Regulatory Change Helps Drive Popularity of Fee-Based Investment Accounts

CPABC IN FOCUS MAGAZINE

The investment services industry is changing at a dramatic pace, with investors demanding more choice, more transparency, and more personalized advice. One of the fastest growing trends within the financial services sector is the use of fee-based accounts. While there are many reasons for the increasing popularity of these accounts among advisers and clients alike, recent regulatory changes have been a major catalyst.

Traditional vs fee-based account structures

In the past, the most common type of account structure has been a transactional one, wherein commissions are charged for each buy or sell transaction. With fee-based accounts, however, advisers do not receive commissions—instead, they agree to a set fee schedule, usually charged on a quarterly basis. This fee is normally based on the portfolio’s market value and composition. Buy and sell recommendations are based solely on the client’s strategic needs and goals. If an investor’s account increases in value, so do the fees paid to the adviser; conversely, if an investor’s account declines in value, so do the fees paid. With a fee-based structure, the adviser has a direct (and overt) incentive to ensure that the investor’s account increases in value.

Client relationship model initiative enters second phase

The recent increase in the use of fee-based accounts correlates to a large extent to the implementation of the second phase of the “Client Relationship Model” (CRM), a regulatory initiative passed by the Canadian Securities Administrators in March 2012 The CRM affects both the Mutual Fund Dealers Association and the Investment Industry Regulatory Organization of Canada.

While the key objective of CRM1 was relationship disclosure and enhanced suitability, the key objective of CRM2 is to increase transparency/disclosure for investors with regard to fees paid, services received, potential conflicts of interest, and account performance. All of these mandatory disclosures are being phased in from 2014 to 2016.

In July 2014, CRM2 mandated pre-trade disclosure of all fees prior to an investor agreeing to buy or sell an investment. With a traditional transactional account, an adviser must disclose all of the fees a client is required to pay, such as any commissions for transactional accounts when buying or selling positions. However, many investors have complained about “hidden” and unexpected fees, especially with respect to mutual funds. With CRM2, all of these fees now have to be fully disclosed prior to the transaction.

This move to greater transparency is a major shift from certain types of transactions that had no disclosure requirements in the past. For example, an adviser used to be able to purchase a bond and embed their commission in the cost of the bond on the trade confirmation slip. Now, fixed income trades also require full disclosure. In other cases, even if there was disclosure in the legal sense of the word, understanding this disclosure required clients to read the fine print in lengthy prospectus documents. Similar CRM2-type regulations for full disclosure were implemented in Australia and the UK in 2013, requiring transparency regarding all fees. Not surprisingly, this resulted in a significant reduction in the number of financial advisers working in the industry in both countries. It’s possible that we could also see a reduction in the number of advisers here, once the new rules are fully implemented in Canada.

Fee-based accounts are already onside of the new rules, as transparency is embedded in their structure: The client has a discussion about fees with their adviser up front, and a fee-account agreement with full disclosure is then signed by both the investor and the adviser. 

Comprehensiveness

Another reason for the growth in popularity of the fee-based platform is the fact that many advisers now offer a comprehensive wealth offering, which includes both investment and planning-related services. This differs from the role of the stock broker of the past.

Clients have a variety of financial planning needs, primarily with regard to retirement and estate planning. Many advisers can offer detailed financial plans and provide access to experts in related areas, such as insurance, and will and estate planning. An adviser will often communicate with the client’s accountant and lawyer to ensure everyone is on the same page.

In a traditional transactional account where commissions are charged for every buy or sell, it has always been challenging for advisers to be compensated for additional services such as financial planning. Consequently, many transactional-based advisers simply would not offer these services to their clients.

Some unique benefits

Certain benefits are unique to fee-based accounts.

Rebalancing without additional cost

For example, this structure enables wealth advisers to rebalance portfolios as needed to reduce risk at no additional cost. Multiple types of rebalancing are important when managing risk. At the macro level, let’s assume a client’s optimal asset mix is 60% in equities and 40% in bonds. After a period of strong equity markets, the client’s equity percentage rises to 68%. Reducing equities by 8% and allocating this to fixed income is rebalancing at the macro level. At the micro level, there is an optimal position size for one holding. In this example, let’s assume the optimal position size is $24,000 for each company held in the portfolio. If one stock rises significantly above or below the optimal position size, then consideration for a rebalancing trade should occur.

Several trades could be required on an annual basis to rebalance a portfolio. With transactional accounts, the commissions for doing multiple small adjustments would likely be prohibitive. However, not doing the trades because of the commission payable in a transactional account means that you’re not managing risk as effectively.

The adviser’s ability to make tactical shifts in an account is another benefit of fee-based accounts. For example, there are times when investors benefit from moving in or out of USD-denominated holdings. Being able to make these changes when the currency is right should be done without concern for the trade’s commission cost. Being able to move between sectors based on current outlook can also be strategic, especially when transaction charges are not a factor (if a transaction charge is 2% to sell and 2% to buy, then the cost of any switch trade has to increase by 4% to break even).

Income splitting and “householding”

Fee-based accounts also offer couples and families one more opportunity for income splitting by setting up account-designated billing for their fees. For example, the higher income spouse can pay the fees for the lower income spouse. Let’s assume the lower income spouse has an RRSP and a TFSA. The higher income spouse can put funds into the lower income spouse’s account as a contribution of fees without attribution. In another example, a client with multiple fee-based investment accounts (i.e. one non-registered and five registered) can arrange to have all of the fees paid out of the non-registered account.

“Householding” is a term used in fee-based accounts to link accounts together for fee-billing purposes. As the total of the householded assets increases, the percentage fee for the adviser’s services decreases. Let’s say we have a middle-aged couple with $400,000 in investments. The couple has parents with $680,000 in investments, over which the couple has power of attorney. The couple also has a corporate account totalling $120,000 in investments. By householding, or combining all accounts under one agreement, the household value becomes $1,200,000, which results in lower overall fees for everyone.

Deducting investment council fees

Another benefit of a fee-based structure for non-registered accounts is the ability to deduct investment council fees as “carrying charges and interest expense.” Many investors are still not aware of these tax benefits. Anyone who has non-registered accounts would be well advised to read the Canada Revenue Agency’s (CRA) interpretation bulletin on this topic (IT-238R2). The investment council fees cannot be deducted for registered accounts, but there is the benefit of paying the fees for registered accounts from a non-registered account, especially for younger clients where registered accounts are deferred for many years.

Adviser-managed accounts

Over the last several years, adviser-managed accounts have been the fastest growing segment of the broad fee-based group. In this type of account, the adviser is licensed as a portfolio manager and able to use his or her discretion to execute trades.

In setting up the adviser-managed account, one of the criteria is that the account must be fee-based. The regulators have made it clear that a portfolio manager is not permitted to use discretion when it comes to commissions or transaction charges. One of the starting points to setting up a managed account is to get a clearly defined investment policy statement that sets out the relevant guidelines that will govern the management of the account. At this same time, a fee-based agreement is signed that clearly outlines the negotiated fee structure.

Shifting to a new model

As the financial services industry continues to change and evolve, so do the solutions being offered. There is now more flexibility and choice in how a wealth adviser and an investor can work together.

High-net-worth clients are looking for advisers who have the credentials and licensing to offer discretionary portfolio management. Within that context, there is also an expectation that financial planning and other related services will be part of the overall fee-based structure. The traditional model of solely doing stock trades for trading commissions is becoming an increasingly difficult business model to sustain.

Kevin Greenard is a portfolio manager and associate director of wealth management with ScotiaMcLeod, a division of Scotia Capital Inc. and ScotiaMcLeod Financial Services Inc.