The debate over banning embedded commissions is heating up, with regulators pondering the issue seriously while industry groups are split on the potential ban. What has been missing in this discussion is the importance of ethics and disclosure to prevent conflicts of interest — regardless of the compensation model that financial planners and financial advisors use.

Some groups, such as investor advocates, argue that commissions lead to biased advice and higher costs for investors. On the other side of the argument, industry trade groups, such as the Investment Funds Institute of Canada, claim that a ban will restrict access to advice for mass-market investors. There is some truth in both of these opposing views.

The banning of commissions in the U.K. has seen the number of financial advisors diminish substantially, with the related access to advice reduced for investors with small accounts. The conflict of interest in commissions is obvious in cases in which advice may be biased toward higher-priced active funds vs lower-priced index funds, as Morningstar Research Inc. claimed in its recent submission to the Canadian Securities Administrators’ consultation paper on the future of embedded commissions.

Read: Morningstar calls for an end to embedded commissions

This must be analyzed in a broader context to determine the costs and potential conflicts within the three main compensation choices — embedded commissions, asset-based fee model and the flat-fee model. To do that, let’s compare these three compensation models, taking note that:

  • No single compensation model ensures investors that the advice that they receive will be entirely unbiased and objective.
  • All compensation models have their limitations.
  • Each compensation model may be an optimal choice for certain sets of investors’ situations and, therefore, an ability for investors to choose from all three models may be in their interests.
  • Regulators may need to regulate compensation arrangements more closely but their best tool is ethics in the form of a best interest standard and enhanced disclosure, as seen with the second phase of the client relationship model (CRM2).

Embedded Commissions:

The main criticism of this model is that an advisor’s economic interests appear to be in direct conflict with the investor’s. Specifically, the advisor is paid a commission regardless of the success of his or her recommendation — and the advisor may steer clients to products with the highest-paying commissions but not the best performance.

However, advisors who operate on a commissions-based model argue that they can’t do this on a consistent basis or they will lose the trust of their clients over the long run. Also, when commissions-based accounts are converted to asset-based accounts, clients may pay more (at 1%-1.5% of assets), especially if they mainly have buy-and-hold portfolios, a sizable portion is in cash or bonds, and/or minimal trading activity. Clearly, these are ethical and disclosure issues.

Asset-based Fee:

In this model, it may appear that an advisor’s economic incentives are aligned to the client’s. For example, as the value of a client’s portfolio rises, so too does the advisor’s compensation — and vice-versa if the portfolio goes down in value.

But is this always the case? Is there a disincentive for asset-based fee advisors to act if the solutions available to an investor do not involve advisor management services or the recommendation reduces the amount of an investor’s assets under management, meaning lower compensation for the advisor? Let’s consider the following:

  • Will the asset-based advisor advise his or her clients to reduce debt (pay off the mortgage or loans) or invest in real estate, as this lowers the assets to manage and lowers the advisor’s compensation?
  • Will the asset-based advisor advise clients to hold liquid assets such as cash or income-producing products that require little ongoing management, resulting in lower fees?

Once again, these are ethical and disclosure issues.

This type of model is best suited to long-term, growth-oriented investors who prefer a hands-off approach and have actively traded accounts.

Flat-fee Model:

This model is usually in the form of an annual retainer or hourly billing. This is acclaimed as the best as the advisor only bills for services and is total objective in his or her advice.

Critics of this model argue that there are inherit pitfalls with this form of compensation, such as:

  • Retainers sometimes incent the advisor to do as little work as possible for the fee (called shirking) or assign work to lower-paid assistants with less expertise.
  • Is there an incentive to overstate the billing hours to justify the bill?
  • Also, are the flat-fee advisor’s recommendations judged against his or her client’s outcomes?

Certainly, these are also ethical and disclosure issues.

This model seems best suited to full financial planning clients or those who need event-driven advice.

Based on this analysis, we should conclude that no form of compensation model is free of conflicts; in fact, each model may be in the best interests of certain investors, depending on their needs. Finally, although regulators may wish to fine-tune their compensation rules, their most effective tools are disclosure and ethics. Let’s not lose this perspective in this evolving debate on fees.