Just How Fair Are Your Fees?

Investors strongly prefer to cough up for financial advisory services by paying a commission per transaction, according to a recent report from research firm Cerulli Associates.

About half want to pay a commission, while a flat fee based on the total dollar amount of the assets managed is preferred by just over a quarter of investors polled.

This is contrary to what bodies want in other major markets, such as Britain and Australia, where regulators are pushing financial advisers, including private banks, to stop charging clients commissions and move to a fee-only model.

The reason for this is simple. Financial advisers who are paid commissions are motivated to sell clients high-margin products, to sell them often, and not always with the clients' best interests in mind.

"Commissions create a conflict of interest. The higher commission the product provider pays, the more likely the adviser will recommend the product," says Tony Noto, a Shanghai-based financial adviser at Noto Financial Planning. Noto has been in the industry for 10 years and charges his clients on a project basis.

Alternatively, the fee model usually involves charging clients a flat percentage of the money managed. Because an adviser has locked in its fee in that arrangement, it has no incentive to push one investment product over another. Its focus is on managing a portfolio to maximise returns, thus increasing the size of assets being managed and the fee income generated.

Generally, a fee model aligns an adviser's interests with those of the client, whereas the commission model motivates an adviser to sell products.

Take accumulators, for example, which got so many Hong Kong investors in trouble during the 2008-09 credit crisis and typically come with a 50-basis-point commission. That's not too high. But the products tend to turn over quickly, expiring every two or three months.

That works out well for an adviser who can sell the same accumulator product to a client three or four times a year, racking up a new fee each time.

Then there is the case of certain pension products for which an adviser may be paid an incredible 30 years' commissions up front. That adds up to a powerful incentive to sell a product to a client.

An internal document seen by Money Post that is used by a mainland wealth management firm catering to expatriates shows how this works. The document breaks down the commissions it pays its employees for selling long-term investment products.

It explains that commissions are based on all the money a customer is expected to pay into an investment plan over 25 years.

The document states that the firm pays out an upfront commission of 2.4 per cent of the total account value of various long-term products. Of that amount, 0.4 per cent goes to the market executive who originated the sale. The remaining 2 per cent is paid to the adviser who sells the product.

So, if a customer buys a 25-year product involving a monthly contribution of US$2,000, commissions are based on total expected contributions of US$600,000 (US$2,000x12 monthsx25 years).

That means US$12,000 is paid out to the adviser in an upfront fee for selling one product (US$600,000x2 per cent).

"I don't think anyone looking to save US$2,000 a month would consider paying an adviser US$12,000 up front, but that's what effectively happens when you sign up. There is no question where that US$12,000 comes from - out of your initial contributions," Noto says.

The problem is that few clients realise agents may be motivated by a large upfront commission when suggesting an investment, and not by how the product fits a client's long-term financial needs.

The potential for conflict of interest is significant enough that regulators in Britain and Australia are close to banning commissions for financial advisers altogether.

Britain's Financial Services Authority will prohibit financial advisers, wealth managers and private bankers from charging commissions for investment products sold to the public, starting from January 1, 2013.

"We do not believe the potential for commission to bias the adviser, or to undermine trust, can be properly dealt with while product providers continue to set commissions receivable by advisers," the authority said.

The Treasury of the Australian government has proposed a similar ban on commissions for retail investment products to take effect from July 1, 2013.

Hong Kong's Securities and Futures Commission took a tamer route, requiring in June last year that product providers describe fees in clear language.

Private banks in Hong Kong have long wanted to push back on the commission-based model, to get clients to pay a set fee based on the total money invested. This has been going on for about a decade, but with little impact - only about 5 per cent of private banking clients in Hong Kong and Singapore are signed to fee-based accounts, says Alex Jagmetti, managing director and head of Asia Pacific for Falcon Private Bank, a Swiss private bank.

Private banks are also sensitive to the charge of being product pushers. Indeed, most of these firms view themselves as all-round advisers, offering ideas on trusts, wealth management, succession planning and other matters.

They also believe that clients' returns will be greater if they hand management of their investments to a private bank for a fee.

"Generally, with discretionary accounts [a type of fee-based account], the returns are better, the volatility is lower and portfolio construction is better. But it can be a complicated discussion to get clients to that point of view," says Ian Pollock, chief operating officer, north Asia, for Julius Baer, a Swiss private bank.

Todd James, head of wealth services for north Asia for BSI Bank believes clients could be persuaded of the benefits of the fee model if an adviser spent 20 minutes on the matter with them.

But a financial adviser has no incentive to kill his or her cash cow by revealing all the money they make selling high-fee investments.

Many in the private banking industry also argue that the commission-based model is more common in Asia because that is what the clients want. This reflects a regional preference to trade and to be heavily involved in one's investing decisions."It's really about what the client wants. I don't think a bank favours a particular model," says Sen Sui, head of Asia, markets and investment solutions, Credit Agricole Private Banking.

In private banking, a client's main point of contact is with relationship managers (literally, people who manage the relationship on behalf of the bank). Relationship managers are happy to earn commissions acting as brokers for their clients.

To the extent that they are an intermediary for clients and their trades, relationship managers have a tight bond with the client. In the industry's words, they own that relationship - and they don't want to give that up.

The fee model typically sees a client hand over management of most of the portfolio to professionals in the bank. The client's relationship is tied more to the firm and less to the relationship manager.

Usually, this works out well for the client and the private bank, but not for the relationship manager, which is why they are reluctant to sell clients on the concept of fee-based services.

"Local relationship managers do not like discretionary accounts [a standard form of fee-based banking] because they feel they are giving up control of the client," Falcon's Jagmetti says.

For those wanting to experiment with fee-based services, there are options.

Although still a minority, there is a growing number of financial planners that do not accept commissions, and instead ask to be paid by the hour, or by way of percentage of assets managed. This is a more transparent way to pay for an adviser's services.

Meanwhile, private banks all offer fee-based services, and are keen to sign clients on to such plans. James of BSI suggests clients split their portfolio into a fee-based account and a commission based account to get a sense of which system works best for them.

Cerulli's study says investors prefer commissions, but its study also showed that one-third of the people they polled thought advice was free and one third had no idea how much they pay their financial adviser. With commissions, investors are often left in the dark regarding their adviser's compensation, and do not understand how that can affect recommendations.