Choose the right purchase option

Many mutual fund investors find themselves faced with a dilemma when buying new units. The issue: pay a front-end load, usually called a “service charge” and abbreviated to SC or buy on a “deferred sales charge” (DSC) basis.

The SC option involves paying a sales commission up front. The DSC option does not. However, if you sell your units within a specific period of time, which can range from three to eight years, you pay a commission then. The percentage is reduced the longer you hold your units.

One puzzled investor recently wrote me as follows: “Whenever I decide to invest in a mutual fund, my advisor always wants me to purchase the DSC units over the SC units. I feel like he is pushing it for his own benefit, as opposed to mine. What is the benefit of one over the other to the financial advisor?” — S.K., Ajax ON

The problem here is that the dealer compensation structure of mutual funds is complicated and often difficult for the ordinary investor to understand. Plus, policies vary from one company to another. However, this information must be spelled out in the prospectus, so that is the place to look when you are in doubt.

Pay later; pay mo?
In general, an advisor reaps higher up-front rewards when you buy on a DSC basis than when you use the SC option. However, the trailer fees paid after that are often higher for SC units.

A look at the AGF prospectus provides an illustration of this. When you use the DSC option, the advisor receives an immediate commission of 4.9 per cent. However, when you purchase SC units the dealer receives only the commission that you negotiate, which these days is usually not more than 3 per cent and often less.

Despite this, some advisors will recommend SC units because of their higher trailer fees and greater flexibility. In fact, some brokers even offer zero commission on SC units to good clients who are known to be long-term investors.

In the case of AGF, most of their equity funds pay an annual trailer of 1 per cent on SC units but only 0.5 per cent on DSC units. (Trailer fees are paid as long as you retain your units to compensate an advisor for servicing the account.)

Remember time value of money
Let’s say you want to buy an AGF fund on this basis. If you go the DSC route and hold for five years, your advisor will receive a total commission of 7.4 per cent over that time (4.9 per cent up front and 0.5 per cent annually). If you buy on an SC basis with a 2.5 per cent commission, the advisor gets a total of 7.5 per cent. It appears to be a wash, but the time value of money comes into play. By receiving the bulk of the commission up front through the DSC option, the advisor gets most of the payment in advance and can use or invest the money. If the advisor does a lot of fund business, the amounts involved can be substantial. If you hold the units for less than five years, the advantage of the DSC option to the advisor becomes even greater.

If your advisor is promoting DSC units, it may be because he or she prefers a larger up-front commission. But it could also be because the advisor honestly believes they are the better choice for your account, perhaps because he/she knows that you are unlikely to sell before the DSC period expires.

A good advisor-client relationship is based on open and full communication. You have the right to pay the lowest fee possible, consistent with the advisor receiving decent remuneration for the work being done on your behalf. So don’t be shy. Talk it over with him or her and ask exactly why the DSC recommendation is being made. Also ask if the advisor is willing to use the SC option on a zero or low commission basis and collect the higher trailer. If the answer is “no”, ask why not. It’s your money and you have a right to know.

Adapted from an article that originally appeared in Mutual Funds Update