Embedded commissions good for fund firms, bad for investors

Banning such fees has been proposed, but faces pressure from financial advisers

What you don’t see can cost you — a lot!

Canada is an international laggard when it comes to investor protection. Advocacy groups like CARP are working hard to obtain better protections for investors, but we’re up against some stiff opposition.

Take the issue of embedded commissions.

Most mutual funds include an embedded commission: The commission is paid to the financial adviser or salesperson by the mutual fund company, rather than directly by the investor. This is important because the amount of commission paid, and the decision as to whether a commission is paid once, or every year that a client holds the investment, is set not by the investor, but by the fund company.

Imagine a real estate developer, desperate to sell some overpriced apartments, offers double the going commission rate to real estate agents. You don’t have to be a trained psychologist to predict that pretty soon a certain number of real estate agents will be showing those apartments to their clients, and pushing hard for those particular sales.

In this scenario, the clients can view these apartments as well as others on the market, and make their own decisions. The harm should be fairly limited.

But what about the investors who do not have the financial skills to assess different investment products, but instead trust their financial advisers to recommend products that are in their best interest? Unfortunately, research shows that all too often such investors are out of luck.

A recent study led by Douglas Cumming, the Ontario research chair at the Schulich School of Business at York University, revealed that the percentage commission paid on funds with embedded commissions determined the stickiness of the money invested in those funds. Cumming found that when a mutual fund paying a typical commission underperformed, investors took their money elsewhere. But when mutual funds paying above-average commissions underperformed, investors’ hard-earned dollars remained in the fund.

That’s a significant problem — but it’s not the only one. Most mutual funds include what is known as a trailing fee or trailing commission, so the fund company not only pays the adviser a selling commission, but also a bonus or trailing commission every year the investors’ savings stay in the fund. Because the additional commission is paid automatically by the mutual fund company, there is no requirement that the adviser provide any services to the client in return for the commission paid.

Embedded commissions have now been eliminated in the U.K., Australia and the Netherlands. The Canadian Securities Administrators (CSA) issued a discussion paper on banning embedded fees last December. This has powerful industry lobby groups worried.

One such group, Advocis, the financial advisers association of Canada, recently launched a petition to challenge the proposed ban.

At CARP, we build our policy positions on the views of our 300,000 members. So we asked

them how compelling they found the arguments lobby groups are making in favour of keeping embedded commissions.

Argument No. 1: Individuals who have a financial adviser are better prepared for retirement than those who don’t. If investors are aware of how much they are paying for advice, they’ll stop doing so and will be less financially secure in retirement as a result.

Argument No. 2: When the U.K. banned embedded fees, the number of advisers in that country declined to 31,000 from 40,000. Lobby groups are concerned that fewer advisers will mean more people are left without financial advice.

Argument No. 3: Without the financial incentive of future trailer commissions, advisers may be unwilling to take on clients with less money, so those with assets below, say, $100,000 will be left without access to financial advice.

After considering all the arguments for and against embedded fees, 79 per cent of CARP members polled supported banning them.

If you agree, go to CARP.ca/ BanHiddenFees and add your support.

Wanda Morris is the VP of Advocacy for CARP, a national, non-profit, non-partisan advocacy organization with 300,000 members and chapters across the country. CARP advocates for financial security, improved health care and freedom from ageism for Canadians as we age. Find out more at www.CARP.ca/about. If you have a question, please send it to askwanda@carp.ca.