Fees and Commissions: “To embed or not to embed – that is the question”

Although I have written extensively on the topic and have expressed some concerns about the proposed mandatory use of a fee model in order to replace the traditional commission structures, business writers, journalists (and regulators) think and believe that the new fees will do wonderful things for investors.

I do not share that view.

For instance, I do not think charging a separate fee in order to buy a Guaranteed Investment Certificate (GIC) makes much sense. Currently, a GIC is sold with an embedded fee or commission of 0.20% to 0.25% per year of maturity.

EXAMPLE: a $10,000, 1-year GIC @ 2.0% has an embedded commission of $20 to $25. If my payout is 50% of that amount, I earn a gross commission of $10 or $12.50. My cost to buy the GIC is $15, so in reality, I’ve lost money on this particular transaction. The client gets a great deal - the advisor not so much. But that is the cost of business –you can’t expect to make money on each and every transaction. However, unlike mutual funds where costs are disclosed, the fees and commissions for GICs are not open, transparent or disclosed. They are embedded in the cost of the product.

Wait a minute; shouldn’t we be calling the police or the regulators?!!! The commissions are hidden and not disclosed and I need to know this information in order to make an educated and informed decision! The Globe and Mail editorial columnists would of course, describe this as heinous behaviour on the part of financial advisors taking advantage of the public while lining their pockets with hidden GIC commissions.

Unfortunately, the newspaper may forget to point out that an advisor could easily obtain up to double the interest rate an investor might get from their own bank.

So what is a better system?

1. Advertise a 1-year GIC rate of 2% (costs all included). This is our current system of embedded commissions.
2. Advertise a rate of 2.25% and then hand the investor a separate bill for 0.25%.

From a money psychology viewpoint, which of the two above options would you prefer?

I don’t know about you, but I think I would want to stick with the traditional all-in-one final price: Option #1 (all costs included) because what I see is what I get.

Let’s use another example:

You are at Canadian Tire and need to buy a screwdriver. The price sticker on the shelf says $7.77 ea. You grab one off the shelf and proceed to the checkout.

The cashier duly tacks on the 13% HST (for Ontario) and the price is no longer $7.77, it’s really something higher.

While the cashier is ringing up the sale, you are doing some mental gymnastics..let’s see... $7.77 times 1.13 is what...? Damn the new math. The cashier snaps you out your reverie. Her cash register is faster than you are. “That’s $8.78.” she says.

Shoot! You have a five plus a couple loonies. Have to use the new credit card. What is that new PIN number again?

Wouldn’t it be nice to rewind the tape, retrace our steps back to the tool aisle and see the price of the screwdriver priced at $8.78 and when you go the checkout the price you see is the price you get? And yes, for the few of us who absolutely need to know, the tax breakdown on the cash register receipt can give you the detailed breakdown of the taxes that were included in the price.

Does the above example make sense? Of course it does. It is simpler and easier to understand.

Unfortunately in the alternate universe of murky regulatory reform, it doesn’t make sense at all. In that universe, all-in-one pricing even with a detailed breakdown of all included costs is evil incarnate and must be banned permanently. Price plus open-ended variable fees depending what each individual investor can negotiate, is the only way to truth and transparency.

Imagine buying the same screwdriver in that alternate universe. Each one would have a different price.

Most unfortunately, the press and the regulators believe the alternate universe is a better universe.

I disagree.

Embedded costs, fees or commissions are not evil just merely because they are embedded into the price of the product. GICs have always been sold with embedded commissions (fixed and invariable). Does this make GICs evil or the advisors who sell GICs unethical or immoral?

Of course not.

Are mutual funds with disclosed commissions evil because these costs are embedded into the final pricing of the product?

I think you already know what my answer might be.

For mutual funds, exchanging a 1% built-in disclosed commission for a 1% (or higher) tacked-on fee with a conversion cost to the industry of perhaps a couple billion dollars – makes no sense to me.

The current system gives investors a very wide number of choices. Currently you can choose between a traditional commission structure or some sort of fee-for service billing based on a flat fee or percentage of assets. Some individual practitioners might even prefer hourly billing.

If embedded costs are the same or less than unembedded costs, why go through all the agony of changing a system that is fair and equitable and just plain works?

Sometimes the best course of action is to do nothing when nothing is the best thing to do. My advice to the press and regulators is this:

[1] quote attributed to Jack Bogle –founder of Vanguard funds.