Real estate investors famously focus on location, location, location. If they started reading up on hiring a financial adviser, they might conclude the three most important things are fees, fees, fees. At least that’s the view from the outside looking in after scanning various newspapers, magazines, and investor advocacy websites.
Is that all there is to successfully managing your personal finances? Finding the lowest-cost solution?
Every day, investors recount stories of being shocked when they discover just how much they’re paying for financial advice or products, or only the latter. An investor starting from scratch and contributing $3,600 per year into a run-of-the mill mutual fund sporting an MER of 2.5% will have paid north of $37,000 in costs over the first 25 years. The same investor using a 0.25% MER exchange-traded index fund (ETF) with a no-cost automatic contribution option would pay less than $5,000 in costs and have $50,000 more in his portfolio. (We assume each fund can match a market return of 6% per year before fees.)
Results are even more dramatic for large lump-sum investments. In both scenarios $100,000 yields savings of over $87,000 in fees and a portfolio that’s $175,000 larger for the Do-It-Yourself (DIY) indexer over 25 years.
Framed as simply as that, the “fees matter” argument is hard to ignore. But the flip side of any discussion around cost is value. What do you get in return for what you’re paying? Given that the needs of financial consumers are varied, there’s more than meets the eye to this discussion.
It’s about more than just investments or investing
Certified financial planner John DeGoey, portfolio manager with Burgeonvest Bick Securities, tackles these issues in his book, The Professional Financial Advisor III. “Advisers play different roles for different people, depending on their needs and circumstances,” he says. “Many think their role is to pick stocks, pick funds or time markets, but those are decidedly not part of a reputable adviser’s skill set. Instead, the good ones help investors set and work toward goals, plan for life’s surprises, engage in constructive behaviour modification, and maintain accountability with things like regular saving and setting up RESPs for the kids.”
Ideally, financial advisers handle more than just investments. They provide financial planning and motivation to keep clients on track.
Let’s assume you started investing early, have a perfect portfolio and can stick with your investing plan. Perhaps you’re self-employed, with a stay-at-home spouse and three children. You get into a car accident, your spouse dies, and you’re in a coma for three years. Now what?
A financial plan addresses all the risks that affect your finances, not just those in the stock market. While investing can be a grand hobby for some, estate planning and insurance planning rarely are.
Constructive behaviour modification ensures that clients buy low and sell high, rather than just agreeing to it in principle. Investors are inclined to do the opposite, as you can confirm with a glance at fund flows between equity and bond funds during bull and bear market runs. Money pours out of equity funds after stocks tank, then pours back in after years of positive returns. That’s the polar opposite of buying low and selling high. “Intellectual wherewithal is unlikely to be the culprit of financial woes. Usually, it’s lack of focus and discipline,” adds DeGoey.
Being capable of opening a discount brokerage account and executing your own trades is not the same as being qualified to manage your personal finances. Many people manage their own investments but still need help with financial planning. More need help with both. MoneySense readers skew to being more capable and qualified than the larger population, but the latter is often uninterested or unwilling to roll up their sleeves.
Keith Copping, an adviser with Macdonald, Shymko & Company Ltd. in Vancouver, agrees. “We have clients who can successfully implement the advice or plan we provide, but there are also cases where the extra cost of full implementation would work better. We give clients the choice and have a lengthy discussion up front. Failure to implement a plan effectively has a ‘cost’ attached, so it’s not just the fee cost that must be considered.”
Several factors make the issue of cost models multi-dimensional: differences between various compensation models are not widely understood, practical challenges for advisers may be unappreciated by consumers, and choices are limited. Portfolio sizes vary, as does ability to pay out of pocket.
The issue of advice delivery models is more nuanced then you might believe.
Breaking down the fundamentals
First, it’s important to understand there are three distinct services for which consumers engage financial professionals. We’ve already highlighted the first two: planning and investment advice. We’ve touched on a third: implementation or execution. The choice of the right adviser compensation model is tied to how much consumers can practically separate payment for these three aspects of financial advice, and whether or not it’s a good idea for a particular consumer in the first place.
For the uninitiated, a DIY couch potato portfolio combined with paying a financial adviser by the hour, or alternatively, a flat rate for a financial plan and investment policy statement, are often held up as the holy grail of “sticking it” to the sometimes gluttonous practices of the financial industry.
Consider investors with $1-million portfolios. They can get a financial plan, investment advice, and trade execution for roughly $20,000 per year by using a 2% MER mutual fund in a traditional commission model. But if they used a DIY couch potato portfolio (annual cost about $3,000, including commissions) and hired a financial planner on a flat-rate basis (a plan and monitoring may cost $3,500 the first year and $1,500 thereafter), they would save $13,500 in year one and $15,500 annually thereafter. Unfortunately, this cost savings is a utopia that may be unachievable for many investors. Not just because there aren’t a lot of true fee-for-service planners operating in Canada but also because of the hidden “cost” of inaction, improper execution, and inability to stick to a plan on the part of investors who attempt to fly solo.
Investors can do more harm than good by focusing exclusively on lowering fees. Not everyone can execute a financial plan and adhere to an investment policy statement on their own. A former colleague once quipped the most under-appreciated function of advisers is to act as a ‘stupidity brake.’ That’s less politically correct than “constructive behaviour modification.” Anyone who’s tried to implement a true couch potato strategy will tell you extreme conviction is required to stick to the plan—the very simple plan. Paying someone who recommends doing nothing, especially in the face of unrelenting news stories about the latest market meltdown, can be perceived as laziness when it could be the most valuable advice you could get.
A more practical model for mid- to high-net worth investors is the asset-based remuneration model, often referred to as ‘fee-based.’ With a 1% annual fee on assets (for example), an adviser’s compensation would be transparent and separate from product-based commissions. A fee-based couch potato portfolio may have an all-in annual cost of roughly 1.3% but that would include investment advice, financial planning, product acquisition and execution. For our $1-million portfolio, we’ve dropped annual costs from $20,000 to $13,000—but savings come from a switch to cheaper products. Adviser compensation ($10,000) is the same as in the commission example. But with adviser pay not dependent on product choice, the adviser is more likely to recommend or at least accommodate a couch potato portfolio.
As interest in couch potato portfolios grows, consumers and advisers are realizing not everyone is capable of handling it on their own. Low-cost couch potato strategies coupled with planning and coaching from an adviser is a model set to grow by leaps and bounds in the next five years. But before we can examine which financial advice cost model works best for whom, we need to take a step back and re-think what we know about fees and commissions.
Commissions vs. fees
There’s a difference between commissions and fees in financial services, although the terms are often used interchangeably. Fees are payment for a service rendered for a client and originate from the client. Commissions are payments based on transactions or products. They originate from a product manufacturer like a mutual fund or are triggered by a transaction such as buying or selling a stock.
Commission Model The traditional model of commissions, with transaction costs for buying and selling securities, as well as commissions embedded in the cost of products like mutual funds, has long been dominant. Many classes of mutual funds generate ongoing compensation to advisers. Some use the term “trailing fee,” but it’s actually a “trailing commission.”
When mutual funds first exploded in popularity, more of the costs investors paid became embedded and, practically speaking, were hidden. This model bundles product, transactions, advice, execution, and cost together whether you like it or not. But you can’t get advice from advisers who offer only commissioned advice without first buying a product or making a transaction. In some cases, there is no planning advice: only investment advice.
For investors with modest nest eggs, this is the only practical option in the current milieu, but it may also turn out to be the best and cheapest model. Say a salesperson convinces someone to contribute $250 a month into a fund with a 2.5% MER. Commissions in year one are under $50 but pay for product, cursory advice (maybe all that’s needed at this point), and execution. Add the value of initiating a healthy saving or investing habit in someone previously bereft of either, and the traditional commission model starts to look attractive—as long as there is transparency.
Once portfolios breach six figures, other advice models become viable mathematically. But they’re not flawless. No one model is.
Fee models come in two flavours: asset-based and fee-for-service.
Asset-Based Fees: The asset-based fee model is set as a percentage of a client portfolio. If you had a $500,000 portfolio with an annual 1% fee, each year $5,000 is deducted from your account for advice and execution. The charge is transparent, so clients see this figure in writing. They write a cheque or have fees deducted from portfolio cash balances. Product costs are separated. Individual stock and bond transactions are covered by the advisory fee, but ETFs retain their product cost (they can’t be stripped out). Mutual funds used are “F-Class,” with compensation stripped out. A commission-model version of a fund may have a 2.5% MER, but clones in a class designed for asset-based accounts may have an MER of just 1.5%. This means no payment from the product manufacturers goes to the adviser or firm, reducing potential conflicts of interest and raising transparency. This may or may not lower costs. This advice model has increased tremendously in popularity over the last 10 years.
Fee-For-Service: The pure fee-for-service model is relatively rare. Quite simply, fees are charged either by the hour or by the project on a flat-rate basis. Hourly fees may run between $100 and $275 an hour. A flat rate for a financial plan and investment policy statement (IPS) ranges from $1,000 to $5,000. Fee-for-service is also offered by a newer category of financial advisers known as money coaches. Money coaches tend to focus more on financial behaviour, and work on a more intensive basis for a contracted period of time. They can also develop financial plans, but do not sell securities.
The fee-for-service model is the most transparent, most unbundled methodology. You can engage an adviser for investment advice or financial planning advice, or both. Execution is separate and often not even an option. This works wonderfully for investors who can execute on their own via discount brokerages and engage other professionals such as lawyers and insurance agents as necessary. But again, being capable of handling one’s own trades with a discount broker does not mean one should necessarily handle one’s own trades.
Which model is best for whom?
Let’s step back and look at a financial analysis of which model is best for whom.
For those with no savings, a flat-rate, simple financial plan could run $1,500 on the low end. Few in this situation will pony up that kind of money. An asset-based pricing model may not even be available at asset levels below $100,000. So initially, commission-based advice may cover everything a new investor needs: a cursory financial plan, product, and execution, all for the lowest costs. In that sense, high MERs may well be a small price to pay for novice investors, for all the lack of explicit transparency inherent in the model. But it should be noted that advisers can achieve transparency in a commission model simply by being transparent. If they take the time to break down the costs and embedded compensation that commissioned products carry, they fulfill the ultimate expectation of consumer advocates: providing investors with informed choice.
As asset levels rise, negotiability of fee-based models looks more attractive: that is, while you may have to pay 1.5% of assets with a $150,000 portfolio, it would be reasonable to push for just 1% at $500,000. The explicit transparency, on the other hand, can become a focal point. Some consumers prefer to have costs embedded. When I was an adviser, I switched a client from a traditional commission-based mutual fund portfolio to a fee-based arrangement that was marginally less expensive. After eight quarterly statements, the client wanted to go back to the commission model. He couldn’t stand seeing the fees, even though after running the math on both models he understood it was slightly cheaper. He was self-aware enough to realize that for him, this figure was an anchor that pre-occupied him. But I believe he was an exception, and most investors would opt for explicit transparency in order to pay less, especially as the difference in costs increases with portfolio size. Still, it serves to highlight important psychological factors we all need to consider.
Once assets rise north of $1 million, the DIY portfolio coupled with a fee-for-service financial planning model starts to pull away, at least in terms of absolute cost. But it works in practice only if consumers possess true, honest self-awareness about their own limitations. There are varying degrees of rationality among financial consumers.
Advisers who operate purely on a fee-for-service model are rare, especially in Canada. (The model is much more common in the United States). In our market, there are issues on the supply side (advisers) as well as demand side (consumers).
For advisers, the pure fee-for-service model is economically unattractive. A commission-based or fee-based practice has tremendous scalability. The heavy lifting in a relationship is performed early on. Aside from moderately intensive reviews every three to five years, an established relationship becomes less work and is more lucrative for advisers as time marches on. Assets grow and compensation models tied to asset growth clearly exhibit ever-rising compensation. By contrast, a pure fee-for-service model implies a direct relationship between an adviser’s work and compensation and is effectively capped by the number of hours an adviser can work.
Many advisory teams in Canada generate more than $1 million in commissions or from asset-based fees from clients. Few fee-for-service planners could earn even half that. At $200 an hour and a standard work week, at best they could bill 2,080 hours in a normal year, assuming every hour was billable day in and day out. Realistically, half their time would not be billable, since they must also devote time to sales and marketing, and running their businesses. I’ve yet to hear of fee-for-service advisers in Canada forced to turn away clients because their schedules are too full.
Karin Mizgala, CEO of Money Coaches Canada—which operates exclusively on a fee-for-service basis—agrees. “There usually isn’t the same financial upside for a fee-for-service adviser compared with an adviser selling investments or insurance. However, a credentialed fee-for-service adviser can earn a decent professional income similar to an accountant.”
Dan Hallett, vice president and principal at HighView Financial Group, has found clients have a hard time with the review-and-monitoring process. “Some come in for annual reviews, but end up scheduling reviews at 18 months or 24 months. With an hourly fee model, after the initial work and recommendations, many clients minimize contact to keep a lid on fees. Clients may be happy getting advice with relatively low fees, but it’s not ideal because the client isn’t being looked after the way they should be,” he says.
Some investors find their enthusiasm for the fee-for-service model wanes over time. They could have a situation down the road where not only do they not have an adviser checking in on them, but they aren’t even checking on things themselves. The cost of inaction or overconfidence is hard to quantify.
A focus on fee reduction is important, all other things being equal, but all other things are not equal. The end goal of fee reduction is greater financial well-being. That may be measured primarily by potential portfolio size. But greater financial well-being encompasses more than that. It includes security today as well as tomorrow. The degree of assistance a consumer requires must be factored into the analysis of which advice model works best for an individual. For some investors, opting for the lowest fees may turn out to be a costly mistake.
What the heck does “Fee-Only” really mean?
There’s mass confusion on what actually constitutes a fee-only advisory practice in Canada. Outside the industry, there are at least three distinct compensation models: commission-based, fee-based, and fee-only. Fee-based is synonymous with fees charged on a percentage-of-assets basis while “fee-only” has been synonymous with fee-for-service.
Inside the industry, it’s a bit different. Commission-based advisers receive most of their income through commissions, but may offer other models. Fee-based advisers receive most of their income from fees levied as a percentage of client assets under management, but may also receive some commissions. But as long as adviser compensation originates directly from the client and never from product or transactions, they can use either a fee-for-service or a percentage-of-assets fee model, or both, and still refer to themselves as “fee-only.” This is a very subtle point that most laymen, and even financial journalists, do not fully appreciate.
John Gibson, president and founder of EES Financial Services Ltd., is considered a founding father of financial planning in Canada. His company has offered strictly fee-for-service advice since 1968. “We are Canada’s oldest ‘fee-only’ financial planners. Some use the term ‘fee-only’ as a marketing tool more than as a philosophy. People call themselves all kinds of things in Canada. But put us in the room with anyone and we’ll sort out that confusion,” he says.
The problem is the widespread confusion over terms may mean few people will actually be in that room. There is a lack of consensus on the definitional difference between “fee-only” and “fee-for-service” within the adviser community.
Don’t look to regulators for clarification: the terms “fee-only” or “fee-for-service” are not defined under securities legislation. In fact, fee-for-service financial planning and investment guidance doesn’t even require a license if an adviser doesn’t execute transactions or provide advice on specific securities with respect to an individual’s particular situation. While lack of licensing is not an indictment in and of itself, it warrants extra caution and perhaps heightened self-awareness of an investor’s limitations.
Among advisers, opinions are split as to whether advisers who don’t exclusively offer fee-for-service should be holding themselves out as “fee-only” advisers, given the clear incongruence with public perception.
“I consider fee-only to refer to fee-for-service, being an hourly or, more often than not, a flat-fee rate,” says Jason Heath, managing director of Objective Financial Partners. “The media has embraced and promoted this form of advice and I think that has led to the industry embracing and promoting themselves as fee-only even when they don’t fit this definition. It may be more appropriate to refer to advice-only, being completely removed from the sale of assets.”
My own belief is some advisory teams, though not all, advertise themselves as fee-only to knowingly take advantage of this confusion about terminology. The perception of consumers, propagated by the media (of which I have not been an exception) has clearly been that “fee-only” in Canada refers strictly to fee-for-service advisers.
In the United States, the National Association of Personal Financial Advisers (NAPFA) is clear. It considers fee-only advisers to be those who offer either the fee-for-service or percentage-of-assets model. Technically speaking, costs incurred from either of these models are classified as fees, not commissions.
In Canada, Cary List, CEO of the Financial Planning Standards Council (FPSC), says that while there is no regulatory definition, the FPSC’s expectation is that a fee-only relationship refers to planners whose compensation originates directly and exclusively from their clients. “We don’t promote one form of compensation over another; however, if somebody is advertising themselves as ‘fee-only,’ while they may receive those fees on an hourly basis, a flat rate, or as a percentage of assets, they cannot receive compensation from anyone else. It’s about transparency and truth in advertising.”
Speaking of which, many advisers offer hourly charges and flat rates prominently, but may then offer to offset those fees if clients decide to execute the investments with them on a percentage of assets basis. If the à la carte plan costs $5,000, you can forego forking over the cash up front simply by having the adviser purchase the underlying investments for the client. Some might consider this practice a dubious form of bait-and-switch. Others would argue it’s just smart marketing: most prospective clients lured in by the option of fee-for-service advice are generally well-to-do if they are ready to cut a cheque for many thousands of dollars.
For years, investor advocates, journalists, and bloggers have incorrectly used the term “fee-only” when they really were referring to pure time- or project-based fee-for-service. It’s time everyone got on the same page in order to reduce the confusion: “fee-only” refers to advisers who receive fees originating directly from the client, be it through hourly or flat-rate charges, or fees charged on a percentage-of-assets basis. Within the fee-only classification, an adviser may use either or both of a fee-for-service model or a fee-based model.
The delineation of fee-for-service and asset-based fee models is important—not because one is better than the other, but because there has been rampant confusion that has gotten in the way of consumers making informed choices.