May 28, 2006

Commission vs. fee-based vs. fee-only
Which advisory model is best?

There is a slow but steady trend among financial advisors whereby they are transitioning from a pure commission-based model, to one where they charge fees based on portfolio value. Advisors resident in each camp continue to debate strongly the relative merits of each model. Which model is best? It depends.

Business models

Since there are no universally accepted definitions, here are my definitions of commission, fee-based, and fee-only advisors.

The dominant model used by Canadian financial advisors is to sell products (i.e. load mutual funds & life insurance) of companies that will pay a commission to selling advisors. Clients need not write a cheque for the advisor's services and receive no invoice.

Fee-based advisors come in different forms and may use different terminology. Many fee-based advisors simply operate on a front-end load basis - charging no front-end sales charge but doing so to secure the higher trailers paid on front-end funds. These advisors may also use mutual fund wrap programs like Harmony, Quotential, Sovereign, or Viscount. Advisor compensation remains embedded in the products used and advisors earn commission income (i.e. load mutual funds).

Fee-only is the term given to those advisors whose only compensation source is the client; with no fees or commissions accepted from any other party. These advisors may use low-fee mutual funds (i.e. F-class or no load), exchange traded funds, and individual securities. Such advisors, if they serve high net worth individuals, may use separately managed accounts or simply position themselves as a manager of managers. Since fee-only advisors use products that pay no commission, they invoice clients separately for their services.

Annual cost of commission advisor: about 2.50%

Clients of advisors working on commission would pay an average of about 2.5%, including GST. That's the median of all mutual funds in Morningstar Canada's PALTrak software program so it's representative of what the typical client is paying. Roughly half of these clients buy mutual funds on a deferred sales charge (DSC) or back end load basis.

Annual cost of fee-based advisor: 1.50% to 3.00%+

Clients of fee-based advisors could be paying anywhere from 1.5% to well over 3% per year. I suspect the broad range of fees here is due to the embedded nature of advisor compensation. For instance, an advisor could use pooled funds from Acuity or Standard Life (Legend series) and receive up to 0.5% per year in trailers and the client would pay no more than about 1.5% per year in fees. However, these products also allow advisors and clients to agree to add additional fees on these products taking the cost up to an additional 1% or so per annum. Also, many wrap programs, often used by so-called fee-based advisors, carry annual fees in the 3% to 3.5% range since many build in 1.5% per year for the advisor.

While the total cost to the client is comparable to the commission model, it's unusual to find any DSC or back-end loads with fee-based advisors. (However, this is not unheard of as some wrap programs have DSC sales options.)

Annual cost of fee-only advisor: 1.25% to 2.50%+

Clients of fee-only advisors can also face a wide range in fees but the important distinction here is that all of the advisor's compensation comes only from the client. The range in fees, again, results from the choice of product.

Advisors using ETFs and individual securities should be able to structure a balanced portfolio for a client for about 1.25% per year - assuming a 1% annual fee for the advisor. However, many advisors have fee schedules that start at about 1.5%, which drives the total portfolio cost into the 1.9% range for a passive investment portfolio.

If, instead, the fee-only advisor is making at least partial use of F-class mutual funds (i.e. actively managed funds with advisor compensation stripped out), the cost will likely approach that of the commission model. Fees for F-class mutual funds range from about 60 basis points for some bond funds up to 1.75% or more for some global or specialty equity funds. So, clearly, the bottom line fee here is highly dependent on the product choice and could even exceed that of the commission option.

In all of these models, the client is (directly or indirectly) paying the advisor not only for providing the advice but also for implementing all of the recommendations agreed to by the client and for ongoing service (i.e. regular reporting, fielding calls, annual reviews, etc.).

While the total cost of each model may be quite similar, each differs significantly in the level of transparency and resulting accountability.

Transparency

The highest level of transparency is achieved by the fee-only advisory model since there is no doubt about who is paying what to whom and why. All the cards are laid out on the table in an invoice to the client. The only downside here is the consumer psyche.

Remember the uproar that ensued when the embedded manufacturer's tax was replaced with the more transparent GST? Yes, people pay more attention to what they pay when it's in their faces, rather than when it's 'out of sight, out of mind'. And switching from the latter to the former is painful, indeed, despite any associated benefits.

The fee-based model comes in a distant second since the compensation is still embedded in the product cost. So, transparency may depend on the choice of product and the diligence of the advisor. For example, wrap programs will usually show the quarterly fee details, even if fees are simply paid by selling units of the wrap pools. This disclosure gets a thumbs-up, but what it doesn't include are those fees charged directly at the fund level.

It is common practice for operating expenses and, in some cases, base fees for the wrap manufacturer to be deducted at source - i.e. at the fund level. Fund-level expenses are not shown on quarterly statements as fees paid since they are already factored in daily (in the calculation of each fund's net asset value per unit). An advisor may go out of her way to summarize these all-in fee figures for clients but it is not required.

While mutual fund disclosure is quite good today (despite the odd beef), only 'keener' clients of commission advisors - a small minority - have any clarity when it comes to their total portfolio costs and the portion that is paid to their advisor (and his dealer). So, transparency depends entirely on how keen the advisor is to fully inform clients about such details.

For instance, when I was the in-house analyst for a MFDA firm, I designed investment policies (and drafted investment policy statements) for clients of some of our advisors when my help was requested. The first page was a cover page. Pages two and three explained the various forms of fees and commissions and quantified these items for each client - in percentage and dollar terms. The result was a level of transparency exceeding that of fee-based advisors and equal that of fee-only advisors. But, again, this depends entirely on the advisor. (Incidentally, my experience has been that advisors looking to woo wealthy clients would do themselves a favour by opting for full disclosure. See this October 2004 article on this topic.)

Accountability

Generally, the more transparent the advisory model, the more a client is likely to hold an advisor accountable not only for the quality of his advice, but also the quantity. In short, a client is less likely to question the value received for his commission dollars when the commissions are somewhat out-of-sight. On the other hand, when the compensation is more in-your-face - as with receiving an invoice and having to write a cheque - clients are more likely to shrewdly compare fees with services received.

Having been on both sides of the fence (I started as a commission advisor and have been providing fee-only advice for several years) I can say that this accurately describes my experiences.

The superior model

No one advisory model is categorically superior to the other. With minimum fee levels the norm for fee-only advisors, clients will less than $250k to invest are likely best served by qualified fee-based or commission advisors. Indeed, it is this variety of choice that allows most people to gain access to financial advice that might not otherwise be available in a fee-only model.

Then again, regulators continue to grapple with the fact that most individuals calling themselves 'financial advisors' actually carry a sales license. Accordingly, these salespeople or advisors only get paid once they sell a product. With so many of these folks conducting themselves as truly professional advisors, there is a mismatch between the value of the services actually provided and the value of the service that actually triggers compensation.

In theory, fee-only may be a superior model based on costs, transparency, and accountability. However, if all advisors choose this model, many people would simply refrain from getting any advice - a choice that is arguably the most costly for the majority of investors. Plus, a model doesn't make a superior advisor. Only superior individuals make superior advisors.

And of the question that graces this article's by-line (which model is best?) one might ask: best for whom - advisor or client? My response is that, longer-term, what is best for the client is also best for the advisor. After all, what is better for an advisory business than taking good care of clients?