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Mar 1, 2014

Letís Talk About Choice

by John DeGoey

John DeGoey

As you may know, 2013 was a year when many financial services industry stakeholders busied themselves with a suddenly ‘on the radar’ discussion about mutual fund compensation. Specifically, the Ontario Securities Commission put out a paper soliciting feedback regarding the desirability of trailers going forward. To begin, I’d like to set the record straight about these so-called trailers. Some people call them trailer fees; others call them trailing commissions. Clearly, they cannot really be both simultaneously, as the two words fee and commission have very different meanings . I believe (as do CRA and our securities commissions) that trailers are commissions – and that calling them fees is akin to calling an apple an orange.

There are certain groups that have gone on about their commitment to client choice in this discussion. In essence, they say that there’s a strong desire for embedded compensation within the broader public. Furthermore, they contend that if embedded compensation (read: trailing commissions) were to be banned, then small investors (let’s define this as those with under $100,000 in investable assets) would be left without access to investment advice – as if to imply that banks will somehow no longer exist. To my mind, many small investors would actually be better off working with a salaried bank employee, because there would be fewer inappropriate recommendations (e.g. leverage) and no back-end loads to contend with ever again.

Furthermore, these stakeholder commentators have asserted that independent advisors would not take small clients if embedded compensation were banned. Why?  If advisor Joe takes on client Harry who has $70,000 to invest and Joe gets paid 1% ($700) through embedded compensation, why would anything change if the compensation was unbundled because embedded compensation was banned? The same advisor could advise the same client using the same products and receive the same compensation either way. The all-in client cost would be unchanged, too. There’s simply no reason for Joe not to work with Harry under these circumstances.  If the circumstances were such that Joe would not work with Harry using transparent, unbundled compensation, then he shouldn’t be working with him today using opaque, bundled compensation, either. The nature of the payment has no impact on the substance of the hiring decision.

Of course, there are a few small differences, but theonly ones I can think of would actually make things better for one or both parties if embedded compensation were banned. To begin, unbundling (banning embedded compensation) improves transparency, meaning people like Harry would understand once and for all that financial advice is not free. Second, for non-registered accounts, Joe’s fees would be tax deductible under the Income Tax Act – section 20 (1) (bb). In contrast, commissions are not deductible. Finally, unbundling makes way for ‘product arbitrage’ whereby expensive embedded compensation products can be taken off the shelf and cheaper ones can be used as substitutes. For instance, an actively managed mutual fund can be taken out of a portfolio and an index fund or ETF that costs about 1% less can be used instead.  That’s an expected 1% increase in return for the investor.  There’s even room for a Pareto Optimal solution where the product is substituted and Joe charges a bit more.  Even if Joe charges 25 bps more than before, Harry would still save 75 bps a year. On $70,000, that’s $525 a year.  Mind you, if Harry’s account was at $400,000, the saving would be $3,000 annually.

Let’s get back to the concept of client choice. The groups that go on about client choice seem to define ‘choice’ narrowly – and, dare I say--self-servingly. To them, the only ‘choice’ is between embedded compensation

and non-embedded compensation. To them, the competing options regarding the advisor’s business model is the only ‘choice’ being discussed. Their discussion of the topic is incomplete – and their omissions are both glaring and contrary to the public interest. There are at least three ‘choices’ that clients need to consider:

Business model

– embedded compensation or not?

Value proposition

– active products or passive products?

Advisory relationship

– non-discretionary or discretionary?


The thing that always strikes me is the way the ‘proponents of choice’ seem to never say a word about the second and third choices–as if to suggest that those choices are of no consequence or do not exist. I can assure you that they are both of considerable consequence. My personal view is that the second and third choices are at least as important as the first one. But here’s the irony: the proponents of choice regarding the business model decision are effectively cutting off choices regarding both value propositions and advisory relationships when people choose to pay through embedded compensation.

Regarding value propositions, the option to use lowcost passive products is one that virtually no advisor offers to his or her clients. I wrote about this last year (“Incorporating Evidence into Advice” CMS, October 2013) if you want to read up on it. Since many passive products do not offer embedded compensation, the availability of embedded compensation products effectively means that advisors who use embedded compensation products will never offer their clients a passive option like an ETF or an index fund. That alone is contrary to the principle of client choice.

Much of 2013 was also spent discussing the desirability of moving to a ‘statutory best interests’ (Fiduciary) standard.  It is impossible (read: illegal) to earn commissions in a discretionary account. Once again, if Harry wanted Joe to be a Fiduciary, there would be no way Joe could possibly be a Fiduciary if he earned embedded commissions.  Once again, the ‘choice’ business model precludes a vitally important option regarding a potential advisory relationship. People who earn commissions simply cannot be Fiduciaries. In the interest of full disclosure, I have recently encouraged my clients to move to a discretionary arrangement because I wanted to be held to a Fiduciary standard. Even then, however, I offered a choice, and a number of them continue to work with me on a nondiscretionary basis.

All told, the people advocating for greater choice are doing more harm than good, in my opinion. In protecting one choice, they are effectively removing two other choices from how their clients can work with them. One step forward; two steps back. The time has come to do what other countries like England and Australia have already done – ban embedded compensation. Doing so is the lesser of two evils – and entirely consistent with the principle of real client choice.

John J. De Goey, CFP and FELLOW OF FPSC is a Vice President and Associate Portfolio Manager at Burgeonvest Bick Securities Limited (BBSL). The views expressed are not necessarily shared by BBSL.