When we hire a professional, we know how they are paid. For lawyers, accountants, and even taxi drivers, the meter is running as they do the work. The costs may be higher than we'd like, but it is at least transparent and easy to understand.
With advisers, it's often a different story. They make money in a range of different ways, Most often, it is based on on the amount and type of product they sell. It is seldom tied to how well their clients' investments perform.
Advisors are regularly put in a difficult position of serving a client (and maximizing your returns) and needing to make a living (and thus picking products that maximize their return).To better understand the behaviour of your adviser, make sure you know how he or she is paid.
How commission works
Let's start with the basics. Most full service advisers are paid on commission. They earn most or all of their income from the assets that they manage. Here's how the system works:
An adviser usually has to share his or her commission with the firm. Their commission generally goes through a 'compensation grid' which keeps varying amounts for the firm. Small firms may pay out 90% to the adviser, while larger bank-owned firms may pay out as little as 20%.
The more commission an adviser makes, the higher the percentage that they keep. Pretty simple, but this type of pay system rewards advisers for increasing trading volumes. This can have a dramatic effect on their clients' costs - and true return.
Example: The 'grid' makes it easy for an adviser to increase his pay cheque by 50% with only a 22% increase in overall commissions. If these commissions aren't coming from new money being managed - they may need to come from activity in the current portfolio. Maybe yours.
The additional income may be paid to the adviser in one big quarterly amount. This again rewards advisers for adding periodic activity to client portfolios -- which can in turn add cost and lower returns.
An adviser gets more commission for some products. Often the products that are least advantageous to buy (and most difficult to sell) pay the highest commission.
Example: Let's say an equity mutual fund with a deferred sales charge will pay a 5% commission to the adviser at the time of sale. A short-term bond may pay only .25%. The equity fund carries with it the risk of both capital loss and high redemption charges, but pays 20 times more to the adviser. There certainly is an incentive to choose the mutual fund- and the client needs to be aware of this.
Mutual funds: an adviser's best friend?
Commission is one reason that advisers like mutual funds. The other is that they get high amounts of ongoing income in the form of 'trailer' fees. For as long as you own the fund, your adviser receives trailers of up to 1.5% of its value every year. Wrap accounts (mutual funds sponsored by the adviser's firm) pay even more- up to 2.3%.
Isn't this a conflict of interest? It can be. Advisers are sometimes paid trailer fees that cost investors twice as much as other, more proven product. If your adviser recommends only internal wrap accounts, you need to ask yourself whether this person is working in your best interest or their own.
The take-home message: Watch your investment costs closely
Consumers looking for value need to assess their investments in the context of the commission system. By pushing advisers to earn commission, the system favours mutual funds, wrap accounts and other managed products that add costs to investors and work against maximizing returns.
There are many investment choices that are low risk, low cost, and probably in the end, offer a better return. Ask your adviser what they are.
Content in this section is provided in partnership with the Investor Education Fund, a non-profit organization promoting financial literacy to Canadians. To find out more go to GetSmarterAboutMoney.ca.