Every investment advisor may have a different opinion on the best approach to investment management. One is to purchase direct holdings such as common shares, preferred shares and bonds. Another may be mutual funds, hedge funds, closed-end funds, real estate structures, exchanged-traded funds, managed accounts, insurance products, derivatives, …the list goes on.
Understanding the pros and cons of each approach to investment management is important in choosing the right option for you. In addition to having multiple investment approaches, people have multiple account types to choose from. The process begins by determining the investment management approach, and then the type of account. Regardless, you should understand all the associated fees for buying, holding and selling.
Fee-based accounts at full service investment firms are growing in popularity. Fee-based accounts may be suitable for people who appreciate investment and planning advice but also want to 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 advisor 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.
To illustrate the benefits of fee-based, we will use the Brown’s portfolio.
Mr. and Mrs. Brown currently have $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 and offered two recommendations.
- 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. For the sake of simplicity we are using a fee-based account with a flat 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 four 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 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 71 then you should stop paying fees with non-registered funds at age 66.
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 than 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 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.
Those with 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.
Fee based accounts may come with a minimum annual fee, such as $1,500/year. 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 indirectly increase your overall cost of investing.