We all know the expression ‘there’s no free lunch’, and no matter which industry or profession you’re talking about, that holds true. In the Financial Services industry, specifically the Financial Advising part of it, there’s seems to be this misconception that, unless you have a Fee-For-Service Advisor, the services provided by your Financial Advisor are ‘free’ to you. Now, the reality is, that in one way or another, your Advisor gets paid – whether directly or indirectly by you.
Generally, in the investment world, Financial Advisors will fall into one of 3 categories: Commission based, Fee based or Fee-For-Service.
Fee-For-Service
This is probably the easiest one to explain. As you can tell by the title of it, this is where you as the client, would pay a Fee to the Advisor for putting together a Financial Plan for you. Some Advisors have different levels of plans, which can be more or less detailed based on your needs, and will charge you according to the level or ‘package’ that you choose. The Advisor would generally charge you either a flat fee (generally between $2000 – $4000) or an hourly rate ($200-$400/hour) to put together a plan for you, and then you decide whether you want to implement the plan or not. The implementation does NOT have to be done by that Advisor, so you are free to decide when or with who you do that with. Some Fee-For-Service Advisors don’t even offer the implementation option through themselves and will tell you to either find your own person, do it yourself, or will refer to someone they know who can implement.
Traditionally, this has been something that has been used by the higher net worth clients, as sometimes their situations (tax planning, estate planning, succession planning etc…) can get very complicated, and they don’t mind paying a fee to make sure they have the best plan for themselves. This fee can usually end up being very minimal compared to the overall benefit they would have received and the fee can also be written off on their taxes.
The Fee-For-Service side of things can often be seen as the most ‘un-biased’ type of Advice a client can receive, as the Advisor generally will recommend the most efficient and effective plan to the best of their ability. The Advisor will generally not have any bias or ‘favouritism’ to any one company, as they are getting compensated only for putting together the plan and it might not even be implemented. Now, IF the implementation was done by the Advisor also, they would get compensated by the investment/insurance companies that the business was put through as well. However, since there is only a small percentage of Financial Advisors that do Fee-For-Service, the competitive nature of that side of the industry creates an environment of due diligence and proper planning.
Generally, a much higher percentage of Financial Advisors on this platform would have completed their CFP (Certified Financial Planner) designation and other credentials, as to add more credibility and professionalism to themselves. The amount of time and money spent by these Advisors to continually upgrade their knowledge and understanding on all the aspects of Financial Planning (investments, insurance, taxes, estate planning etc…) is something that should not be overlooked, and is something that generally would enable them to do a better job for their clients. This is also one of the reasons why these type of Advisors feel that they should charge a Fee in order for a client to use their service.
Commission Based
The Commission Based Advisors make up, by far, the largest percentage of Advisors in the industry. These Advisors generally get paid up front based off the amount of the investment made by the client. This payment can either be made by the Fund Company or the Client, and the way the account is set up will fall into one of 3 categories: Declining/Deferred Sales Charge (DSC), Low Load (LL), or Front End (FE).
Declining/Deferred Sales Charge (DSC)
DSC, or Declining/Deferred Sales Charge, is where the Advisor would get compensated both up front, as well as, along the way (while the assets are still held under that Advisor). DSC has been very popular in the Commission Based world, but has come under a lot of scrutiny over the last several years, and rightfully so. The way DSC works is as follows:
The client will invest money through an Advisor, which will then be invested into ABC Fund Co. ABC Fund Co will then pay the Advisors firm 5% up front sales commission, and then the firm will pay the Advisor a percentage of that – For example: A client invests $100,000; therefore 5% (or $5000) is paid to the Advisors firm, and then the Advisor would get a percentage of that amount. Also, on top of this, the Advisor would get what’s called a “Trailer Fee” or “Service Fee” of 0.5%/year (based on the asset size), which they would get as long as that client stays on the books – a $100,000 investment would pay $500/year in Trailer Fees.
Now, since the Fund Company has paid the Advisor/Firm up front, they want to make sure that the client sticks around long enough for them to recoup the money that was paid to the Advisor/Firm, so they put the client on a “Schedule”. This is somewhat of ‘locked in’ type of schedule – similar to having a penalty to break your term or payoff your mortgage early. This means, if the client were to redeem or transfer their funds out of that Fund Company within a certain number of years (usually 7 years) , the client would pay a penalty. The penalty is declining annually (usually will be about 5.5% – 6% in the first year, and going down from there), but doesn’t always go down evenly.
On one hand, we can see why the Fund Company would want to have this ‘schedule’- so they could recoup the up-front costs to them. On the other hand, if they are paying out 5%, why would the first year redemption fee be higher than that? That doesn’t seem to make any sense, since they are also saving 0.5%/year in Trailer Fees that they would have paid to the Advisor had the Advisor chosen to use the Front End Option (discussed below). This type of strategy seems like a win-win-lose situation – Win for the Fund Company, Win for the Advisor, and Lose for the Client.
There is one positive, however, for the client, which comes in the way of “Free Units Switch”. Every year, the Fund Company will allow the client to move 10% of their investments from the DSC version of the Fund to the Front End (FE) version of the fund as “Free Units”, which means that portion of the investment is no longer part of the DSC schedule. For example, on a $100,000 investment, the client would be able to move 10% (or $10,000) over to FE that year, which means if the client wanted to redeem that portion of their investments, they would not get charged a penalty.
Clients also are able to move from one fund to another, within the same company, without being hit with DSC fees. However, the DSC schedule just moves over with each fund that they are switching to.
Although the Free Units Switch does allow a little flexibility, the reality is, putting clients into a DSC investment does not seem to be in the client’s best interest. Many things can happen over 7 years which might require the client to redeem a portion or all of the investments. It could be a family emergency, loss of a job or even that the client would be better suited for an investment offered through a different Fund Company. Being ‘locked in’ or on a ‘schedule’ only benefits the Fund Company and the Advisor (who is getting paid very nice up front). The reality is many clients don’t even realize that they’ve been put on a DSC Schedule, and only find out when they need to redeem funds or want to move their investment out to another company.
It’s no wonder the regulators are looking heavily into removing this option altogether from the landscape, as complaints have been piling up rapidly by clients who have had to pay hefty redemption fees to get access to their own money.
Low Load (LL)
Essentially, the Low Load (LL) option can be seen as “DSC Light”. Whereas, DSC would pay 5% up front to the Advisor/Firm, LL would pay 3%. Also, where DSC has a 7 year schedule, LL would have either a 3 or 4 year schedule (depending on the Fund Company). Everything else that applies to DSC also applies to LL, except the Free Units Switch – not all companies have this feature on LL funds.
Front End (FE)
This option differs drastically from the above two. Where the DSC and LL option put the client on a ‘schedule’, with Front End funds, there is none. This means that the clients can move or redeem their funds at any point, without any penalties. There is, however, one option that some Advisors do take advantage of, which might not be in the client’s best interest. The Front End option gives the Advisor the ability to charge the CLIENT from 0% – 5% up front, which is deducted from the investment, before the money is invested. For example, if a client was investing $100,000, and the Advisor charged 5%, that means $5000 would come out of the investment and go to the Advisor/Firm, and only $95,000 would actually be invested.
The Advisor ALSO gets 1.00% as a Trailer Fee while the investment stays on the books – compared to the 0.5% the Advisor gets both on the DSC and LL options. Why is this higher? Well, if we were to assume that an average Mutual Fund has an MER (expense) of 2.5% per year, we need to know how that 2.5% is broken down. Generally, the MER is broken up as follows: 0.5% to the Fund Company, 1.0% to the Portfolio Manager, and 1% would be allocated to the Advisor as a Trailer Fee. Above it’s mentioned that on the DSC option, the Advisor only gets 0.5% as a Trailer Fee. This is because the Advisor had already received their commission up front, so the Fund Company only gives 0.5% as a Trailer Fee, and keeps the other 0.5% for themselves.
Now, the reality is, the majority of Advisors would not charge anything up front (i.e. 0% Front End Charge), but there are still some that do. Many Advisors who DO charge up front with this option see it as akin to the Fee For Service side, where the client will actually pay up front for putting the plan together. Charging the client on the Front End is obviously something that should be discussed and agreed upon by the client before the transaction has happened, so there would be no surprises when the client receives their statement. Also, in the event that it is NOT discussed and the client gets charged, they would receive a confirmation of transaction from the Fund Company to show how much the charge was. If the client is not happy or not accepting of this charge, they can request the Fund Company to reverse the transaction stating the reason of non-disclosure by the Advisor.
If we were to assume that an account was being set up with 0% FE charge, then, on the Commission Based platform, this option by far is the best option. There is great Value in having flexibility and not being locked into something. Unfortunately, most Advisors are still setting their clients up with DSC and LL funds, just so they can get a nice paycheque up front. As clients, you should make sure to get the full details of the investment and how it’s set up, before you sign anything. Paying a penalty to access your own hard earned money is definitely a ripoff and should not even be an option.
Fee Based
The Fee Based platform is something that is slowly gaining traction in the industry and more Advisors are now transitioning over from the Commission Based platform. This platform is very similar to having an investment as “Front End”, without the ability to charge an up-front commission to the client. There is complete flexibility by the client to access or move their funds at any point, without any fees or penalties. So, how does the Advisor get paid? Through actual service to the client. Advisors on this platform get compensated solely through AUM (Assets Under Management), and receive a “Service Fee” or “Trailer Fee” type of compensation.
Advisors are able to negotiate a Fee of up to 1.00% with their clients, which is then added to the management fee of the Investment Company. For example, if the Investment Company is charging 0.8% as the management fee, and the Advisor is charging 1.00% as their Fee, the total Fee to the client would be 1.80% (which is less than the approximate 2.5% Mutual Fund MERs on the Commission Based platform). All these fees are disclosed and discussed with the client up front, and even show up on their statements, so clients know exactly how much they are paying in fees, as a dollar amount. On the Commission Based platform, the fees are imbedded into the unit price of the Fund, so the client never sees the charge, making it very difficult to know how much they are paying, and evaluate if they are receiving the Value for the fee they’re paying.
There are other benefits for using the Fee Based platform, such as potential tax deductions for Fees, having access to Private Wealth Management services, lower costs to the client, as well as better overall money management and relationship management. The Fee Based platform is all about transparency, flexibility and a higher level of service from the Advisor. Since there is no ‘lock in schedule’ or up-front sales commissions, Advisors must ensure that they are doing their job, and providing their clients with true Value. The reality is, if they don’t, their clients can easily ‘fire’ them and find another Advisor to take over their portfolios without any costs or problems. This way ensures that Advisors are actually earning their Service Fee and that they are doing what’s in the best interest for the client.
We all know that ‘life happens’ and there are situations where funds need to be moved or redeemed for whatever reason, so it doesn’t make sense for clients to have to pay a penalty to access their own hard earned money. Hopefully, at some point in the near future, the regulators will altogether remove the Commission Based platform, making it much more beneficial for clients. Now, what that also means is that there will likely be a good chunk of Advisors that will no longer be in the industry, but that can be seen as a good thing, as many of them probably shouldn’t have been in the industry to begin with.
Over decades, there have been countless clients who have been put in unfavourable positions by their Advisors by being on a DSC schedule, just so the Advisor could get a nice commission up front. It’s time to eliminate this and provide full transparency and flexibility to clients. Having an Elite level Financial Advisor working alongside with you can help you not only put together the right portfolio for you, but also make sure you avoid un-necessary fees and receive a much higher level of service.
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