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Understanding Investment Fees: Do You Know What You Are Paying?

As published in the Holiday 2015 Edition of NJ Lifestyle
More often than not, when we ask a potential client what they are currently paying in investment fees, we receive one of two answers:

  1. I don’t know.
  2. I don’t pay anything.

The first answer is understandable, as the transparency of investment fees leaves a lot to be desired, and the second answer is just wrong. Fees come in various forms; including commissions, portfolio management, operating expenses, and 12-b1 fees. Although you may not see the fee, it does not mean you are not paying it.
Commissions are a type of fee charged by a broker or advisor for handling the purchase or sale of a security. If you have ever sold a house, you know that commissions can eat up a substantial portion of profits or even principal. The same holds true for stock and bond trades. Commissions can vary widely from $4.95 and below per trade offered by online sites, to a few hundred dollars for transactions at a full-service brokerage firm. Commissions also come in the form of sales loads on mutual funds, which can be as high as 5.25% upfront. Variable annuities introduce deferred sales loads (surrender charges) to clients, which means if you sell your investment before a specified time, a percentage charge is levied on your assets. This type of charge is imposed in order to recoup the large commissions that were paid out to advisors, which can be as high as 8% for annuity sales. If your advisor is a commission-based advisor, it is important for you to ask the questions and understand what the commission rate is and how it is calculated. Commissions can quickly add up and lower the overall performance of an account.
Rather than charging commissions on transactions, other advisors charge a flat percentage fee on the assets under management. This fee is often termed an investment advisory fee, portfolio management fee, or an asset management fee. Services included under a fee-based arrangement differ from advisor to advisor. It is important for you to understand what your fee entitles you to: financial planning, portfolio review meetings, investment research, access to institutional share classes, etc.
Mutual funds and exchange-traded funds (ETFs) have an underlying annual operating expense. These investment products are pools of assets managed by investment professionals, and therefore have management and marketing fees. These fees, known as the expense ratio, are stated as a percentage and are deducted directly from the fund’s assets. ETFs tend to have lower expense ratios as many of the portfolios are passively managed and structured to track a particular index. Mutual funds can carry much higher expense ratios as the majority of funds are actively managed strategies, with the portfolio manager looking to beat a particular index or reduce risk exposures. When purchasing either a mutual fund or ETF, you should know ahead of time the underlying costs,
as higher fees can have a negative impact on performance.
When we have a potential client ask their current advisor how the advisor is compensated, one of our favorite responses from the advisor is; “You don’t pay me an advisory fee. I am compensated directly from the mutual fund companies.”This statement is technically true; however it is the client who pays the mutual fund company, which in turn pays the advisor’s firm. So in the end, it is the client who pays the advisor a fee. This type of fee is known as the 12b-1 fee.
A 12b-1 fee, or distribution/service fee, is a fee that is charged on top of the fund’s existing operating expenses. It will usually range from 0.25% – 1% depending on the fund share class, and this is the fee that the advisor collects as compensation for managing your assets. 12b-1 fees go unnoticed and are deducted by the fund company, rather than being deducted directly from a client’s account. This lack of transparency is why some investors believe they are not paying investment fees. There are some advisors who feel uncomfortable talking about fees, and will attempt to hide their compensation in the form of 12b-1 fees. While we are sure this is the exception rather than the norm, fees should be an open and honest conversation that every investor should be having with their advisors.
At CRA Financial, we are fee only advisors. We do not earn commissions. Our clients pay a percentage of their assets under management, and receive complete, comprehensive financial planning and investment advice. We believe in full transparency as a means of building deeper relationships. We understand that investment fees can be detrimental to long-term performance, so each of our portfolios are structured to reduce the impact of fees through the use of low cost ETFs, mutual funds, and other investments. From a tax perspective, it
is important to note that commissions and 12b-1 fees are not tax deductible, whereas investment advisory fees can be, subject to adjusted gross income limits. Overall, clients and advisors shouldn’t view fees as a taboo discussion. The fee discussion should be a primary conversation before selecting the right financial advisor to help you obtain your investment and financial goals.
Tom Reynolds, CPA & Matt Reynolds CPA, CFP®
(Co-Managing Partners, CRA Financial)
Francis C. Thomas CPA, PFS (Investment Advisor)
Robert T. Martin, CFA, CFP® (Investment Advisor)
This article is for informational and educational purposes only and should not be relied upon as the basis for an investment decision. Consult your financial adviser, as well as your tax and/or legal advisers, regarding your personal circumstances before making investment decisions.