Should you switch to fee-based before retiring?

When Patrick Kinsella learned that global regulators were moving toward banning fee-based commissions, he feared for his business.

It was early 2013 and Kinsella, principal at Kinsella Wealth Management in London, Ont., had attended a presentation by a mutual fund company where he learned about the U.K. banning embedded commissions at the beginning of the year—and that other countries, including Canada, were leaning in the same direction.

Unaware of the trend, he was blindsided and worried about his book.

“I had always been compensated by DSC fees,” he says. “Fee-based seemed like such a foreign country.”

Despite his reticence, Kinsella learned all he could about switching. The research won him over, especially a 2012 PriceMetrix report that said advisors who increased their assets in fee-based accounts by 25% or more saw revenue growth of 47% over three years—more than double the average growth rate of 21%.

By mid-2013, Kinsella was making the switch, which continues today. He has transferred about 6% of his book each year, moving current clients over as their funds mature and offering fee-based service to new clients. Because his practice is mature, trailer fees from advisor series funds have given him sufficient income during the transition, he says.

Switching to fee-based renewed Kinsella’s passion for his business, which was sparked as he drafted his value proposition for the transition (see “Winning clients over to fee-based”).

There was another surprising benefit to the transition: his business is worth more.

“I have noticed a steady increase in income, not [the] decline I originally anticipated,” he says. Revenue is up about 30% year over year, and he estimates his practice has increased in value by about 25% since he started the transition.

Originally motivated by fear, he now recognizes the value of the switch to his retirement—something likely on the minds of many Canadian advisors.

Get real about revenue

Generally, a fee-based book is worth more than a commissions-based one because it has the stability of recurring revenue, says Howard Johnson, managing director of mergers and acquisitions at Duff & Phelps Canada in Toronto. That’s because valuations are based on revenue stability and diversification.

In fact, fee-based outperforms on a number of metrics. For example, the 2012 PriceMetrix report that Kinsella read (its most recent on switching to fee-based) said the average account return on assets was 1.18% in fee accounts and 0.54% in transactional accounts.

But fee structure is only one variable when assessing value, Johnson says. A book’s composition is also a factor: the number of clients and the quality of the relationships with the advisor, as well as demographics and, of course, assets.

Danny MacKay, co-founder of AdvisorBridge.ca in Guelph, Ont., a firm that facilitates book sales, says that 80% of a book’s revenue typically comes from 20% of its clients. He assesses that 20% for retention, looking at age, for example, and whether their assets are increasing or decreasing.

MacKay doesn’t suggest advisors switch to fee-based to make a sale more lucrative, as commissions-based books remain attractive. Commissions-based accounts must be transitioned in due course anyway in light of industry trends, he says.

As the buyer speaks with the clients, “that’s the opportunity to present their value proposition and move to their fee model,” he says. Even poorly serviced books present untapped opportunities, such as estate planning, he says.

Plus, switching can be “extremely risky,” MacKay says, especially if the practice will be transferred to the buyer relatively quickly, or if client fees will change. “It looks terribly disingenuous to the clients to suddenly do this transition in front of a sale,” he says. (Most of the sales MacKay facilitates are exit strategies done within months.)

Lost clients would affect a sale, which typically includes a retention clause so the buyer doesn’t pay for lost revenue. Further, buyers likely won’t appreciate the switch, because they “don’t want someone else’s attempt to dress up a book,” he says.

If all your advisor friends jumped off a bridge, would you jump, too?

Advisors close to retirement might feel pressure to change along with an industry moving toward fee-based accounts, but the commissions-based model is alive and kicking: 54% of North American advisory relationships have no fee-based accounts at all, said a 2017 PriceMetrix report. These tend to be with older advisors, with two-thirds of those licensed for 20 years or more maintaining books with less than 25% in fee assets, the firm’s 2012 report said.

Also consider that a book’s value could drop, regardless of fee structure, as baby boomer advisors retire and create a buyer’s market, says MacKay. Further, there aren’t a lot of buyers: the announced sale of an attractive, $250-million book in southern Ontario last year received only seven inquiries when posted on LinkedIn, he says.

Downward fees are also affecting books, regardless of fee structure. PriceMetrix finds that transactional revenues as a percentage of assets fell to 0.39% in 2017, down from 0.51% in 2014—a result of less trading activity and lower prices per trade. For households with US$1 million to US$1.5 million invested, fee account pricing dropped to 1.08% in 2017 from 1.16% in 2014, a result of advisors lowering fees for both existing and new client accounts.

As a multiple of gross revenue, valuations are usually in the 1.8x-to-2.3x range for the deals MacKay facilitates, typically for MFDA advisors.

Advisors concerned about a lower multiple for a commissions-based book have options when negotiating sale terms, which are just as important as price, says Johnson. For example, a selling advisor with a stable client base could negotiate with the buyer to take payment for their book over a longer period.

For younger advisors, it makes more sense to align with the industry transition to fee-based and to improve valuation: to the degree that books get valued on growth potential, fee-based should be prioritized (along with client mix and depth of client relationship) because it has a big influence on a book’s future performance, a separate 2012 PriceMetrix report said. Similarly, to the extent books are valued on their ability to retain revenue after a sale, fee-based should be prioritized, the data analytics firm found in a 2014 report.

Selling clients on the switch

MacKay says buyers should be “bigger, stronger and faster” than the departing advisor to ensure a successful transition with a high rate of retention. That typically translates to a buyer who is younger and offers a higher level of service on an IIROC platform—a fiduciary is particularly attractive to clients, he says. “We want to make sure that the client is actually moving up in the world of advice.”

Nicky Trasias, an advisor at HollisWealth in Waterloo, Ont., clicked with her senior advisor when she was hired as a young associate. About eight years later, she started to transition the older advisor’s book—which was commissions-based—to her mostly fee-based practice.

Some clients used the transition as an excuse to go elsewhere, which they had likely wanted to do for a while, Trasias says, but she estimates retention was about 98%.

However, the time costs of a transition that took several years were significant, she said.

She’s an IIROC advisor, while her mentor was MFDA-registered, so she had to transition each client to her platform. A further complicating factor was a firm acquisition: her mentor’s clients weren’t completely transferred to her ahead of the firm being acquired in 2017, with associated system changes.

“It’s easier to acquire a book of business if you’re on the same platform and at the same dealer,” she says. “It’s easier to explain to clients, as well.”

Some long-time clients think they’ve been getting advice for free, she says, and are “taken aback” by the fee discussion. The transition took so much administrative and emotional work that, as a buyer, she’d avoid a commissions-based book if she had to do it again.

In contrast, costs haven’t been significant in Kinsella’s case. Client discussions required an explanation of the evolution of embedded fees, as well as fee-based services, he says. Client conversations turned into discussions about “compensation, clarity, transparency and ultimately what the client viewed as my contribution,” he says. “I was frankly pleasantly surprised at how open clients were. They didn’t mind paying as long as they felt they were getting value.”

The great exodus: advisor retirement

Danny MacKay, co-founder of AdvisorBridge.ca in Guelph, Ont. recalls facilitating a book sale where a buyer was quickly found within the same firm, demonstrating that some firms do a poor job at succession. “There isn’t enough mentorship in the industry,” he says. “I can almost see a crisis building.”

Firms with mentorships recognize important trends affecting asset retention, such as heirs choosing their own advisors—likely younger—over their parents’ advisors, says MacKay.

Edward Jones has a business plan for the coming retirement wave, adding 150 net new advisors over the last two years, says Ann Felske-Jackman, principal, financial advisor talent acquisition at Edward Jones in Mississauga, Ont.

When advisors at the firm decide to retire or specialize and have the option to transfer their books, they access firm-sponsored programs, which typically take two to four years to complete, and compensation is internal (new advisors don’t pay for books).

Winning clients over to fee-based

In a document for advisors, Dynamic Funds says more clients will be willing to make the switch to fee-based if they perceive that the tangible and intangible benefits they receive are greater than what they pay. Advisors can create value proposition statements that detail the benefits they provide clients, compared to working alone or with another advisor.

Dynamic says to focus the statements on value-added services, which might include increased RRSP contributions, updated wills, renegotiated mortgages, tax filings and debt reduction.

Transitioning to fee-based may mean establishing different services and advice, Dynamic says. For example, Ronald Harvey, senior financial advisor at IPC, says he promotes his accounting background when acquiring new fee-based clients. If clients reject fee-based, advisors can continue to work with them and revisit the conversation in a year, says the Dynamic document.

Regulation varies by jurisdiction

After consultations beginning in 2012, the Canadian Securities Administrators last year proposed a ban on deferred sales charges (DSCs) and on trailing commissions where no suitability recommendation is made. A one-year transition period for fund companies was proposed, and existing DSC funds would be allowed to run their course until their scheduled expiry dates.

However, the Ontario government doesn’t support the proposals, saying DSCs have helped investors save for retirement and other goals. The CSA’s comment period ended in December but further progress is in doubt.

Canadian regulators aren’t alone in considering a DSC ban, and some global regulators have gone further. The U.K. banned embedded commissions, including front-end commissions and those on permanent life insurance. Australia has banned front-end and trailing commissions, and imposed a statutory best interest duty.

The European Union banned third-party payments to firms providing independent advice or portfolio management related to advice or services. To this regulation, the Netherlands added a commissions ban on all financial products.

In a 2018 report, the Investment Funds Institute of Canada says only 13% of global mutual fund assets are covered or slated to be covered by an embedded commissions ban.

Focus on client retention

Retention is as important as valuation and requires buyer-seller fit, says MacKay. Sellers might look for buyers similar to themselves in personality and style, or the fit might be complementary, he says, giving the example of a portfolio manager and planning advisor. Either way, a good fit means greater client retention—important to both seller and buyer, since both will earn revenue from the book as it’s transitioned, according to sale terms.

Ronald Harvey, senior financial advisor at IPC in Ottawa, demonstrates a complementary fit as he buys his partner’s book. Their firm started transitioning from deferred sales charges a few years ago, so his book is mostly fee-based; his partner’s includes no-load funds.

Relative to his more detail-oriented partner, Harvey describes himself as a “bigger-picture person” who forgoes investing details in favour of showing clients how they’re on track. When he asked one client in her 70s what her plans were for her money, she said, “Nobody’s ever asked me that.”

The difference in advisory styles won’t necessarily translate into portfolio changes as Harvey takes over the book. “When I’m going to undo something another advisor did, I at least have to [know] why it was there in the first place,” he says.

He stresses the importance of meeting with clients as an observer several times with the retiring advisor. For the benefit of clients, transitions should be like dimmer switches, not on-off switches, he says.