Has your Advisor ever explained to you how they get paid? Do you understand how your Advisor is compensated? Can you explain to somebody else how much money your Advisor will make by selling you an investment? If you cannot answer these questions with some confidence, then you should ask your Advisor to answer your questions or find your answers from other sources.
Knowing how much money your Advisor makes for providing advice, making recommendations, and trading your securities should be important to you. My goal is to educate you about the different compensation models that can influence your Advisor’s advice and to make it easier for you to start having these important conversations with your Advisor.
I will focus my discussion on Advisor Compensation as the main conflict of interest that exists in a client-advisor relationship and what compensation models are good, bad, or ugly. My definition of a conflict of interest as it relates to the advisor-client relationship is: A personal interest that an advisor has that competes with the advisor’s interest in a client to the point that distorts the advisor’s judgement in service to that client.
I have been an Advisor for the past three decades. I have been registered to trade in securities under the following categories: mutual fund dealer, investment dealer, portfolio manager, and exempt market dealer. For the majority of my career, I was employed under various titles, such as Trust Officer, Mutual Fund Representative, Investment Specialist, Senior Financial Consultant, Branch Manager, Investment & Retirement Planner (IRP), Financial Planner & Investment Advisor, and under various compensation models such as salary plus bonus, salary plus bonus and commission, commission plus bonus and referral fee and commission only. I could explain to clients that I was paid a salary or was a direct employee, so I could provide unbiased advice, and this was good. I also could explain why an Advisor on commission was tempted to recommend certain classes of funds that served the Advisor’s interest more. For example, a client could not explain why their Advisor had sold them a Deferred Sales Charge (DSC) fund instead of a no-load or zero-commission Front-End (FE) fund, and this was bad and ugly.
Bank compensation models sometimes evolve to become complicated for their employees. The bank’s compliance system provides rigorous oversight to protect clients from unsuitable trades, but with the multiple commission structures, bonus levels and sales targets at play, these moving parts no doubt create some confusion. Moreover, the bank’s sales management practices create pressure to sell products for its employees. In June 2018, a bank owned mutual fund company paid a $1.1 million penalty to the Ontario Securities Commission because they paid their IRP employees a higher rate of commission for the sale of units of certain various proprietary funds than for the sale of units of other third-party funds, and this was bad and ugly [footnote 1].
Since retiring from being an employee in 2018, I have been registered to trade in securities under the categories of investment dealer, portfolio manager and exempt market dealer, without the pressure that existed as a paid employee, and I thought that this was good. I found, however, that on many occasions my advice would come without pay, and this was bad for me and good for my client. Client Focused Reforms (CFRs) came into force last year that require all Advisors to disclose all material conflicts of interest to you before opening an account, and in a timely manner after additional conflicts of interest may be identified [footnote 2]. However, I don’t think that CFRs have been the magic cure for bad advice, and I don’t believe it has helped clients deal with the inherent conflict of interest that compensation poses to the client-advisor relationship.
How does your Advisor explain their own compensation conflicts in their advice to you? Do you understand how they get paid? Can you explain how their compensation model could influence their recommendations to you? I have been paid over the full spectrum of compensation models over the past three decades. With this knowledge and experience, I can help you assess the advice that you are receiving from your Advisor and identify the potential conflicts that may exist and empower you to effectively work with your Advisor with a solid understanding of their compensation conflicts or to avoid the compensation conflicts altogether.
At one end of the spectrum, there is a relationship of full trust and advice, where the Advisor makes all your investment decisions for you (on a discretionary or non-discretionary basis) as to how to invest your money and charges an annual fee based on Assets Under Management (AUM). This type of Advisor is normally registered as an Investment Advisor or Portfolio Manager.
At the other end of the spectrum there is a relationship where the Advisor simply sells you a particular security from their approved product shelf in exchange for a sales commission from the issuer of this security. This type of Advisor is normally registered as a Dealing Representative. I am not saying one compensation model is better than another, but your Advisor should be explaining how they will get paid by selling you a security and the conflicts that exist. Does your Advisor recommend a fund to you and get paid nothing or $5,000 commission upfront? Does your Advisor get paid $500 per year or $1,000 as a trailing commission by selling you the fund? What are the other costs that you will incur for owning this fund, such as a Management Expense Ratio (MER) or Trading Expense Ratio (TER)? You should be able to answer all these questions.
Advisors that charge you an annual advisor fee, based on AUM, may hold themselves out as being more ethical than an Advisor that charges a sales commission for each trade of a security. A Portfolio Manager will claim to adhere to a higher standard by acting as your “fiduciary” more than a Dealing Representative. Your Portfolio Manager is required to set aside their personal interests and should be fully disclosing all their fees and all other associated (MERs and TERs) costs and charges that you will incur. You should also understand how your Portfolio Manager’s personal interests (their compensation) will influence the advice and service that you receive.
Charging a fee, based on AUM, can present dire consequences for you. Portfolio Managers should be explaining how your decision can significantly increase or decrease their personal compensation. Here is a list of RED FLAGS that create compensation conflicts that could cause you significant financial harm if you do not carefully consider how your Advisor’s advice will impact your Advisor’s pay:
- Recommend investing your commuted value of your defined benefit plan to a Locked-In Retirement Account (LIRA) OR keeping your pension plan at your employer's when you retire.
- Recommend investing OR paying off your mortgage.
- Advising to keep your money invested OR make a charitable donation or gift to your family.
- Advising to keep your money invested OR buy a more expensive house.
- Advising to buy a laddered GIC portfolio OR managed income portfolio.
- Charging a higher fee for managing equity OR a lower fee for managing a balanced or fixed income portfolio.
- Paying a management fee OR charging for each trade instead.
All Advisors will have very compelling reasons why you should accept their recommendations, but they should be also explaining how their recommendations will earn them more or less compensation, how they control this conflict and when they must avoid doing business with you because their conflict cannot be managed appropriately. Ask yourself the questions when faced with a RED FLAG decision: How will my decision impact my Advisor’s Assets Under Management, how will my decision impact my Advisor’s pay and by how much money?
If your Advisor sells you a security to earn a sales commission, instead of charging you an advisor fee, based on AUM, make sure that you consider whether or not a sales commission per trade will cost you more or less money over time than an advisor fee based on AUM. Under Client Focused Reform, you need to give your consent for your Advisor to proceed with your trade based on the conflicts of interest that exist and have been discussed with you. There could be other solutions available to you but are not being offered to you simply because it is beyond your Advisor’s scope. It doesn’t mean that you can’t get the solution you want with another Advisor or on your own through direct investing.
I hope that I have helped explain why all compensation models have conflicts. Different forms of Advisor compensation will pose different conflicts. It is important that you understand how your Advisor’s advice may also serve their personal interest and what the cost is to both you and your Advisor by accepting or declining their advice. Make sure that you know all your options. Are there other options that will serve you better, but your Advisor is not registered to offer you? If you can answer with certainty, then you will have confidence knowing your Advisor’s recommendations are in the best interest of you. It is up to you to say whether a conflict is good, bad or ugly. If you are not having these important and sometimes difficult discussions about how your Advisor is paid for their advice, that is bad. If you are having these open conversations about your Advisor’s compensation and you feel good about your Advisor’s advice and how much they will get paid, that is good.
Don’t let the advice you are receiving from your Advisor get ugly.
The views expressed in this discussion are my own.