A fee-based account is where a fee is charged based on the market value of the assets being managed. This is distinctly different than a transactional account where commissions are charged for every buy and sell transaction. When clients open a fee-based account, they sign a fee-based agreement that establishes the agreed upon fee, how the fees are calculated, when the fees will be charged, and which accounts are to be fee-based.
There are a number of benefits for clients in moving to fee-based accounts. Working on a “fee for service” basis, rather than a commission or transactional fee basis, means the best interests of the client are more aligned with those of the Portfolio Manager. If fees are based on the market value of the account, then the only way a Portfolio Manager will be compensated more is if they can grow your account in value. If your account declines in value, then so does the compensation paid to your Portfolio Manager.
Clients also benefit from the additional services they receive from their Portfolio Manager. Financial professionals are rarely called stockbrokers today because the services offered to their clients extend well beyond buying and selling stocks. At Scotia Wealth Management we have Total Wealth Planning meetings to cover many topics such as tax, protection strategies, education planning, retirement planning, and estate planning. Financial professionals today spend a significant amount of time understanding each client’s needs and integrating this into an increasingly complex tax and regulatory environment.
As a result of our overall services being much more than the buying and selling of stocks, the amount billed for fee-based accounts is referred to as an “investment counsel fee” for income tax purposes. The main benefit of this is that the fees relating to non-registered accounts can be deducted on your income tax return as a carrying charge. If your fee is one per cent before tax, and your marginal income tax bracket is 30 per cent, then your fees have a net after-tax cost to you of only 0.70 per cent (one less 30 per cent tax rate x one per cent fee).
Fees are typically charged quarterly at the end of the quarter. As an example, Jill Jones opened new fee-based accounts and invested $1,500,000 on the first of January with an agreed upon annual fee of one per cent. Jill will start incurring the agreed upon fee on January 1 throughout the rest of the quarter but will not be billed until after the quarter ends. Around the middle of April, the first quarterly fees would be charged. Jill’s fees are effectively one-fourth of one per cent after each quarterly period. Other methods of compensating that are not fee-based often have commission charges as high as five per cent on the first day of buying the investments, or there are charges associated with redeeming your investments. Instead, with fee-based accounts there are no upfront fees and no charges to redeem your investments.
For a Portfolio Manager to be successful with a fee-based business, we believe it is important to establish good long-term relationships. We are confident in our approach and business model where clients are not charged up front and are only billed one-fourth of their agreed-upon annual fee, after each quarter ends. When explained to clients, it is our experience that most would prefer to spread the fees out over time as services are provided versus paying a large amount on the first day, and additional costs thereafter.
How are fees determined?
One question we are asked is how the quarterly fees are billed. Fees are agreed upon between the Portfolio Manager and the client. This level of customization is unique to fee-based accounts. To illustrate, we will use Jill Jones who has three investment accounts totaling $1,500,000: $1,000,000 in a non-registered account, $400,000 in her Registered Retirement Savings Plan (RRSP) account, and the remaining $100,000 is in a Tax-Free Savings Account (TFSA). The biggest factor that determines the fee is the dollar amount the client has available to invest. For example, fees for an account under $500,000 may be 1.50 per cent, $500,000 to $1,000,000 may be 1.25 per cent, $1,000,000 to $2,000,000 may be 1.00 per cent, $2,000,000 to $3,000,000 may be 0.90 per cent, $3,000,00 to $4,000,000 may be 0.8 per cent, $4,000,000 to $5,000,000 may be 0.70 per cent, over $5,000,000 may be 0.6 per cent. In this example, Jill would fall under the 1.00 per cent fee. Once Jill reaches $2,000,000, then her fees would drop to 0.90 per cent.
Type of fee schedule – flat or tiered
Portfolio Managers have the option to use a flat fee schedule or a tiered fee schedule. Some advisors charge a flat fee, regardless of the amount deposited. Other advisors use a tiered fee structure that rewards you by decreasing your overall fee as your investment portfolio increases (either from additional deposits, or an increase in market value). Within tiered fee schedules, there are two types: absolute and rolling. The fee calculation is different for both absolute and rolling fee schedules. Our team chooses to use an absolute tiered fee schedule. In the case of Jill, her fees are 1.00 per cent, as noted above. Some Portfolio Managers may choose to use a rolling fee schedule. Using the same incremental fee percentages as above for Jill, her fees for the portion up to $500,000 would be 1.50 per cent, between $500,000 to $1,000,000 would be 1.25 per cent, and the portion between $1,000,000 and $1,500,000 would be at 1.00 per cent. If Jill was on a rolling fee schedule, then the fee would be 1.25 per cent overall. The rolling tiered fee schedule will always be higher than an absolute tiered fee schedule.
How are the fees calculated?
Once the above fee schedule is agreed upon, including both the percentage rate and the type of fee schedule, then the next logical question to ask is how the fee is calculated. With our clients we will always put excess cash into a Class A high interest savings account that does not attract fees. Some Portfolio Managers will have “F Class” savings accounts in which case they will charge a fee on the cash balance – in some cases this will result in a negative return. Portfolio Managers have the choice on how this is set up.
What is also different is how fees are calculated within a client’s account. Typically, the market value of the holdings is the benchmark for this calculation. Within every firm, the time frame for when market value is calculated may be different. You may have some firms that calculate the market value at month-end, some may do it daily. Another component that can be factored in is whether they are calculating the “true value” of each security. To illustrate true value with fixed income, there may be accrued interest on bonds at the end of a month. For example, Jill owns a bond with an original issuance price of $50,000, with a coupon of 4 per cent. This bond pays semi-annual interest of $1,000 on June 30 and $1,000 on December 31. On the March 31 statement, the bond has essentially accrued half of $1,000, or $500. If Jill were to sell this $50,000 bond, the purchaser would have to pay Jill the accrued interest – thus the term true value.
Let’s use another example, where Jill owns a company, ABC Ltd. The company declared a dividend to shareholders of record on May 10. The dividend of $490 is not payable until June 5. Even if Jill were to sell the holding on May 31, she would still be entitled to the dividend. The true value of Jill’s holdings should include the earned dividends that have not yet been paid. When financial firms modify how these fees are calculated, they are obligated to disclose what has changed and the effective date of the change.
How are fees paid?
Jill has the three accounts as noted above (non-registered, TFSA, and RRSP) and the default is for each account to be charged the respective fee amount based on one-quarter of one per cent of the market value of each account. The first quarterly amount for Jill is one-quarter of one per cent of the balance in the non-registered account, one-quarter of one per cent of the balance in the RRSP, and one quarter of one per cent of the balance in the TFSA.
There are a few different options for how Jill can cover the quarterly fees. The most common approach, and the default option, is to have the fees charged to each of the respective accounts. Jill continually has dividends and interest income coming in from the investments within each account and a small portion of these are used to cover the fees.
Jill can also sign a form that all fees will be taken from the non-registered account. The fees for both the TFSA and RRSP accounts are covered by funds from the non-registered account, enabling the TFSA and RRSP to grow even faster. In the case when fees are covered from the non-registered account, we will set up the dividend reinvestment plan for most of the holdings within the TFSA and RRSP.
The third option that clients have is to periodically mail in cheques to cover the fees. This is rarely done as the income within the account more than covers the fees. It is an option if a client wishes to do it.
For clients who do not have the form to automate the payment of fees to registered accounts, we may periodically calculate the fees and provide options on whether it makes sense to deposit funds or transfer funds to reimburse registered account fees. We have written two previous articles on this for RRSPs here, and TFSAs here.
Tax benefits of investment counsel fees
One of the benefits of these transparent fees is that they are considered investment counsel fees, rather than commissions. From a tax standpoint, this is significant as a tax deduction is available for investment counsel fees related to non-registered accounts. It is important to note that if you have the fees for the registered accounts being paid for, from the non-registered account, that this portion is not deductible. The annual fee summary we provide to clients at the end of each year is the portion that they may deduct on their tax return.
Liquidity without a cost
Liquidity is another benefit of fee-based accounts. As there is no cost to buy investments, the same applies to changing or selling investments. If you require money for any reason at all, there is no commission payable for selling or rebalancing your investments. Rebalancing can include reducing a position that has performed well, dollar cost averaging on a position that has underperformed, adjusting sector exposure, modifying asset mix, and changing the geography of your investments.
Another benefit of fee-based accounts is the ability to link additional family members to the platform – this is referred to as “house-holding”. Clients with children and grandchildren often would like to introduce them to the benefits of full-service brokerage, but their children or grandchildren may not individually have the capital to be able to open accounts at a full-service brokerage on their own. A couple of examples include parents wishing to assist adult children in opening and funding Tax Free Savings Accounts, and grandparents who wish to open Registered Education Savings Plans for their grandchildren. Fee-based accounts that are linked can make wealth transfer strategies within the family group of accounts significantly easier to execute.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250.389.2138, email firstname.lastname@example.org, or visit greenardgroup.com.