Should you pay the DSC?
Let me start by sharing with you an email I got from Ellen who is one of my readers who posed an interesting scenario:
“My current portfolio is worth $177,797.71. I am concerned about the MERs (2.26%) I am paying and I am thinking of switching to the TD e-series funds (MER- 0.5%). The remaining Deferred Sales Charge (DSC) fees are $3160. Should I pay the one time DSC charge to save money every year?”
What is the DSC?
A deferred sales charge is sometimes called a back end load. Basically it’s the fee or penalty for selling an investment before a specific period of time usually somewhere between 5 to 8 years. Often mutual fund companies will allow switches within a fund family but the DSC is charged if money is pulled out of the company. It’s a way of locking the client into the fund because the mutual fund company had to pay the advisor an up front commission at the time of purchase and needs to recoup this cost over time.
Let’s look at the math
On a $177,797.71 portfolio with an MER of 2.26%, the annual cost of investment is $4018.23 assuming 0% growth.
If we compare that to the TD e-series with an MER of only 0.5%, the annual cost is 82% lower at $711.19. That’s a savings of $3307.04 per year every year. That’s pretty significant.
Should Ellen pay the DSC to get out?
In Ellen’s case, I think this is a no brainer from a mathematical perspective. It will cost her $3160 to get out but from that point forward she will save herself $3307 per year. She wins before the first year is over.
It’s not all about the math
I’ve said many times that we live in a world where everyone can manage their own investments. However, very few people are wired to do this properly. I meet thousands of people every year that so not have the knowledge, confidence, desire, time and/or passion to invest money themselves.
Anyone can save money in fees if they are willing to do it themselves. In Ellen’s case, she has to be confident that she has these qualities listed above.
Is her advisor adding value?
I’ve also said many times that Advisor must justify their existence and their compensation with some level of value. I don’t believe advisors can add value when it comes to providing higher returns on a consistent basis. The truth is they do not have the foresight or ability to control or predict the future.
Instead Financial Advisors must find other ways to add value beyond just focusing on the investments. This is where financial planning, retirement planning and estate planning can be a big differentiator.
Analyzing the investments
One of the other considerations that we cannot cover here is the comparison between the investments that she currently owns with the lower cost TD e-series funds.
Some advisors will argue that you might pay higher fees but the returns could be higher. Advocates of low cost investing would argue that over time, lower fees will win over higher fees. Who’s right?
I think you have to be careful when comparing past performance because it’s not a great indication of future performance. You can get different results when you look at different time periods and just because one investment outfperformed over the past 10 year period does not necessarily mean it will out perform over the next 10 year period.
I do believe lower fees matter over time. It’s like running a race with a 5 pound weight vs a 30 pound weight. The runner with a 30 pound weight is definitely at a disadvantage, especially over the long term.
What would you do if you were Ellen?
“Is her advisor adding value?” I would hazard to say the only value being added is to the advisor’s bank account. In many cases, DSC series funds have equivalent non-DSC series funds in the same family, and the only reason for an avisor to put their client into the DSC fund is the greater payout to the advisor. Oftentimes this information is not told directly to the client unless the specific question is asked, which many people don’t know to do. There are enough reasonable funds out there that I can’t conceive of any acceptable reason (in the client’s best interest) to enter into a DSC fund. Any advisor who recommended one to me would have a hard time (read: near-impossible) convincing me otherwise.
Dan said: “the only reason for an avisor to put their client into the DSC fund is the greater payout to the advisor”.
That’s worth repeating!
While I don’t do investments, on the life insurance side of things Dan’s point is exactly true with investments – investments with deferred sales charges pay more money than those without deferred sales charges.
Thanks for your comments guys. For the record, advisors who sell DSC don’t necessarily get paid more. They may actually get paid the same but they get paid more early on (up front) and less later (trailers).
I went through the exact same thing a few years ago with my sons’ RESP, though the amount isn’t quite as significant as the subject of this post. But the math is the same regardless of the amount. I guess $3100 seems like a awful lot of money upfront, and perhaps that’s what’s keeping a lot of people form doing it. I was hesitant at first, but in the end I did see the light.
Based on the info given, it is difficult to make a judgement call.
What is she invested in currently? What has been her returns?
Is this a non registered or registered account? Is she leaving her adviser just to save money or is she unhappy with her existing investments and unhappy with her current adviser?
If she is strictly saving money and going the DIY route (not recommended by the way), yes she can strip out the adviser costs of the funds and manage her own investments. Adviser-less funds will certainly be cheaper but in the real world chances are she will not outperform. According to the empirical research, she is likely to underperform – by a lot.
Additionally when you think about it, switching to another investment to one where costs are cheaper is no guarantee of anything. Using the same logic you could switch to stocks that don’t have MERs at all.
Would that guarantee better performance -not likely!
If this is a non-registered account she could switch her free units to a fee-based account and lower her MER costs by about 1% (assuming these are equity funds). The fee would be tax
deductible which would help save some costs.
I agree with Jim, DIY investors are very rarely equipped to handle investments by themselves. So the answer is no, she should not pay the penalty of an early redemption to “save costs”.
If she is determined to fire her adviser and any and all future advisers for the remainder of her lifetime and Jim and I can not convince her otherwise, she could transfer out the free units, redeem the 10% free each year until the remaining DSC fees expire and then part ways with her adviser.
If she is unhappy with her current adviser, then change advisers right now.
DIY investing even for an experienced, knowledgeable investor can be a minefield all by itself.
Again, DALBAR tells us that the average investor loses a few percent and up to several percent per year primarily due to inappropriate investor behaviors. Just like all car drivers consider themselves above average drivers, DIY investors often overestimate their own abilities ( We are human, after all). These factors are far more significant factors than extrapolating potential MER cost savings by firing your adviser and pursuing low cost or no cost investments. As an adviser, I am biased I suppose, but good advisers add gamma to their client’s returns(See Morningstar research on that).
I am of a view that 1% per year asset based compensation is fair and equitable compensation for a good adviser and investors should be prepared to pay that amount of money to a financial adviser who is managing your life savings.
The best solution in the interim is for Jim Yih to advise Ellen to talk to a financial adviser that Jim knows and trusts explicitly. I think a second opinion is warranted don’t you think?