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.
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.
Good for the little guy?
Dan Hallett, vice president and director of asset management at HighView Financial Group, notes the prevalence of the DSC structure has diminished considerably over the years, and suggests they may have no future at all. More and more investors are becoming aware of how DSCs work and are reluctant to lock in with a company for seven years.
But in some cases, investors may not have a choice — if, that is, they want access to investment advice.
You’ll be hard-pressed to find an advisor who targets the $50,000 client, and small- and medium-sized portfolios tend to get neglected. But the DSC structure actually makes it worthwhile for advisors to take a second look at clients with a smaller asset base, says Hallett, giving these investors improved access to advice.
Investors with small- or medium-sized portfolios could just walk into a bank branch, where the DSC structure won’t be an issue. But banks have a more limited product shelf, and Hallett suggests advice is better elsewhere.
Another issue is the impact compensation structure will have on an advisor’s ability to attract the $500,000 client.
“It’s not the way it was 15 years ago, when there were a bunch of new clients coming out of the bank branches. You didn’t have to steal business from your competitor to increase your book,” Hallett observes.
The prudent advisor needs to think about what her competitors will do to snatch up her clients. The first thing targeted will be fee structures. Competitors can say, “Did you know your advisor is raking in $30,000 up front from your investments?”
Hallett suggests transparency and disclosure can be powerful tools against barracuda-like competitors. Advisors are less vulnerable when the competitor is unable to tell the client something about his relationship with his advisor he didn’t already know.
Hallett concedes there’s some risk in taking his approach of offering painstakingly transparent explanations of fees, right down to dollars and cents. “[Transparency] in itself never wins you business, and if your competitor isn’t as forthcoming but talks a really good game, you run the risk of scaring people off” when you lay everything on the table, says Hallett. But more often than not, he’s found clients appreciate complete transparency.
DSC of the future
The DSC structure has been evolving. The low-load model is just a mini-DSC. It usually involves a 1%-to-2% commission instead of the DSC’s 5% to 6%. The trailer fee is generally 1% for equity funds and 0.5% for bond and balanced funds. And instead of being locked in for seven years, you’re in for three.
“I don’t know for sure if [the DSC structure] is ever going to disappear. But its natural evolution is to move towards a low-load structure. It ties people in for less time and gives the advisor something upfront, but doesn’t sacrifice the trailer fee,” Hallett says.
The low-load model makes the most sense for advisors who plan to stay on a commission-based fee structure, Hallett says, because investors who have gone through a DSC schedule already are more likely to be aware of other options. There has already been client pushback against the DSC structure, and there’s every reason to believe this negative sentiment will grow, he argues.
While the case can be made the DSC structure is prone to potential conflicts of interest, could that not be said of every other fee arrangement?
All fee models can lead to abuse. For example, under the hourly fee arrangement, an unscrupulous advisor may convince his clients of the need for unnecessary work. The flat-fee-for-service approach is no less open to abuse, as it provides advisors with less-than-stellar ethical credentials with an incentive to take in more clients, and spend a less-than-adequate amount of time with each, so as to maximize the amount he pulls in per hour.
In Hallett’s assessment, whether a conflict of interest arises is more a question of an advisor’s ethics than the way he’s paid. “Good wealth stewards,” he says, “are not defined by their method of compensation, but rather by their character and conduct.”