The Pros and Cons of Fee-Based Advisors
Full disclosure remains key
Last week's introduction of the trend toward fee-based advice detailed how different types of advisors are riding this hot trend. However, no professional advisor is free from potential conflicts of interest. And no one approach is superior in all cases. In fact, both approaches have merit, but the key is how much your advisor discloses to you in the process.
Benefits of fee-based programs
Fee-based compensation arrangements have benefits for both advisors and investors. Advisors benefit from larger on-going fees (but less up front) and better time management. Frankly, once advisors set up a client in such a program, the advisor need only do "maintenance" work thereafter for the most part. The brokerage firm or wrap provider will continually monitor the program managers for individually managed accounts (IMAs) and pooled wrap programs, respectively. Long-term, the advisor makes more money and can work more efficiently because s/he need not continually read research reports and monitor stocks, or keep updated on the growing universe of mutual funds.
Clients in IMAs or pooled wrap programs do have some advantages - namely the transparency of fees and improved performance reporting. IMAs and pooled wraps show their fees on their quarterly statements. When was the last time your broker or financial planner spelled out your total fees alongside your statement of holdings? Most simply don't unless you're in a fee-based arrangement. Also, a point of frustration with most investors is that they have no idea what their personal rates of returns have been over time. IMAs and pooled wraps usually provide personalized performance reporting, not just a fund or manager's published record. Some fee-based arrangements are product-neutral - meaning the advisor gets paid regardless of the type of products they recommend for you. However, IMAs and pooled wraps are, themselves, investment products and don't fall into this category.
Some advisors are opting to pick a more customized combination of stocks, exchange-traded funds (ETFs), mutual funds, and bonds. Then, they simply invoice the client a fee each quarter, based on a percentage of the portfolio's value. Conceptually, this is the same as the other approaches mentioned, but this approach is more flexible because you're not limited to a specific company's asset management program. Let's call this the more customized fee-based approach. Another client benefit is that there is often greater tax efficiency when securities are owned directly, as opposed to investment funds. That said, none of these arrangements are perfect.
Disadvantages of fee-based arrangements
There exists the perception that fee-based arrangements are cheaper than, perhaps, a portfolio of regular mutual funds due to the tax treatment of fees. However, that's a myth. Some promoters of fee-based arrangements often say "my fee is deductible because it's charged directly - unlike your non-deductible mutual fund MERs [management expense ratios]". That is perhaps one of the most misleading statements I've ever heard.
Fact: Fees for general financial planning are not deductible. According to paragraph 20(1)(bb) of the Income Tax Act, only fees paid for advice on the buying and selling of securities and the administration thereof (i.e. investment counsel fees) are deductible. Hence, a client receiving full financial planning from their fee-based advisor could find a chunk of their fee non-deductible. Further, only investment counsel fees with respect to taxable accounts are deductible. So, for clients with 40 per cent of their portfolios in taxable accounts, only 40 per cent of the total investment counsel fee is deductible. It's quite realistic that a client of a fee-based advisor will find that only one-third of the total fee qualifies for a tax deduction. That is based on this example and each case is different.
Fact: Management fees that are invoiced directly to the client (i.e. fee-based) have a slight tax advantage over the "at source" method of charging mutual fund MERs. For a taxable balanced portfolio, that's roughly 0.17% annually if the gross fees are the same. The tax advantage of fee-based arrangements gets larger as the equity component of the taxable portion of the portfolio rises. In other words, for clients who have proportionately more stock exposure in their non-RRSP accounts, the tax advantage of fee-based arrangements increases because stocks don't generate a lot of taxable income.
Pooled wraps are only as customizable as the advisor recommending them. If you have an existing stock portfolio (maybe with big built-up gains), the advisor has to adjust your mix accordingly. But then, the pooled wraps' optimization and rebalancing features will lose their effectiveness because the program is actually monitoring only part of the portfolio. IMAs are more flexible if you hold stocks already, but not if you hold investment funds. In both cases, there is a lack of customization.
The more customized fee-based approach mentioned above alleviates this problem, but it's not without its own biases. Advisors practising this approach charge their own fees, so they will have a bias toward the cheapest products available. That's not necessarily the best thing for the client. Let's assume you go to see a fee-based advisor to get a proposal. You clarify the services you need. The advisor may figures he can charge you 1.9 per cent annually based on your portfolio size and the services you require. If the advisor recommends the products with the lowest fees (i.e. ETFs, bonds, etc.) s/he will be able to keep more of that 1.9 per cent. Remember t hat ETFs are pools of stocks but cost anywhere from 0.08 to 0.55 per cent per year because they are not actively managed - they simply mimic a stock index. Indexing has its merits but if we assume you're portfolio will cost 1.9 per cent either way, lower fee products will put more money in your advisor's pocket without necessarily providing you with a greater benefit. In other words, the fee-based advisor couldn't make as much money recommending some of the good actively managed funds available as s/he could by recommending cheap index products like ETFs.
Why should you care if your cost is 1.9 per cent either way? Well, consider the fact that most actively managed funds beat their respective indexes or benchmarks before fees and taxes. In other words, if no fee advantage exists, index products aren't as good a deal for investors compared to tax-efficient actively managed products. However, they can allow your fee-based advisor to earn a better living. Now, most advisors are smart and ethical professionals but it's important to get all of the cards on the table from day one.
Fee-based approach in disguise
Some advisors that work on a commission basis may call themselves fee-based. How? Remember that load mutual funds (and some no-load funds) pay on-going trailer fees regardless of the purchase option chosen. Advisors selling mutual funds with a front-end load of 0 per cent can get an attractive on-going trailer fee of up to 1 per cent annually. However, many would consider this to be a fee-based arrangement in disguise because there is a bias toward load mutual funds due to payment of generous trailer fees.
Unless you have at least $100,000 it's unlikely that it will be worth a fee-based advisor's time to work with you - unless you can negotiate an hourly fee. While some might say otherwise, there is no single fee structure that is universally superior. Any arrangement is only as good as the professional whose services you've engaged.
Only you can decide which arrangement works best for you. However, before entering into any agreement with an advisor (fee-based or otherwise), make sure the following has been fully disclosed to you: a full cost breakdown, the source of all costs (paid by you or embedded into products), the services proposed, and the details of potential conflicts of interest. Only when you're armed with all of the relevant information will you be prepared to make this very important decision.
Disclosure of conflict
While Sterling Mutuals Inc. (my employer) is best known as a discount fund dealer, it also has a fast growing network of full-service financial advisors. Hence, it's important for me to mention that Sterling advisors are paid via product commissions and cannot currently operate using a true fee-based approach.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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