I have been advising clients since 1998. Having gone through multiple financial crises , the greatest being the Global Financial Crisis in 2008, I know through experiences and with evidences, that in order to give clients a good investment outcome, the following steps are necessary:
- Having a suitable asset allocation (different proportion of our money invested in equities and bonds) based on clients’ need, ability and willingness to bear risk. This is done based on understanding their current financial situation and future goals as documented in their financial plan
- Selecting suitable instruments (such as unit trusts) that are low in total expense ratio (also known as the unit trust’s annual management fee) to execute the asset allocation
- Performing regular rebalancing of the asset allocation
- Doing regular progress check in the context of clients’ overall financial plan so as to keep them motivated to stick to the plan
- Performing risk/behavioural coaching so that clients can stay invested or not make rash decisions during market volatility
As you can see from the above, these require quite a bit of work and competence to do it and most consumers do not have the knowledge, experience and tools to do it themselves. As such good financial advisers are engaged to perform all the above steps. And if we believe in the value of good advice, we need to compensate advisers adequately. The compensation that advisers charge to perform the above is called wrap fees. In addition to wrap fees, most financial advisers also charge a front end sales charge on the investment amount. The real purpose of the front end sales charge is to allow advisers who do not charge a flat fee like Providend, to be compensated for financial/investment planning and setting up of the investment accounts. But there is a risk that some advisers might abuse it and “churn” (taking the sales charge each time advisers sell and buy unit trusts for the client) their clients. Most advisers are also paid a portion of the unit trust’s annual management fee when they execute clients’ investment plan using these unit trusts.
So in general, consumers when engaging financial advisers to advise and manage their CPF monies via the CPF Investment Scheme pay the following fees:
- Front end sales charge – currently up to 3% of the investment amount, each time clients makes an investment
- Wrap fees – up to 1% p.a.
- Unit trust’s annual management fee – Up to 1.75% p.a.
While services need to be paid, all the above fees eats into the return and affect investment performance and as much as possible, should be reduced.
As such, in the recent enhancement made to the CPF Investment Scheme (CPFIS), the following changes were made:
- Front end sales charge – to reduce to 0% ultimately
- Wrap fees – to reduce to 0.4% p.a. ultimately
- Unit trust’s annual management fee – No change and fund manager can charge up to 1.75% p.a.
While the above enhancements will ultimately reduce the initial sales charge to zero and the total recurring expense to up to 2.15% p.a., there are still a few problems:
- The recurring expense of up to 2.15% p.a. is still too high. It still eats substantially into the returns of the investment portfolio. In my opinion, a fee closer to 1% p.a. range is more appropriate. There is a need to reduce the annual management fee to achieve that.
- While I have always been an advocate of not taking commission in giving advice, to reduce sales charge to 0% may hurt good advisers who should be paid for performing financial/investment planning for the clients. If we are afraid of advisers “churning” clients account, one way to mitigate this is to only allow advisers to charge the initial sales charge once for new money and subsequently not allowed to take any more sales charge when they rebalance clients’ portfolios.
There are enough evidences to show that low expense indexed funds or evidence-based investing funds such as those from Dimensional Fund Advisors (average management fee of 0.3%) consistently perform better than expensive actively-managed unit trusts (that can charge up to 1.75% p.a.) over the long run. Although there are currently no indexed funds or DFA funds available for investment under CPFIS, it could be made available in the near future. But with the wrap fees (that are paid to financial advisers) being ultimately reduced to 0.4% p.a., advisers might not be motivated to recommend these low expense funds (which advisers do not get a cut of the management fees) but rather high expense actively managed funds (where advisers get a cut of the management fees) to the detriment of their clients. Advisers who will still recommend low cost indexed funds in the interest of their clients might instead be disadvantaged. What might be more appropriate is to allow advisers to charge a wrap fee of up to say 0.7% p.a. but reduce annual management fees that unit trust managers can charge to say 1% p.a.. If unit trust managers do not find this financially viable, they can always exit the CPFIS and make way for lower expense instruments. With this change, even if advisers want to continue recommending high expense actively managed funds, the cost is substantially reduced to below the 2% p.a. range.
Getting a good investment outcome is like visiting a restaurant with a good chef. How good the dish is, is lesser dependent on how expensive the ingredients are but on how good the chef is. It does not make sense to pay so much for ingredients that do not matter and so little for the chefs that actually matter. In the financial services space, unit trusts are like ingredients and financial advisers are the chefs.
But perhaps for financial advisers, the recent enhancements to CPFIS is a good time for contemplation. Why is it so that when so much work (as highlighted above) is required from financial advisers for good investment experience, that wrap fees being paid to advisers are cut? And yet, high cost unit trusts that are partly responsible for poor investment experience can continue to charge high fees? Is it because we are not doing the work that is required of us or our work is not being recognised?
The writer, Christopher Tan, is Chief Executive Officer of Providend, a Fee-only Retirement Financial Adviser. Besides being financially trained, he is also an Associate Certified Coach with the International Coach Federation. The edited version has been published in The Straits Times on 25 March 2018.