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Alternatives to deferred sales charge

Alternatives to deferred sales charge

January 30, 2014

The Deferred Sales Charge (DSC) method of paying mutual fund salespeople a commission typifies what is wrong with the investment business.

The commission is good for the salesperson but in many cases not good for the client. There should be a change in the way compensation is paid in the financial services business. That change is long overdue.

The DSC on the purchase of a mutual fund happens when the investment advisor selling the fund to the client is paid a commission. This is often 5 percent of the amount of money invested.

In order for the mutual fund company to justify this commission expense, they require a client to stay invested with their firm for 7 years. The client is charged an exit fee if they take their money away from the fund company during the first seven years. Initially, that can be about 7 percent. That charge then declines slowly over the seven year period.

The problem with this method of compensation is that it is based on a transaction that can be a conflict of interest between the client and the investment advisor. Research finds that often the commission is hidden.

In my opinion the commission of 5 percent for only one transaction is high. If investors understood how and what commissions were charged would they be willing to pay them?

Their high commission costs are passed along to the investor by the mutual fund company. This occurs in the form of ongoing management fees that are charged to the client ever year they continue to own the mutual fund.

After the initial sales commission, the investment advisor receives an annual trailer commission of usually one half of 1 percent whether or not they provide any ongoing service to the client. That trailing commission has to be recouped by the mutual fund company and it too is included in the ongoing annual expenses paid by the investor.

The Canadian Securities Administrators’ 2010 study found that only one third of investors were aware of trailing commissions. Only one in four understood Deferred Sales Charges.

At issue here is lack of fee disclosure. The 2012 Investor Education Fund report states that only 64 percent of investors said their advisor told them about the costs of owning mutual funds and only 45 percent discussed their compensation.

The same Investor Education Fund study found that 70 percent of clients believe their advisor has a fiduciary duty, meaning they will put the interest of their clients first. The Canadian Securities Administrators said there is no regulation or court ruling that requires the client’s interest to be put ahead of their investment advisor.

The standard of care is that investments are suitable for their clients but suitability does not include considering sales commissions, ongoing trailer fees or ongoing costs. My view is that it is not possible to judge whether an investment is suitable without understanding the cost.

The standard should be that fees are clearly disclosed by the advisor and fully understood by the client. There should not be any potential conflict of interest between the client and the investment advisor. The clients’ interests must come first.

There are systems that allow mutual funds to be purchased on a fully disclosed and transparent fee-for-service platform. Unfortunately, only less than 3 percent of mutual funds are purchased that way.

Clients are paying large commissions to their investment advisor by purchasing mutual funds that are sold with a Deferred Sales Charge. In our new and ever-changing business world what investor thinks it makes sense to commit to a seven year term for the purchase of a mutual fund just so a salesperson can be paid a commission?

Why would anyone purchase a mutual fund that has a Deferred Sales Charge?