Fee-based accounts at full service investment firms may be one way investors can reduce the fees they are currently paying.
Fee-based accounts also offer transparency and liquidity; both are important in today’s financial markets. The fee is charged based on the market value of the investment accounts and allows a specific number of free equity and fixed income trades.
Advisors do not earn income per trade, so each buy and sell decision is based on the investor’s strategic needs. Commissions and trading costs are not an issue as a liberal number of free trades are included with the fee. In a fee-based environment investors are reassured that decisions are driven solely by investment objectives. If an investor’s account increases in value so do the fees to your advisor. Conversely, if an investor’s account declines in value, the fees paid to the advisor do as well. With this structure, the adviser has a direct incentive to work on having your account increase in value. This should remove any perceived conflict of interest as advisors and clients are on the same side of the table.
Recently, we provided a second opinion for a couple, the Browns, with $500,000 in mutual funds in a non-registered account.
After reviewing the Brown’s mutual funds, we estimated that the management expense ratio (MER) was approximately $11,500 annually (or 2.3 per cent). These fees were embedded in the mutual funds they owned. We also noted that they held over 410 companies in the various funds they owned and many funds had duplications in the holdings.
They mentioned that it was becoming more difficult than it should be to monitor their investments and diversify through different sectors. Based on our analysis and discussion with Mr and Mrs Brown, we came to the conclusion that they had outgrown mutual funds.
Purchase direct equities. This will enable the Browns to obtain a clear understanding of the income they will be receiving, when income is realized, reducing duplication, and limiting the number of holdings to less than 30.
Open a fee-based account. The fee-based account will have a fee of one per cent (1 per cent x $500,000 = $5,000) that is fully transparent. This is significantly lower than the $11,500 that they are paying through the embedded MER.
By opening a fee-based account and purchasing direct equities, the Browns will also be saving taxes. The one per cent fee is fully deductible in the year paid as the account is non-registered.
At the end of the year they will receive a summary of the fees paid that they may claim in part IV on schedule 4 of their income tax return. If the couple is in a 30 per cent income tax bracket then they should expect to pay $1,500 ($5,000 x 30 per cent) less in taxes for the deduction of investment counsel fees paid.
The net cost to the couple is approximately $3,500. Fees paid relating to registered accounts are not tax deductible. The two main benefits of fee based for RRSP accounts are the lower costs and the ability to pay the fees through additional contributions. Although the payment of the fees does not result in a tax deduction it enable investors to tax shelter more funds within their RRSP.
We recommend paying fees relating to registered accounts with non-registered funds up until five years before you begin withdrawals. If you plan on converting your RRSP to a RRIF at age 70 then you should stop paying fees with non-registered funds at age 65.
Compare this to what Mr and Mrs Brown are currently doing. Annual fees of $11,500 that they are paying are embedded in their mutual funds and reducing the market value. They are not able to deduct the MER annually.
When they sell these funds they will effectively get credit for tax purposes for one-half of the MER paid. The accumulation of MER will either reduce their capital gain or increase a capital loss.
Fee based accounts allow investors to speed up a deduction by allowing the investment council fees to be claimed in the year paid rather then in the year the investment is sold. In addition, investors are able to claim 100 per cent of the fee, rather than just one-half in the future.
Prior to doing any selling of mutual funds we need to do a couple of additional steps for the Browns. First, we need to obtain complete details of each mutual fund holding and whether any deferred sales charges (DSC) may apply for selling.
We would also like to get a complete picture of their adjusted cost base and up to date market values of each holding, along with their historical tax gain (loss) carry over information. This information will enable us to map out the transition from mutual funds (transactional account) to individual equities (fee-based account). This assists us in transitioning an account over time factoring in both redemption charges, if applicable, and income taxes.
The timing of fees is important to discuss. With our fee-based program, fees are not billed in advance. They are billed one quarter of one per cent after each quarter, prorated if an account is opened part way through a quarter. The following is an example of how the fees are billed assuming a deposit of $500,000 on July 1. No fees are charges in July, August, or September. On October 15th a fee of $1,250 would be charged to the account assuming no change in the total market value of the account. This is calculated by multiplying the market value times one per cent times one quarter. If the market value increases so does your quarterly fee. As the market value of your investment account changes, so will your fees.
Individuals who have net capital losses from other years may find fee-based accounts particularly attractive. By stripping out all commissions and fees you are more likely to realize a capital gain to apply against your losses.
Typically, these types of accounts come with a minimum annual fee, such as $1,500. As a result, this type of account is suitable for investors with $150,000 or greater at one financial institution. One of the many downsides to spreading your investment accounts amongst several institutions is that it reduces the number of account options available to you; this may increase your overall cost of investing.