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From Planipedia

Thanks to PlanPlus and WEA for sharing their material for this Best Practices Guide.

Contents 1 Overview 2 Investment Commissions 2.1 Cons 2.2 Pros 3 Insurance Commissions 3.1 Cons 4 Assets Under Management (AUM) Fees 4.1 Cons 4.2 Pros 5 Fee for Service 5.1 Cons 5.2 Pros 6 Net Worth Fee 6.1 Cons 6.2 Pros

Overview

One of the only debates in the financial planning world that is more intense than that of active versus passive investment management is that of fees and commissions. Almost all associations in the industry agree that an unethical planner can take advantage of a client regardless of how things are billed, and that conversely an ethical and professional financial planner can meet all fiduciary responsibilities to their clients regardless of how they are compensated.

Non-the-less, it is incumbent upon financial planners and associations to aspire to modes of compensation that remove or reduce any explicit or other form of potential conflict of interest on the part of the planner.

It is important for anyone reading this article to appreciate that just because a form of compensation could create a bias, it is our sincere believe that this not prevelant. Some of the best financial planners in the industry are compensated with commissions. There is also a balance that needs to be struck to ensure the absolute protection of the client but at the same time recognize that the business model must make sense for a financial planner. We have seen top quality fee-only planners through in the towel because they could not make a living trying to get consumers to cut a check for planning services.

There is no perfect answer, but as a best practice we should aspire to make whatever models are used as fair and effective as possible, recognizing shortcoming when they exist.

Investment Commissions

A commission is paid by the product manufacturer to the advisor. This may include an up front fee, an annual fee tied to the MER on a mutual fund or Deferred Sales Charges (DSC). Again, we want to stress that because a conflict could occur most advisors recognize that if they generate bad advice to generate more commissions it will eventually catch up to them. For financial planners there should not even be the threat of this concern.

At the Global Update meeting held in at the FPA Conference 2009, presentations by UK, India and Australian representatives outlines that commissions are beining discontinued by the regulator across not just financial planners but the entire financial services industry by 2012.

• For India there is a ban effective August 1st of 2009 on Front End loads on mutual funds. An outright ban is being discussed for 2012 but not yet passed.
• For the UK, all compensation for the advisor must be negotiatred and paid by the client by 2012.
• For Australia, all commissions on products after 2012 must be agreed by client and charges capable to be turned off if the client does not feel they are getting the level of service outlined by the advisor.

Cons

• If the advisor is compensated by product sales that is where they will focus – product features
• Receiving larger commissions on equities compared to fixed income means a bias to more equity in the portfolio
• In some markets like Asia, large front end loads (6% or more) may bias advisors to “churn”, sell one fund to buy another and generate a commission
• Since advisors are paid on investments, they want to maximize this. It could influence advice to not pay down debt.
• Many mutual fund sales people cannot sell ETFs, potentially the cheapest way for a client to access the market. As such they may never be recommended.
• Certificates of Deposit, Guaranteed Investment Certificates and Bonds provide lower commissions 0.2% per annum) compared to a fixed income mutual fund (0.75% or more).
• Advisors could be biased against annuities which, when purchased, will reduce assets under management and only pay an upfront commission with no trailer or ongoing fee.
• Clients may be faced with decisions to take the commuted value of pensions and transfer it into investments on which the advisor would be compensate creating a possible bias to choose this option as opposed to taking the pension as an income

Pros

• Very easy to manage as client is not faced directly with paying a check for advice, comes out of the MER on a fund

Insurance Commissions

Insurance commissions are very complex and non-transparent and few advisors will actually disclose the actual dollar commission they will receive on an insurance sale. If an advisor is too embarassed to tell the client what this is it is hard to believe they can feel they are taking a fiduciary role with the client. Our challenge is not to argue on if the client should be told, but to establish a way of doing so that puts the commission in light of the bigger picture.

There is an added complication in that in some countries like Canada it is against the law for financial advisors to rebate any portion of the insurance commission to the client to protect clients from indirect sales scams. As an example if I know I will earn a $20,000 commission and I tell the client I will contribute $2000 to your investment account when you sign uop for this insurance, it can be used to entice a client inappropriately. On the other side of the coin, insurance companies have not developed the equivalent of no-load insurance which means that even if the advisor was trying to opperate fee-only, they cannot rebate the commission and the client will get no reduction in costs if the advisor does not take it. Insurance companies should be encouraged to develop less complicated, more transparant compensations that will allow financial planners to handle insurance recommendations with comflict of interest.

Cons

• Life Insurance can have complex and hard to explain commissions leading to lack of disclosure or ambiguous disclosure.
• There is no direct relationship between the fee/commission received to the service delivered – i.e. the commission may or may not be appropriate as a planning fee.
• Advisors may receive bonuses, reduced expenses or perks to concentrate investments or insurance products with a specific company.

Assets Under Management (AUM) Fees

Fees are charged as a percentage of the total investments under management for that client

Cons

• If fees are variable based on equity or fixed a bias to equity may remain
• Bias to maintain investments and not retire debt
• No relation of fee to service (necessarily)
• Could be biased against annuities which reduce investments and have low commissions
• Clients may be faced with decisions to take the commuted value of pensions and transfer into investments on which the advisor would be compensated.

Pros

• Removes bias to specific products or churning
• Creates a solid business model for the advisor with recurring revenue

Fee for Service

This is an hourly rate charged based on the time required to complete a planning engagement

Cons

• Clients may avoid asking advisor for help for fear of the cost
• Can include tax return preparation, either personal or corporate to keep ongoing relationship
• Consider retainers to allow client to call any time on an issue without worry about the meter running.
• Direct relationship between the fee and the service delivered

Pros

• Most professional and unbiased
• Planners not licenced in investments or insurance may have concerns to address product issues, or may even be restricted from doing so.
• Engagements become modular as clients try and limit costs
• Hard for the planner to create equity in their business – on an hourly billing treadmill.

Net Worth Fee

This is similar to an AUM fee but charged on the net worth, not just the investment capital. An exclusion for the principal residence may occur.

Cons

• Great during accumulation phase with increasing net worth – what about during decumulation?
• No relationship between fee and service provided (necessarily)
• Advisors need to take a look at their professional liability insurance - does it cover this level of advice coverage.

Pros

• Fee includes offbook investments, businesses which encourages advisor to truly understand all assets and liabilities.
• No bias to not retire debt – anything that makes the client wealthier is good
• Must capitalize the value of annuities, pensions to include in net worth and remove bias.