source, pays the mutual fund dealer (the adviser's head office) where it is split between the dealer, the branch office (where the adviser works) and the adviser, then keeps the remaining commission.

All mutual fund performance reports and rates of return include the adviser remuneration. Therefore, the rate of return listed on your end-of-year statement is the real and actual number.

Although this system has worked successfully for many decades, and in my opinion, is fair and equitable, it has recently come under fire by the press who has gone as far as saying that all commissions are abusive, unethical and must be banned.

I find these public comments to be preposterous, incredulous, and inaccurate.

In a previous article, I offered a solution where commissions might be called fees instead. Somehow, in the view of the press and perhaps the regulator, fees are OK but commissions are not.

Why prefer fees over commissions? Stocks have had commissions for centuries, bonds have commissions, houses have commissions, and even GICs have commissions. Some investments, like GICs have embedded commissions - commissions that are built into the price of the product. The client who is buying a GIC from a broker really has little interest whether the selling broker is making a commission or not. They are however, interested in getting a better interest rate than their bank!

Here's a real world example: You can buy a GIC 1-year term from a local bank branch today and receive 0.90% interest. Bank staff do not earn a commission for selling this GIC to their customer because they are on salary. However, if you bought a GIC from a broker, you could easily obtain 1.80% - double the interest! However, the press would object to the practice as unethical and abusive because the 1.8 % includes a small embedded 0.2% commission for the broker.

Logic apparently does not seem to apply in this strange investing universe. The investor gets double the return but this is apparently bad because the broker has earned an embedded commission!

[Editor's note: Some readers may be tempted to point out that the CSA is targeting only mutual funds, but I have heard this may not be the case. The CSA may also be looking into how GICs are sold.]

To embed or not to embed - that is the question.

As far as I know, no one has thought to bring in behavioral economics into the discussion. In their quest to reform the industry, the regulators (or the press) do not appear to be looking at the impact on basic investor behavior. For instance, will un-embedding commissions and replacing them with fees encourage investing or discourage investing?

I asked world renowned behavior economist, Dan Ariely [1] the question, "How would the proposed new fees affect investor behavior?"

Dan's answer was startling. Actually he answered my question with a question:

"Maybe people will not seek advice if they have to pay directly. If they pay directly, they will be definitely much more upset."

[Editor's note: Now we know why non-adviser mutual fund firms are chomping at the bit to ban commissions. They know all too well, that many investors will refuse to pay direct fees to advisers. Therefore, it would be in their best economic interest to have commissions banned in order to destroy their competition.]

Behavioral economics has become increasingly important, especially with respect to actual investor performance. Study after study has shown that the average investor badly and drastically underperforms their own investments by essentially repeating irrational, but predictable behaviors. If we can be made aware of these behaviors (by your adviser, perhaps), then hopefully we can become better investors overall.

"Whatever you do, I think it's clear that the freedom to do whatever we want and change our minds at any point is the shortest path to bad decisions. While limits on our freedom go against our ideology, they are sometimes the best way to guarantee that we will stay on the long-term path we intend." -- Dan Ariely

I definitely recommend reading Dan Ariely's bestselling book "Predictably Irrational" for more background information. One of Mr. Ariely's recent studies concerns the "pain of paying" where he gives a number of actual examples. For instance, you might want to increase the "pain of paying" to help curb overspending. To do this, you would pay everything in cash rather than use a credit card. See Dan's video as to why this is effective. However, for some things where you want to encourage consumption (like investing perhaps?), you want to lessen the "pain of paying" - not increase it.

The press and the Canadian Securities Administration of course, always have the best intentions. They want to see investments conflict-of-interest free, everything open and transparent, and believe that investors should be completely financially literate with respect to their investments.

But I think they missed something quite important. Sure, markets are making record highs and some clients might be willing to pay fees if their account balances are going up every month. However, what happens if the stock market stalls or goes into a big 60% decline like in 2009? Suddenly, we now truly understand the "pain of paying" and there will be no doubt that there will be lots of pain in the next market downturn - whenever that might be. The pain of seeing your life savings cut in half (or more) plus to add insult to injury, you receive your broker's bill for advice in the mail. My view is that investors will revolt and refuse to pay by not investing.

"If someone has say, $1 million dollars in a bank account, savings account, retirement account and pays 1% asset under management a year, he probably is willing to pay. But if he had to pay directly, exquisitely $10,000 a year, he probably will not do it."—Dan Ariely

I think Dan Ariely nailed the argument right there. I think what he is saying is that the investor is willing to pay an embedded commission because likely, the investor inherently knows an adviser has a cost element attached to it, but the investor is not willing to pay an un-embedded fee/bill for the same amount of money. The client would prefer a built-in commission over an open, transparent but exquisitely painful bill.

What we can conclude at this point:

1. According to arguably the world's foremost expert in behavioral economics, the questions may very well be, "How many investors are going to stop investing entirely or are not going to be put in the correct investments? How many investors would just stop saving?" As Mr. Ariely notes, the abject aversion to fees may cause fees to drop overall as investors may refuse to pay them. Normally, in a capitalist society, this might be considered a good thing, but there are other consequences that he describes as "terrible".

2. As a result, the regulator may be inadvertently harming the client with the good intention of improving things not realizing that these good intentions may lead to catastrophic results.

In effect, behavioral economics tells us that we may be actively discouraging consumption of a product/service just at the time we need it the most. Additionally, we can also conclude that there is no benefit to the investor by forcing them to pay directly, and there is no benefit to increase the pain of paying for a product which we need to be consuming.

We may further conclude that not only is there no benefit to making these changes - we may actually do harm to the client and discourage investing in general.

Clients may have spoken but they are not being heard. They want an all-in-one investment that is simple and easy to understand without all the jargon. They would be happy (perhaps) to receive a piece of paper with all the disclosed costs and adviser remuneration. Although this is already being done, the document currently in use, is overly long and complicated.

The regulator can play a key role by shortening up massive legal disclosures now in existence and condense them to one or two pages. Advisers could be required to verbally disclose all these details and to also ensure that the client understands; the regulator could also require the adviser and the investor to sign off on this important document.

Rather than legislating a one size must fit all solution, give clients the choice. Simplify the disclosures and shorten the documentation. Give the client the option to keep the current embedded all-in-one pricing or choose to be billed in a fee-based account. This is the system we use now. This is a far more flexible and fairer solution which offers the best chance of matching a client's financial needs with an investment product or service that best suits their particular situation.