The better business model

I was at a conference recently and I bumped into my old friend Ellen Bessner, author of “Advisor at Risk”. We began chatting about the business. Even though we generally agree on the ‘lay of the land’, we had an interesting discussion about business models. Specifically, we were wondering if an asset-based fee or a transactional commission model works best for clients.

I began by saying I thought an asset based fee was likely better because it is transparent, scalable, directable, potentially deductible and avoids the biases (both real and perceived) associated with embedded compensation.

Ellen quite properly countered that for some clients (especially the planning-oriented clients who essentially buy and hold mutual funds), a transactional commission might be both cheaper and simpler – in spite of my points. While I felt there were relatively few people who might fit into this group, I agreed that, yes, in some instances, the commission-based approach was still more suitable. Nonetheless, I set to work in trying to devise a superior commission-based format that addressed my concerns of transparency and fairness for all clients. Here’s what I came up with:

How it might work

Begin by eliminating all embedded compensation: both commissions and trailing commissions. Next, let the market come up with an up-front transaction charge to both buy and sell mutual funds (including PACs, AWDs, etc.). In short, let advisors choose their own transactional commission rates for funds, just as they do for securities.

Benefits

• Clients would better understand that neither products nor advice are “free”.
• Clients would better understand how and how much their advisor is paid.
• Clients who elect to forego advice would not be forced to pay for it.
• The format eliminates the confusion between A Class funds and F Class funds by eliminating A Class funds altogether.
• Client cost and advisor compensation would be roughly identical either way.

Drawbacks

• Advisor income would be entirely dependent on transactions (no client trades = no advisor pay).
• Most people (clients and advisors) resist change- even if it is for the better.

An Example

Mr. Jones has $10,000 to invest in an equity mutual fund. Instead of investing it DSC or front end load with a higher MER and a trailing commission, the client buys the F Class version of the fund and pays a (for instance) 5% transaction charge. Now, only $9,500 is invested, but it grows at 1% more every year that he holds the fund because the MER is 1% lower (let’s ignore taxes for the sake of simplicity). There’s no ‘load’ per se, but the advisor would likely also charge a commission to sell down the road. Let’s say the client holds for 7 years (as long a DSC schedule might run out) and at that the fund doubles in value over that time.

When the time comes to sell, the advisor could charge (say) an additional 3% on the $19,000 (thereby reducing the taxable gain). Over the course of the holding period, the advisor would make exactly $1,070. Had the money been invested DSC, the advisor would have made $500 at the time of sale plus 0.5% of the fund’s value annually thereafter (likely somewhere between $50 and $100 a year, depending on markets) –approximately $1,025 in total. Had the money been invested at front end 0%, the advisor would have make 1% annually (likely somewhere between $100 and $200 a year) – approximately $1,150 in total. Markets will obviously change exact outcomes, but they would all be quite similar.

Obviously, there would be some experimentation in the beginning as different advisors would have to set and adjust their transaction charges in order to be competitive, while wanting to be profitable, too. The market will likely settle in at a reasonable place and the amount paid by clients would likely be comparable under either system.

This change would be especially good for do-it-yourself investors. I recently called a major discount brokerage house about investing in F Class mutual funds and the representative (with a matter-of-fact tone) assured me that investing in A Class funds (as compared to F Class) “does not affect you in any way”.

I wonder… if his boss were to cut his $50,000 salary down to $49,500, would this be portrayed as a change that does not affect him in any way?

I don’t think my proposal is perfect, but I do think it is an improvement. The example above shows how a transactional client in the future might not only be better off than an asset-based fee paying client, but also better off than a transactional client in the present. The client would pay transparently both to buy and to sell, understand that the advisor needs to be paid (and how much the advisor is being paid) and avoid paying for advice altogether (by buying funds at a discount brokerage) if advice was not needed. To me, those changes would all constitute real progress. Again- not perfect, but conspicuously better than the way things work now.

John De Goey, CFP, is the vice president of Burgeonvest Bick Securities Limited (BBSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BBSL. You can learn more about John at his Web site: www.johndegoey.com.