Advisor compensation: no fee model is free from potential conflicts

By Dan Hallett, CFA, CFP on June 16th, 2010

Financial advisor compensation is one of those topics that is hotly debated but never fully resolved.  A recent article by the National Post’s Jon Chevreau sparked a private exchange between me and another person quoted in that article.  The exchange raised a number of issues, some of which I consider misunderstandings pertaining to advisor compensation.

Is fee-only superior to commission?

Fee-only refers to advisor remuneration that is paid entirely by the client – and nobody else.  Commissions on the other hand see product sponsors paying advisors for placing client money in their products.  If the introduction of the GST in 1990 is any indication, Canadians may prefer bundled and hidden fees.  There are arguments in favour of both forms of paying advisors for their work.

Fee-only advisors, who usually charge some percentage of client assets, don’t usually offer lower fees for clients.  Fee-only advisors’ advantage lies in the transparency and the resulting accountability.  But this is not the exclusive domain of fee-only advisors.  Forward-thinking advisors who are paid by commissions can create the same level of transparency.  When I was a dedicated research support for a MFDA dealer I created investment policy statements for advisors’ clients with portfolios valued at $250,000 or more.

I wrote the IPSs and detailed portfolio recommendations on one condition – the advisor had to include my plain language explanation of various fees and commissions and a dollars-and-cents disclosure of the weighted average MER on the current and recommended fund portfolios.  In every case, our advisor was the first to provide that kind of disclosure.  Presto – clear transparency on fees and a professionally-written IPS.  It’s not rocket science; any advisor can effect the same transparency in a commission model (if they can get their compliance department onside).

Neither model is categorically superior in my opinion.  With good disclosure, the choice comes down to suitability, which is based on client-specific factors including portfolio size, range of services required, client personality and preferences.

Do load funds create an equity bias?

Some charge that because trailing commissions are higher on equity funds (1% annually) than on bond funds (0.5%/yr) that the advisor can make more money if s/he can justify a higher equity weighting.  Indeed, there are consultants like Nick Murray who espouse an all-stocks-all-the-time strategy that, in my view, is disconnected from investor behavioural realities – but that’s another topic.  The argument is that by charging the same fee for all asset classes, the advisor’s conflict disappears.  But this structure is not conflict-free.

Fee-only advisors typically charge an amount starting from 1% per year of the value of their client’s portfolio.  By charging 1% on stocks and bonds, the fee-only advisor may well find himself with the same equity bias as his commission-based counterpart, albeit for different reasons.

Consider that the Canadian bond market sports a weighted yield to maturity of about 3% annually at the time of writing.  An advisory fee of 1%, in addition to the underlying cost of the bonds (let’s assume 0.3% for an ETF) and taxes on both brings total costs somewhere around 1.37% per annum (1.47% after HST is implemented).  That’s almost half of available bond yield.

A forward thinking advisor could easily do that calculation and figure that his clients with balanced portfolios will not be happy after a few years when they find they’ve made next to nothing on their bonds net of fees, in a best case scenario.  This advisor might just as well want to find a reason to recommend a heavier stock allocation simply to avoid the risk of disappointing clients and losing their business.  Such business risk is also tightly linked to compensation because fewer clients = fewer assets on which to charge fees = lower revenue for the practice.

So the answer to the above question is ‘yes’ but it’s ‘yes’ for both fee-only and commission models.

Which method pays advisors/costs clients more?

This cannot fairly be generalized.  In theory, commission-based advisors have just as much flexibility on pricing as their fee-only peers.  In my days with the MFDA dealer, I introduced many of our advisors – and their clients – to funds from solid low-fee boutique money management firms.  Even though the trailing commissions were a skinny 0.2% to 0.4% annually, advisors were happy to include these quality products.  Sure such low-fee funds paid them less but were used for part (not all) of the portfolio.

And the advisor was the only one of her peers presenting a professionally-written IPS containing unique solutions blending traditional load funds with cheaper products from institutional boutique firms.  I still get calls today from those advisors thanking me for designing such solutions for their clients.  My point isn’t to give myself a pat but to demonstrate that forward-thinking advisors can compete head-to-head with their fee-only competitors on fees and quality when they choose to do so.

The commission-based advisors who don’t operate in this fashion may have a harder time competing for larger clients.  Some will use fee-based offerings from various fund companies to satisfy their high net worth client needs but that product segment is seriously lacking in quality.  (Sales pitch alert:  this is where our Guided Portfolio Package, Managed Funds Program and Managed Investments Program can add real value for advisors, dealers and clients.)

Which model is free from conflicts of interest?

No method of paying an advisor is free from potential conflicts.  Commission-based advisors and fee-only advisors have a bias toward advice that leaves more money invested so that they can continue generating revenue off of a larger asset base.  Some consider paying an hourly fee for an advisor’s time, or a flat fee-for-service, is the solution.  It’s not.  First of all, the increased costs of new regulation make this model unfeasible for a firm that is actually licensed to give individualized investment advice.

Second, these structures have unique conflicts.  Paying an hourly fee could motivate ethically challenged advisors to recommend unnecessary work or pad the time sheet to maximize revenue.  Flat dollar fees for specific services will have the reverse effect.  Since the fee is fixed, it could motivate advisors to minimize the amount of time spent on client files in order to maximize the effective hourly rate.

Good advisors know that their revenue comes from clients, whether it’s direct or indirect.  And good advisors feel that it is their responsibility to provide great value for the fees or commissions they receive.  In other words, good wealth stewards are not defined by their method of compensation but rather by their character and conduct.