ALERT: The trouble with fee-based accounts

ALERT : Improper use of fee-based accounts                                                         December, 2014  

We have received a flood of queries and complaints regarding advisors' actively promoting fee- based accounts rather than commission –based accounts. It looks like an epidemic that we hope regulators pro-actively address. Some of the increased conversion activity may be due to proposed regulatory iniatives to prohibit embedded sales commissions/trailers in products.Ironically, unless there is robust supervision , regulatory oversight and self-protection, you may end up paying more as a result.

Commission- and fee-based accounts each involve different advantages and disadvantages for clients, and these basic advantages and disadvantages should be clearly understood before signing up for an account type.

In a commission-based account, you are charged a commission each time a trade is executed. For you, the advantage of this arrangement is that the service(s) received in exchange for the commission paid is concrete and specific-a given trade, which is typically based on a specific recommendation by the dealer representative. Moreover, when the client’s account is inactive-either because no recommendation has been made or because the advisor has recommended a long-term hold on a security-the client incurs no trading commission . Most canadians are Buy-and -Hold so fee-based accounts may not make sense for the majority.

In several cases ,client investments were converted into expensive proprietary products ( incurring early redemption fees on their mutual funds along the way ) and then their accounts moved into fee-based accounts where they were gouged on the fixed rate by paying thousands per year more than what they would have paid had they simply held the Baskets and Private Pools in ordinary non fee-based accounts. In another case , a retiree who made just two trades paid account fees which amounted to more than 10 % of her annual account income of $11,000. The unsavoury practice of placing a client who trades infrequently in a fee-based, rather than a commission-based, account is known as “reverse churning”.  In one extreme case, a 89-year old widower was charged $31,000 for just 4 trades over 2 years!

In contrast, fee-based accounts charge a set percentage of account value or, in rarer cases, a flat fee, for an ongoing service, regardless of the number of trades that occur in the account over the specified period. In principle ,the advantages that fee-based accounts potentially include:

(1)fostering a greater alignment of interests between the dealer Rep and the client, under the assumption that, if the Rep's compensation is based on a percentage of the value of the assets in the client’s account, it is in the best interest of both the client and the advisor to maximize the value of those assets;

(2)reducing the likelihood of certain harmful sales practices, such as churning or making recommendations unduly influenced by compensation, since such practices will not increase the dealer Rep’s compensation, but may expose them to liability and regulatory risk;

(3)increased transparency of the cost of services and advice provided to the client insofar as fee-based charges make it less opaque to clients that they are compensating their Representive for services, including those that do not necessarily result in trades (e.g. a recommendation to continue holding a security or maintain assets in cash ). In a commission-based account, clients may be led to assume that these services ( if provided ) are provided for free, even though they may be embedded into the product fee structure; and

 

  (4) enhanced predictability of fees/charges ( for dealer and client) but not necessarily lower fees for  clients.

Unfortunately, principles and dealer Rep fee revenue goals too often collide.

The type of complaints we are receiving center on pressure to convert to a fee-based account without proper rationale. Those who transact most may be better off in a fee- based account, and those who transact little may be better off in a commission- based account. A number of complaints also surround the question of whether cash,/GIC's should be exempt from the fee.Read and understand the terms of the account agreement before signing.

The fee- based account is really a volume transaction discount, strategically priced at a level that ensures both dealer Rep and dealer earn a good return from their clients who decide to proceed with this option. Such a recurring revenue model is perfect for dealers. While one of its stated potential advantages is that it removes the temptation to churn an account, there is plenty of room to take advantage of the investor: clients who transact little and therefore have a minimal commission trail can be plunked into a fee- based account and thereby increase dealer Rep and firm revenue at the expense of clients. We have also seen IPO's appearing in retail accounts where embedded sales commissions are not only attractive to dealers but actually, in the case of closed-end funds, harmful to investors.

If you are encouraged to unnecessarily leverage your investments, the apparent advantage of lower dealer /Rep transaction fees is negated by increased fees on higher account asset balances and more investment risk for you. Using margin is an increasing danger to be on the alert for as fee-based accounts multiply.

Another common complaint is from clients, especially the elderly, with a basic bond portfolio who are being charged a fee between 1% and 2.25%, a rate that is higher than the interest rate on a majority of the bonds in the client’s portfolio. While this action is not outright illegal, it is highly unethical. A bond is meant to be an income-producing vehicle used to pay a certain interest return for a designated period of time. At bond maturity, the client receives his money.However, when the portfolio is static, meaning the Rep researched the bonds, sold them to you for a good reason, and earned a commission initially, there is no reason to charge an annual fee . To charge an annual fee for managing a portfolio of bonds, when all that the client needs are his mailed interest cheques, amounts to financial abuse.

Several complaints concern investors who hold both a commission and a fee-based account . In those cases,, the Rep charged the client a commission on the purchase of a security and subsequently charged an additional fee by transferring that security into a fee-based account.

Given the attractiveness of fee-based accounts for dealers/Reps, such an account might reduce the probability of say, Rep recommendations that involve a low-cost ETF portfolio requiring only once a year rebalancing. You need to be alert – in fact, ask why ETF's are not utilized in your commission -based account before even considering conversion to a fee-based account.

Investment dealers love a steady revenue stream and a lot of the products and services they provide are designed to deliver this. One example is the unduly popular wrap account, where a mutual fund company takes a few of its proprietary funds and wraps them together in a single portfolio-in-a-box product. Wraps are brilliantly promoted, but not nearly as good as building a portfolio by selecting the best, economical funds from a variety of companies instead of just one. In effect, a wrap does all the security selections and asset allocation freeing up the Rep to hunt for new clients.

Fee-based accounts make some sense for clients who trade actively and rely on the guidance of a professional advisor who might provide a wide range of services that might include estate and tax planning as well as investment recommendations. The important questions to ask are: “Are these services actually provided?” and “Does frequent trading actually lead to better returns?”. There is significant research evidence that it does not. “Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell..” - Warren Buffett

The best-suited clients for fee-based accounts are ones who are active investors and have a solid knowledge of what they’re doing. Unsophisticated investors more intent on collecting income than portfolio growth are the least suited to account conversion.

A large number of complaints involve A class mutual funds in a fee-based account. Effectively the dealer/Rep is receiving the trailer commission on top of the account fee ( double-dipping) .In November, TD Bank subsidiaries were required to repay overcharged mutual fund clients The

subsidiaries were required to pay about $13.5 million to some current and former clients to compensate them for more than a decade of excess mutual fund fees as part of a settlement deal approved by the Ontario Securities Commission (OSC). The OSC was told that failures in the firms’ internal controls and supervisory systems lead to fee calculation errors in some accounts. In other instances, clients were not advised that they qualified for mutual funds with lower MERs, or management expense ratios.Apparently no one figured this out over a period of 10 years. Lesson : Check your account to ensure you're not getting hosed.For a fee-based account ,you should be sold F class funds which have the trailer commissions stripped out of the MER.

In the December edition of the OSC's Investment Funds Practitioner, the regulator indicates that it is problematic for an investment fund series that is intended for fee-based accounts to include embedded trailer commissions. "This type of dual compensation structure is inconsistent with a critical attribute of the fee-based series, namely the negotiation of the dealer's compensation, which is intended to provide investors with heightened transparency of the cost of the dealer's services and a clear expectation of the services to be rendered in exchange for the negotiated fee," it says.

Bottom line : Costs count. In short, fee-based accounts may not be the best fit for certain clients if annual fees end up costing more than the trading commissions that would have accrued in accounts that show little to no activity.Think twice about opening a fee-based account then think again every time you see a charge. Experienced investors who manage their own portfolios can cut their costs dramatically. A portfolio of index exchange-traded funds (or index mutual funds) should cost no more than 0.4 % annually, including commissions to buy and sell.If you buy stocks and bonds directly via a discount broker you can save even more. .CAVEAT EMPTOR