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The cost of fees

The introduction of Cat-standard Isas and stakeholder pensions has effectively anchored charges and commission in a large part of the UK retail investment market. Yet the debate surrounding advice, charges, commission and fees is as heated as it has ever been.

The Sandler review now appears ready to jump on the “commission is bad” bandwagon. Although this is rolling at an ever increasing pace, it is a less stable ride than many would have us believe.

The Government and consumerist lobby prefer fees because they believe investors understand them but there are good reasons for taking a different view. Although no one would dispute that the immediate cash cost of a fee is easy to understand, the opportunity cost is less clear.

Either supporters of fees have not evaluated this or they have chosen to ignore the issue because it does not support their argument.

If we calculate the opportunity cost of fees by adopting the approach the FSA has used for its league tables, it is likely that a different view will emerge.

The outcome suffers badly from compounding and will invoke similar emotions to those associated with commission-based charges.

The opportunity cost of paying a fee can be illustrated by calculating how much the fee would be worth at the end of the investment period if it had been invested instead. This is the same approach as you would use to calculate the effect of actual deductions figure for charges.

For a product such as a Cat-standard Isa or stakeholder pension that achieves investment growth of 6 per cent a year after deduction of 1 per cent charges, the effect of paying a relatively small fee of £200 plus VAT would be £992. This assumes a 25-year investment period.

Add on an annual servicing fee of £50 plus VAT and the cost would rise to £4,373. This would increase to £6,009 if we followed the rules for charges and increased the fee amount to reflect inflation at 4 per cent a year.

The compounded figures are big even though we have deliberately assumed modest fees and have not focused on pensions so that we could have added in tax relief to have produced an even worse outcome. This suggests that much of the positivity on fees is simply because they are never viewed in this way.

This example shows that recurring fees can carry a heavy cost. The effect of paying a monthly fee (very common in the group market) of just £2.50 plus VAT over 25 years would be £2,935.

Viewing fees in this way may lead to a less positive conclusion when comparing them with commission.

The important aspect of this is that any responsible policymaker should not make up their mind without a thorough and even-handed analysis.

Another important point to bear in mind is that fees will not necessarily solve the alleged problem of commission bias as a significant number of fee-based advisers refund commission to reduce the net cost of their fees.

Where this occurs, there is as much danger of commission bias as the commission received has a direct impact on the net cost of fees.

In a similar way, there is also a possibility that fees can be inflated to higher levels by advising products that pay more commission.

If this holds true, only IFAs who charge fees and either reinvest all commission or use nil-commission products can genuinely claim to be untainted by these accusations. Unfortunately, this covers an incredibly small part of the UK retail investment market.

Even these types of adviser will often convert fees into commission to avoid VAT and ensure that fees are funded out of the investment to avoid regularly asking clients to draw large cheques on their current accounts.

As very few clients wish to pay fees, you are left wondering just where a fee-based market would lead us.

This is an incredibly complicated issue that needs a sensible solution.

Structuring a framework to favour fees has the potential to destabilise the market by restricting independent financial advice to a small number of investors.

This means that the various reviews need to make sure they focus on making commission-based advice more independent rather than killing it off altogether.

The deadline for responses to the Sandler review is September 29 so anyone who wishes to make his or her voice heard in this incredibly important debate needs to act quickly.

It will certainly be worth making the effort as the findings of the review could have far-reaching consequences for the UK advice market.


Douglas Black

Born: Bicester, Oxfordshire,June 8, 1957 Lives: Pimlico, London with wife, no children. Age: 44. Education: Administration degree at University of Aston, Birmingham. Career: 1978-82: trainee chartered accountant at KPMG, 1982-83: tutor at Financial Training, 1983-85: group accountant at Standard Chart-ered, 1985-88: group financial director at SGL Communications, 1988-94: management consultant at Pricewaterhousecoopers, 1995-96: finance director […]

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