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The Second Opinion #4: Advisor Compensation
Jonathan Chevreau
Warren MacKenzie, author of The Unbiased Advisor and president of Toronto-based Second Opinion Investor Services Inc., agrees with the distinction last week's column drew between fee-only and fee-based planners.
"You are correct in that some advisors do capitalize on the ambiguity of the two terms."
MacKenzie says the trend has been for some firms originally grounded in true fee-only planning to drift into the more lucrative field of fee-based or what might be more accurately termed "asset-based" compensation.
"There is a difference between what I would call pure fee-only planning where the fee is based on the time involved, and fee-only planning where the fee is based on the size of the account."
He says a conflict arises in that asset-based fee-only advisors have an incentive to recommend investments with higher growth potential. Or to cite last week's example, asset-based advisors have less motivation to suggest client’s first pay down debt.
The Illinois-based National Association of Personal Financial Advisors (NAPFA) bills its members as being "strictly fee-only." Its Web site at www.napfa.org contains a precise definition of a fee-only planner. It is "one who, in all circumstances, is compensated solely by the client, with neither the advisor nor any related party receiving compensation that is contingent on the purchase or sale of a financial product."
NAPFA members may not receive commissions, rebates, awards, finder's fees, bonuses or any compensation from others as a result of a client's implementation of the individual's planning recommendations. In contrast to MacKenzie's purist take, NAPFA's definition permits its asset-based fee-only members to describe themselves as "fee-only."
Both NAPFA and the CFP Canada code of ethics support the notion that "percentage fees" on assets can be described as "fee-only." In 2007, the Washington-based CFP Board clarified "a certificant may describe his or her practice as 'fee-only' if, and only if, all of the certificant's compensation from all of his or her client work comes exclusively from the clients in the form of fixed, flat, hourly, percentage or performance-based fees." [my emphasis]
NAPFA excludes only financial planners who rely on commissions from product sales. They face "an inherent conflict of interest and cannot be considered objective and unbiased," it says. Most American advisors do sell financial products, NAPFA says, and so do their Canadian counterparts. Their income depends on steering clients into certain financial products. NAPFA says the public's widespread indebtedness and failure to prepare for retirement "relate directly to the conflicts of interest that pervade the marketplace."
Adrian Mastracci, president of Vancouver-based KCM Wealth Management Inc., does not bill by the hour but charges 1.4% a year on client assets (for the first $1-million). He considers himself "fee-only" because his clients know upfront they are cutting cheques to KCM proportional to their assets. He receives no "trailer fees" or hidden commissions from third parties such as mutual fund or insurance companies.
A similar confusion can be seen at T.E. Wealth, which has been around 35 years, founded soon after E.E.S., the true fee-only financial-planning firm profiled last week; T.E. founder Tim Egan once worked with E.E.S. founder John Gibson.
Google T.E. Wealth and this description pops up: "Canada's leading unbiased advisor in Fee Only (TM) financial planning and disciplined investment management."
You can buy just a financial plan on a "fee-only" basis but the investment management refers to Managed Money solutions that are asset-based. Warren Baldwin, regional vice president for T.E. Wealth, agrees there is confusion over the term "fee-only," given that his firm provides both the kind of fee-only planning E.E.S. offers but also asset-based investments. Baldwin's definition is similar to Mastracci's: "To me, fee-only means we get no commissions from anybody but fees from our clients."
By contrast, a "fee-based" advisor sells commission-based products like mutual funds, which pay trailer fees, or deferred sales charge funds that pay a 5% commission upfront.
"With fee-based, it's accepted that you're charging a fee but somewhere you're also accepting commissions," Baldwin says. "Fee-only means you're not accepting commissions. That's a key difference."
So as things stand, KCM, T.E. Wealth and firms like them are entitled to describe their services as "fee-only," even if most of their compensation comes from asset-based fees rather than hourly billing or set fees per project.
Dan Richards, president of Strategic Imperatives, says firms like T.E. had their roots in fee-only but have since transitioned into more fee-based arrangements. "Folks in the fee-only business do find they run into resistance ... you talked to the client who hated the clock."
People used to give away advice and made money executing trades. "Today you can't do that because execution costs have come down so much with online trading that you have to charge for the advice, which is what fee-based is all about," Richards says, "It seems Canadians are willing to pay for the same kind of advice if it's bundled and packaged as a percentage of assets."
The convenient ambiguity of the term "fee-only" is a throwback to the industry's sales origins. However, it's arguable that if financial planners wish to be viewed as equals with true professionals like doctors, lawyers and accountants they should emulate them by charging only for their time or defined services.
A pioneer in charging flat retainers is Dr. Carolyn McClanahan, a certified financial planner who is founder of Life Planning Partners Inc., of Jacksonville, Fla.
The former doctor now provides true fee-only planning to other physicians and professionals. Her quarterly retainers are openly displayed on her Web site at www.lifeplanningpartners.com.
Dr. McClanahan says asset-based compensation has fewer potential conflicts than commissions but is not as conflict-free as time-based fee-only arrangements not tied to assets.
The problem is financial planning is still a young profession. When NAPFA was created 25 years ago, fee-only planning was unheard of, Dr. McClanahan says.
"You're talking about changing an industry.
"I think we're turning the tide. Eventually, consumers will see the light and more planners will do flat retainers and hourly management."
In other words, true fee-only planning?
"Yes, you can call it that, but right now the rest of the world isn't with you," she says.
Perhaps not, but Canadian financial planners should eliminate the ambiguity by scrapping the phrase "fee-only" when charging fees computed as a percentage of client assets.
Instead, they should use the term "asset-based," which is far less confusing for clients.
Why this is important: It may not happen often, but occasionally a financial advisor can be influenced by the different level of commissions that can be earned on different investment recommendations.
Most financial advisors are completely honest and go the extra mile to do what is best for their clients. Intelligent advisors know that their most important asset is their reputation for honesty and integrity. Enlightened self-interest is therefore enough to ensure that they will always do what is best for their clients and avoid any action that might hurt their reputation.
However, as in every industry, we do hear about financial advisors who, in order to generate fees, make recommendations for changes that are at best unnecessary and at worst may even be detrimental (after fees) to the client.
It is not always wrong when an investment advisor recommends the investment that pays the higher commission. Sometimes a change in the portfolio is necessary. For example, consider a situation in which two investments are being considered and all other things (e.g., potential return, potential risk, liquidity, tax efficiency, and correlation with the rest of the portfolio) are equal. An advisor can hardly be faulted for recommending the investment that pays the higher commission.
It is unlikely, however, that all other things will be completely equal. Financial advisors must therefore always be on their guard to ensure that their recommendations are those that serve their clients’ best interests.
Some compensation arrangements remove most of the potential for conflict of interest and other arrangements remove all such potential. It is worthwhile, therefore, for the client to understand the different types of compensation arrangements that are available.
The Financial Advisors Association of Canada (Advocis) describes the following five common types of compensation arrangements:
Fee only:
The advisor is compensated through fees as determined based on the time and complexity of the planning needs. Implementation of any recommendations may be facilitated through the advisor but will be done by third parties who are duly licensed for the products being acquired. The advisor will not be compensated over and above the fees as identified in the engagement agreement.
Fee plus commission:
The advisor is compensated through fees based on the time and complexity of the planning needs and will also receive compensation through commissions, finder’s fees, and/or brokerage fees. These additional revenues will be received as a result of the placement of investment, insurance, and other financial products as part of the implementation of the action plan.
Fee offset:
The fees will be determined based on the time and complexity of the planning needs but will be reduced to reflect any commissions or referral fees received for transactions undertaken as a part of the implementation of the action plan. More specifically, the advisor will calculate how much annual fee revenue is required to carry out the engagement and ongoing continuous service, and deduct from this the estimated annual compensation expected in the form of commissions or referral fees, in order to arrive at a net amount payable annually.
Commission only:
The advisor is compensated through commissions, finder’s fees, and/or brokerage fees. These revenues will be received as a result of the placement of investments, insurance, and other financial products as a part of the implementation of the action plan.
Managed account:
Another type of compensation arrangement that exists within the brokerage industry is the managed account arrangement. In this case, no commissions are charged on trades within the account. Instead, an annual fee (usually between .75% and 1.5%) is charged on the assets in the account.
Bottom line:
Even if it is only to put your mind at ease and satisfy yourself that your advisor always has your best interests at heart, you must understand completely how your advisor is compensated.
What you can do now:
If you are not certain as to how your financial advisor is being compensated, ask for clarification.
Carlo Palazzo
The air is calm and cool, the birds are singing their lovely compositions, and a soft wave splashes against the dock of your new cottage. As you start to unpack your bags and get settled in this pristine environment “away from it all”, you uncover an old photo book and take a brief walk down memory lane – great memories, of your spouse, your children and grandchildren, your satisfying career, and your former life in the city. This is going to be a great retirement!
What’s that over there? No, not there. There! With the rest of our un-opened mail from when we left the city – the work, the stress, the 9 to 5, non-stop, go-go-go life of our past. Ahhh…our investment statement. Well, let’s take a look at what a lifetime of hard work and savings brings.
Market Value: $52,687.94.
“What? How can that be?”
Quarterly profit/(loss): ($374,692.32)
Again you cry out, “What? How can that be?” This is not possible you tell yourself. Surely there has been an administrative error in creating your statement. “I know,” you exclaim, “I will contact my advisor and have the matter fixed right up!” With a reassured hop you grab the phone and call your advisor.
“The extension you dialed is not valid”
My stars! What has happened! I know. I’ll try the general line.
“I’m sorry Sir, but I can assure you that there was no administrative error in creating your statement”
“And the advisor is no longer with this firm”
“That is correct”
“But you’re a member of the Canadian Investor Protection Fund. I’m a Canadian. I’m an investor. Protect me damn it.”
“Sorry again Sir, but the CIPF only protects you in the event that we go bankrupt. You’re not protected if you go bankrupt”
What? But how can that be? This is not possible. I worked my entire life for that nest egg. Surely, it is not gone. I know. I’ll call the police.
“Sorry for your loss. We will investigate.”
“And I will get back my money?”
“No. But don’t you worry. Whoever is responsible has a sure slap on the wrist coming their way!”
But that won’t bring my money back! I know. I’ll contact my lawyer.
“I will need a $10,000 retainer upfront, and bill at a rate of $350 per hour. There is no guarantee you will get your money back, and a civil suit of this nature can run you around $50,000 in legal fees – again, with no guarantee that you will get your money back.”
There goes a happy and well-panned retirement!
Despite this being a hypothetical situation, it is unfortunately a situation that happens all too often in Canada and abroad. Good, decent, hard-working, and average “Joe and Jane” investor lose it all to an incompetent, dishonest, and (usually) commission-based financial advisor(s). The advisor’s firm is not likely to help you bring charges against the advisor – and may not even tell you of the advisors whereabouts in the event the advisor is no longer with the company. The regulatory safeguards in place, such as the Canadian Investor Protection Fund, are often misunderstood and filled with coverage gaps. The police are ill-equipped to handle the situation, both in terms of getting back the victims money and in punishing the guilty party. That leaves it up to the victim to try and win back their money in the civil courts – a long, painful, and expensive process in which results are far from guaranteed.
Let’s not be mistaken now. Investment fraud is much more wide spread than you might think. According to a study conducted by the Canadian Securities Administrators (which is a committee of all 13 provincial and territorial securities commissions), more than 1 million Canadians have lost money to some form of investment fraud, the fraud artists stand a good chance of getting away with their crimes, and approximately 75% of victims don’t recover any of their losses.
So you think it can’t happen to you. Why? Is it because you are more skeptical than the average person and do not trust investment professionals so easily? Or perhaps it is because your friend, co-worker, or even family member introduced you to your advisor? Surely, your family and friends won’t send you to a fraudster. And how can someone fool you, given that you simply don’t trust any financial professional?
Actually, according to the same study, about half of the victims of financial fraud in Canada were introduced to the fraudster by a trusted friend, co-worker, or family member. And, victims tend to have three attributes in common – one of them being the tendency to not trust any financial professional. This is all very disturbing, especially when one considers that victims of investment fraud lose more than just their money. They tend to feel embarrassed, depressed, and even lose trust in human nature, capital markets, and the justice system.
Recently, W-FIVE did a story on Mr. Donald Kennedy who invested $155,000 with RBC Dominion Securities. Within a few years, Mr. Kennedy was left with $1,800. As it turns out, his commission-based advisor was “churning the account” – an illegal practice of making excessive and unnecessary trades in order to generate commission revenue for the advisor. According to Mr. Kennedy his advisor made 126 trades in 20 months, with the effect of simultaneously emptying his account and filling the advisors’ pockets.
As sad as this story may be, it gets worse. The advisor who ruined Mr. Kennedy’s account has been involved in no less than 27 reported incidents. According to the W-FIVE story his punishment has been a $50,000 fine imposed by the IDA – which is likely not to be paid. The IDA may only impose a fine on members. If an advisor decides to leave the industry, he is no longer a member, and is no longer subject to the fine. Since the advisor left the industry, he can get away with not paying the fine. And since the IDA and other regulatory bodies that aim to protect investors are not courts, it is not likely that victims will get their money back. In fact, according to the W-FIVE story, the IDA has only ordered restitution on one occasion.
It is important to realize that, in this case, the problem would not have occurred if the advisor was paid an hourly fee (i.e. “fee-only”). The fact that the advisor receives a commission is the only motivation for churning the account. A fee-only advisor does not have that motivation, and in fact, does not even have the opportunity because the advice and sale are completely separate from one another.
Moral of my story?
The investment advice and the investment products need to be separated. It is always wise to pay a true fee-only advisor an hourly rate to give advice, and then take that advice to a salesperson – or better yet, buy online from a reputable discount broker. It just makes sense.