Rebutting the downsides of fee-based advice

There were a couple articles last week by Canada's two power personal finance columnists, the National Post's Jonathan Chevreau and the Globe and Mail's Rob Carrick, pointing out the drawbacks of fee-based accounts. Quite simply, a fee-based account is a method in which full-service financial advisors compensate themselves by charging their fees as a percentage of their client's portfolio size.

If you've been a regular reader of my blogs [and I know there are just millions of you out there], you would know that I have been a fan of advisors who use fee-based in their practice. The transparency it brings to the client-broker relationship is unrivalled. John DeGoey, in his book The Professional Financial Advisor II, believes financial advisors embracing this compensation method illustrates one of the most important steps to bringing a sense of professionalism to the industry. It's hard to deny such a move would remove the conflict of interest that a revenue-driven, transaction-based approach employs, as the advisor is no longer being compensated by each trade or mutual fund switch.


The Drawbacks (the following information is also provided in my Investor Awareness Kit, which can be downloaded by clicking on the link on the top-left corner):

1) A buy-and-hold method with a few trades doesn't justify having to pay a fee based on the percentage of your assets.

Thoughts: A fair point. Detractors of this method do point out that the incentive for the advisor to pursue future investment opportunities is severely undermined if they're already paid upfront. However, I believe that the client will be in touch with this anomaly, if there is one. They'll know exactly what they're paying each year, and they'll know what they're getting in return. An observant comment to Carrick's column written by a financial advisor spoke of the great lengths that they go through. It's not just putting trades through, but also working on the insurance, tax and estate planning. It's the time spent servicing the Investment Policy Statement or updating the financial plan.

Regardless, if there is value or not, the client will know how much they are paying, and it will be far easier to make a qualified decision whether or not the advisor is worth their compensation, as they can put an actual dollar value to their financial advice.


2) For advisors to bias toward securities with embedded fees (most notoriously, new issues) once their clients are placed in fee-based accounts.

Thoughts: Okay, this observation has a great deal of merit, and it's something that should be kept in mind. When a brokerage firm acts as the principal in a transaction (they own the investment product being sold and are not acting as the agent between their client and another party), there are always embedded fees involved paid out to the brokerage. New issues, for example, carry a 3%-5% commission to the broker. Limited partnerships and flow-through shares make up some of the 'sexier' products out there and advisors know how to pitch these in a manner to make their clients salivate. By recommending these products, they are giving themselves quite the raise from the fee they are already collecting from the client.

This is a problem, but it shouldn't be a factor to completely do away with fee-based advice. I've been excited to see brokerage firms broach this issue dead on with them not passing the 'embedded fee' comission to the advisor. While this isn't mainstream yet, several brokerages firm have initiatives in place, and it definitely is a start. We can do our part by educating the client and holding advisors that do commit such reckless behaviour accountable for their actions.

With 10.7% of the full-service financial advisor community using this method, I still feel there is a long way to go in making this the more mainsteam compensation method. It is not to say that transaction-based (being when an investment is bought or sold) should be completely done away with, especially for large portfolios with few trades, but I do disagree with Carrick when he entitles his article, "Fee-based accounts sounds good, but they're just as open to abuse." There simply is many more methods an advisor can employ to take advantage of a transaction-based portfolio.

I agree with DeGoey that fee-based will make financial advisors stronger professionals. The public doesn't need salesmen when it comes to their investments.