What unbundling could mean for the future of advice

This article was originally published in September 2013.

The impact of compounding fees struck a chord with readers (see “Investor knowledge continues to lag,” Advisor’s Edge Report, June 2013). Several wrote with concerns. Some couldn’t believe the math. Others objected to the term “advisor’s fee.” Here are the calculations.

We described a $10,000 investment compounding at 7% with a 2% annual fee that left the investor with only 39% of the accumulated capital after 50 years. We tested two approaches.

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• We created two buckets: one for the investor and one for the advisor. We moved 2% of the value of the investor’s bucket at the end of each year (representing the fee) to the advisor’s bucket, both compounding at 7%.
• We compounded the initial investment at 5% and 7%, with the difference approximating the advisor’s fee. This was John Bogle’s approach from The Pension Gamble, shown on PBS in 2013.

The slight difference between methods is attributable to timing fee calculations at the end, rather than the beginning of the period (see the spreadsheet here).

Advisor’s fee

Sadly, too many investors don’t know what they pay in fees. Investors put up 100% of the capital, take 100% of the risk and, as our calculations show, end up with less than 40% of their own money. For this to be palatable, we need an extended period of strong returns; otherwise, we face ongoing fee pressure. There are solutions. Some funds, like Steadyhand’s, taper fees and offer rebates for long-standing clients. This makes sense, as do fee-only financial planners.

Transparency

CSA Discussion Paper 81-107, Mutual Fund Fees says, “This trend away from transaction-based sales commissions has resulted in advisors today being compensated largely through trailing commissions in connection with the distribution of mutual funds.” As a result, distribution costs are more hidden from consumers.

The automatic conversion of DSC funds to front-end load is described in 81-107 as a “conversion that yields a 100% increase in trailing commission compensation to the advisor without any consent from or disclosure to the client at the time of the conversion.”

Investors may not pay more, as the letter points out, but these arrangements “appear to display an alignment of interests between the mutual fund manufacturer and the advisor that could be detrimental to mutual fund investors,” says 81-107. Who is to blame for poor transparency? You and me.

Asset-weighted mutual fund fees (MERs, front and no-load) increased for equity, fixed income and balanced funds between 2006 and 2011, according to 81-107. DSC charges weren’t mentioned, but their present values are certainly higher thanks to lower interest rates.

Read: How to talk fees

Unbundling: A new world of advice

Product costs are different from fees for advice, noted another reader. Investors can’t avoid product costs, but they can become self-directed.

Product costs are unavoidable, but there is choice. Canadian equity index mutual funds have MERs between 0.72% and 1.01%. ETF equivalents charge 0.08% to 0.25% before commissions.

The Canadian wealth management industry’s revenue model is evolving. Capital market growth alone won’t expand advisors’ books. To grow, firms need more clients and assets. Here are some changes you can make:

• Move to a fee-based model and use lower-cost products that offer demonstrable value to investors.
• Move to a discretionary license to eliminate time-consuming order approvals.
• Use portfolio construction services to reduce time spent managing investments.

This will leave you more time for asset gathering.

U.S. model portfolio assets among registered investment advisors are growing 50% annually, prompting unified management account (UMA) firms to model ETF wrap programs. The next generation will be mass-customized portfolios: personalized, with automatic monitoring, rebalancing and reporting. Automation improves portfolio fit and lowers cost. Current UMA expenses of 1.3% to 3% could drop under 1%, including product fees.

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About 15% of Canadian advisors are discretionary and fee-based, a positive trend. Having clients pay directly for advice aligns everyone’s interests, focuses on lower-cost options, and can reduce compliance burdens, things upon which we can all agree. Advisors who don’t seek better solutions risk losing to those actively exploiting the new reality.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.