Secrets Of Success: Beware the sins of commission

Since the middle of the year, independent financial advisers and other intermediaries have been required by the Financial Services Authority to disclose to their clients in detail, and more explicitly than before, exactly how much they stand to make in fees and commissions for the advice that they are giving.

As the FSA tends to get a lot of stick, it is only fair to say that its efforts to achieve a greater level of disclosure about advisers' commissions and charges seems to me to be one of its most laudable initiatives. It is really far too early to say how well the new regime is working, as there are only a few months of experience to go on.

I would be interested to hear from any readers who have either noticed the change, or modified their dealings with advisers as a result of the information they have been given. One lives in hope that the effect has been beneficial.

Welcome though disclosure is, however, experience suggests that disclosure alone is not going to have the most dramatic effect. When life companies and fund management groups were first required to disclose their charges in a standardised format some years ago, some thought it might make investors more cost-conscious in their choice of funds and life policies.

Yet all the evidence that I have seen does not suggest that, in practice, it has had that much effect. Nor does it, in general, appear to have brought down the price of most products by any material amount. If anything, the cost of actively managed funds, for example, appears to be rising rather than falling.

Neither the CAT standard or stakeholder pension initiatives of the Government appear to have had much effect either in driving investors towards cheap and cheerful products. As for the FSA's worthy attempt to produce comparative tables for financial products, ranking them by cost, I have to say I have never come across anyone who admits to ever having seen or used them.

We can all speculate why this might be so. Apathy and ignorance have obviously played a part. So, too, I suspect, has the fact that it is difficult to present the impact of costs on investment returns, whether they be commissions, management charges or fees, in a way that really focuses consumers' attention on the impact that they might have.

The difference between a fund that quotes an annual management charge of 0.5 per cent and 1.5 per cent does not sound like a huge amount to many people. Yet the impact of such small percentages, when compounded over time, can be hugely significant, especially in an era of relatively low investment returns such as the one that we are assumed to be in at the moment.

Simple maths shows us that a fund whose investments grow at 7 per cent a year and charges 1.5 per a year as a management fee will produce a sum that is 10 per cent less than one that charges 0.5 per cent a year over 10 years. That rises to 19 per cent less over 20 years.

This is one of the arguments for shopping around for the best tracker fund: given that most index funds do roughly the same job, there is little point paying more than you should.

Since my column on the subject of tracker funds two weeks ago, a number of readers have expressed surprise that the same fund provider (Legal & General) should appear among both the cheapest and the most expensive providers of UK equity tracker funds, according to the FSA comparative tables I quoted. This is not actually such a surprise, for two reasons.

One is that different kinds of tracker funds have different management charges. FTSE 100 index funds carry management fees that are on average about 0.2 percentage points higher than FTSE All-Share trackers. According to Fitzrovia, the fund cost consultancy firm, the average total expense ratio of funds in its UK tracker universe is 0.9 per cent a year.

That is fully 60 basis points more than the 0.3 per cent a year you will have to pay on Fidelity's Moneybuilder index fund, currently the cheapest in the market. The five-year cost of the Fidelity fund, assuming 7 per cent growth and a £7,000 ISA investment, is now £211, against £900 or more for the most expensive competitors.

The second reason is that L&G's index funds are marketed through a number of different channels, and some will be more expensive than others. Charging different users different prices is no different from what companies that sell food or airline tickets do every day of the week. Shopping around is the only way to avoid falling foul of this entirely legitimate commercial practice.

With commissions paid to advisers, the worry for consumers is more complex. My table, courtesy of the independent financial adviser John Scott and Partners (which only offers fee-based advice), shows the differences in the typical rates of commission paid on different products.

The first things consumers need to worry about with commission is whether they end up paying more than they need to for the financial products they own as a result of commission-based advice. Nearly all commission has ultimately to come out of the returns their investments make - the real issue is how visible that cost is.

It is poor business to allow an adviser to take an 8.5 per cent upfront commission out of a £10,000 investment bond when you could have a full financial planning session with a fee-based adviser that would hold you in good stead for several years for a fraction of the real cost of that commission.

Remember that what hurts you with upfront commissions is not just that the adviser takes £850 out of your initial investment, but that you lose the investment growth that the £850 would have earned over a period of several years as well. At 7 per cent over a period of 10 years, that roughly doubles the financial impact of the upfront cost.

The second worry is that the lure of commission will lead advisers to put you into products that pay them the highest commission, regardless of suitability.

This is very hard to prove, but it is surely no accident, for example, that the amount invested in unit trusts and Oeics, which do pay commission, now exceeds that in investment trusts, which historically have not done so, by a ratio of four to one.

jd@intelligent-investor.co.uk