Cost disclosure can rock mutual fund industry

An important change is coming in July 2016, when Canadians find out exactly how much they pay for the service and advice provided by mutual-fund sellers. Under new rules known as CRM2 (or Client Relationship Model, phase 2), you will see detailed information on your annual statements showing the amount you paid to the fund firm.

Enhanced cost disclosure may come as a surprise to buyers who think they pay nothing for advice and service from mutual-fund sellers. This is a common assumption.

Many clients believe their only cost is the annual management expense ratio (MER), which goes to the firm that manages the fund’s investments.

They do not realize that fund managers pay a portion of the MER to fund sellers for services provided to you on an ongoing basis. This is known as a trailing commission and is paid each year for as long as you own the fund.

Many clients also believe their adviser earns no up-front commission on a fund purchase. “Every penny of your $10,000 investment goes to work for you right away,” the seller may say.

While nothing is deducted from your investment, fund managers may still pay up-front commissions to advisers who sell funds with a deferred sales charge (DSC). This is a percentage fee that kicks in when you sell a fund before holding it for a specific period.

“Sticker shock,” a term that applies to sudden price increases, is now bandied about in mutual fund publications. While investors were already paying hidden fees and likely won’t face new fees, they may be surprised and resentful once mandatory fee disclosure is adopted.

The Investment Funds Institute of Canada, which represents the industry, has produced a sample report showing what investors can expect in the next 18 months. Here’s what the firm’s cost report may say:

We are giving details about the money we received over the past year to provide services to you.

This money is split between your financial adviser, who receives a commission, and the firm, which keeps the rest.

Payments to the investment fund manager (the MER) are not listed in the report. You can find the MER at the fund manager’s website or in a plain-language document, which is sent to you after a purchase.

You paid these amounts through your purchases or by direct with- drawal from your account. The costs of any investment are important, whether they are charged directly or indirectly, because they reduce your return.

Amount you paid for general administration: $130. Amount you paid for specific transactions: $116. Amount we received from others to provide ongoing services for your account: $789. Total amount received by us to service your account: $1,035.

Amounts are broken down as follows: (1) General administration: RRSP administration $100. Transfer fee $10. Trustee fee $10. (2) Specific transactions: Front-end sales commission $106. Fee for switching to different funds $10. (3) Payment received from others: Commission from investment managers for DSC investments $503. Trailing commission $286.

As part of the CRM2 reforms, you will receive another report that shows how your fund investments performed over the past year. It will disclose your personal rate of return after costs have been deducted.

In early 2017, you will get your first reports on investment fees and charges and on performance.

Let’s say that 2016 was a down year for the stock markets and your account fell sharply in value. At the same time, the fund dealer and the dealer’s firm collected thousands of dollars in revenue.

“The worse the performance report looks, the tougher the questions that investors are likely to ask about fees,” writes Rudy Luukko, investment funds editor at Morningstar Canada.

Financial advisers will have to justify their value to clients once the cost of service is out in the open. Most likely to be grilled are advisers “who did little more over the course of a year than send holiday cards and solicit RRSP contributions in February,” Luukko says.

I believe this change can rock the industry. Many Canadians hold mutual funds for the long term, while being oblivious to the costs they are incurring. They can save money by choosing different investments, switching advisers or becoming a do-it-yourself investor.

It’s not too early to ask your bank, credit union, mutual fund dealer or brokerage firm about how much it earns from your fund investments. You deserve a clear breakdown of direct and indirect costs.

Definitions of key terms for mutual funds: Sales commission: This may be paid to the investment dealer, either at the time of your purchase or when you withdraw from the fund. Front-end commission: This is paid from your initial purchase before your money is sent to the fund manager. Deferred sales charge: This is paid by the fund manager to the investment dealer after your full deposit is sent to the fund manager. You may pay a deferred sales charge to the fund manager for the commission the dealer received when you take your money out of the fund. The DSC usually declines to zero after a specific number of years. Trailing commission: The fund manager pays a portion of the fund’s management fee to the investment dealer for ongoing service to you for as long as you own the fund. Part of the trailing commission is paid to your adviser to monitor your account and provide you with advice. RRSP fee: This is charged to you by the investment dealer for administering your tax-sheltered account. The fees will be dictated by the type of account (regular or self-directed) and may be influenced by the dollar value of your investments held with the financial institution. Transfer fee: This may be charged by the investment dealer if you move your fund to another institution. You may also pay an early redemption fee for funds sold within 30 days of purchase (except for money market funds). Ellen Roseman writes about personal finance and consumer issues. You can reach her at eroseman@thestar.ca or ellenroseman.com