How advisors are paid, and by whom, has long been a matter for controversy. A particularly thorny side of the debate revolves around deferred sales charges (DSC), and whether or not they should be phased out by regulators. Two industry experts offer their perspectives on the subject.
Leaving the family has a price
Fund dealers can be compensated either by the investor or the fund manager. In the first case, a common scenario involves a dealer charging a 3% front-end load, which is subtracted from the original investment. In this arrangement, if a client puts up $1,000 for a mutual fund, $30 is taken off the top, and $970 ends up in the fund.
In the case where the fund manager compensates the dealer, the entire $1,000 investment goes straight into the mutual fund, and the fund manager pays the dealer 5% to 6% upfront. The fund manager recoups this upfront payment through the yearly management fees he charges the investor, which are about 2% in the case of an equity fund.
But what if a client decides to dump the fund after one year? This poses a problem for the fund manager because he’s relying on the annual management fees to recoup the upfront payment he made to the dealer. If the client backs out of the fund after a year — and doesn’t find anything he likes in the same family of funds — the management fees get cut off. Absent alternative arrangements, this would leave the fund manager with a loss.
DSC fees are those alternative arrangements. They’re a penalty the investor pays to the fund manager for not staying in the fund family long enough for the manager to recoup the upfront payment. The fees are set on a sliding scale, so the sooner a client backs out, the heavier the penalty. A typical arrangement will involve a DSC schedule that requires investors to stay in the fund family for six years to avoid redemption penalties. Once the investor does his time, he can dump it penalty-free.
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One advantage of this arrangement is the investor has $1,000 working for him right out of the gate, which is better than having only $970 invested. But according to Frank Lee*, a consultant to the financial services industry, it’s downhill from there.
The DSC scenario raises questions about the dealer’s loyalties.
“The dealer has an obligation to put the interests of clients first, but when the dealer is being paid not by the client but by a fund manager, it’s highly questionable whether his loyalties are with the client. There’s definitely a conflict of interest here,” Lee says.
The second problem revolves around a possible conflict of interest stemming from the upfront cash-flow advantages for dealers under the DSC scenario. Even in the best of cases, when a dealer gets a front-end load payment directly from the investor, it won’t be as hefty as the 5% to 6% he’ll get from the fund manager in a DSC arrangement.
Moreover, an investor can negotiate the front load down. Most people don’t end up paying more than 2%, and if you’re really good at driving a hard bargain, Lee says, you can get it down to 0%. By contrast, in the DSC arrangement, the dealer gets his 5% to 6% from the fund manager, and it’s a fixed amount.
Yet the dealer pays a price for the hefty 5% to 6% he gets upfront in the DSC scenario. On top of the upfront payment, the dealer gets an ongoing trailer fee. Under the investor-to-dealer front-end load arrangement the trailer is usually 1% of client assets, while in the DSC arrangement it’s normally 0.5%.
So while the dealer gets penalized down the road, he gets much more upfront — which on balance is a better deal.
For this reason, “dealers tend to have an interest in pushing clients into the DSC arrangement, even when this is not advisable from the client’s perspective. It’s another conflict of interest,” Lee says.
It might be argued the DSC structure actually encourages a smart approach to investments, even if it wasn’t devised with this in mind. Investors can be impatient and impulsive, and, in extreme cases, impervious to the idea that growth is a long-term process. They want to either see their money double fast or move on to the flavour-of-the-month investment talking heads are trumpeting on TV. DSCs benevolently coerce the investor into being patient.
This is the dealer’s and fund manager’s argument. But it doesn’t hold water, Lee says. The best thing you can do when you realize you’ve made the wrong decision is lick your wounds and get out. And investors aren’t usually guilty of moving in and out too quickly.
“The danger is they just hang on to a bad investment instead of cutting their losses and moving on.”
Another problem: Many clients simply do not realize they are subject to a penalty if they redeem their units one, two, or three years later.
“They think they’re getting a free lunch, because 100% of their money is going to work upfront. They’re unaware of the DSC, and that’s problematic,” Lee says.
There is an element of buyer beware, but the issue of transparency is a strike against DSCs.
There are two ways to approach regulation of these matters. One is to require full disclosure: If everything is plainly disclosed, people will make choices that serve their best interests. The other approach is to assume people can’t always be expected to determine what’s in their own best interests, at least when it comes to complex matters like investments. It’s certainly no rarity even for highly educated people to lack the time and the financial acumen to plough through the documentation on a fund they’ve been advised to buy. With this model, presumably well-intentioned regulators decide to simply ban a practice they deem ill-advised or open to abuse.
Britain and Australia have taken this second approach with their ban on embedded commissions, which effectively means all remuneration must be paid directly by the investor.
“That avoids the potential conflicts of interest inherent in compensation structures that tend to encourage the dealer to look to the interest of parties other than the client,” Lee says.
Not too long ago, the Ontario Securities Commission flirted with the idea of tackling questionable remuneration structures.
Is there room for the DSC after all? Click through below to find out.