Money Matters: You do not pay a commission on this investment

Today, there are typically two methods for the investor to have their investments managed. If the amount being managed is large, at least $100,000 generally and most often significantly larger, the advisor may offer their services on a fee basis provided the advisor holds the proper registration. Since the advisor is being compensated with a fee rather than a commission, the investments offered should be commission-free. If not, you are clearly overpaying for the service. This professional is a Registered Investment Advisor or an Investment Advisor Representative, both being registered.

However, to be registered requires additional paperwork, reporting, supervision, filings, and fees. As a result, this generally means most investment professionals do not add this to their available services. But, the idea of fee income is appealing to some investment professionals. For the non-registered professional, there is only one way to generate fee income for themselves. In this particular case, if it is good for the advisor, it is not good for the investor.

If you are working with a NASD licensed professional that is not also registered, the only way they can be compensated is to receive a commission from a product they have sold to an investor. This brings me back to my title of this article. If you hear these words or something similar, the securities broker saying them must believe you are extremely gullible. All security products they sell pay the broker a commission. As an example, class A mutual funds are reduced in value on the date of purchase to reflect the commissions paid. However, class C mutual funds are not reduced in value when purchased and thus may give the appearance no commission has been paid. However, a commission is still paid and the investor is paying it.

If you recall from a previous article, the difference between class A and class C shares is how the broker is paid. But, it should also include the time horizon of the investor. One of the cardinal rules of investing is you should not place money at risk if your time horizon is short. Since class A shares deduct the full commission from your investment on the first day, your time horizon should be four years or longer to purchase class A shares. A time period of this length or longer will permit the investment to recover the cost of commission and should provide a reasonable growth.

But, some investors still want to invest even though their timeframe is less than four years. The mutual fund industry created class C shares to accommodate these investors. Instead of deducting the full commission on the first day, the annual expenses were increased so the commission could be spread over the holding period. Those investing for two years paid less in commission or in this case annual expenses than the investor holding their shares for three years.

Unfortunately, some brokers saw this as a way to create annual income. By directing investors with long-term time horizons to purchase class C shares instead of class A shares, an income stream would be paid to the broker for as long as the class C shares are held.

To illustrate this fact, I am pulling information from American Fund's Growth Fund of America prospectus. On page 5 of the prospectus, the amount of fees and expenses deducted from the fund are discussed. They total 1.47% annually for class C shares. But for class A shares, the annual expense is only 0.65%. While class A shares have an initial deduction for the load/commission, it is easy to see that class C shares will eventually catch up with class A shares in total expense due to the higher annual expenses. In fact on page 6 of the prospectus, the total expense paid for a 10 year period is compared.

Class A investors, even though they pay a front-end commission, only incur $1,339 of expenses for 10 years per the prospectus. However, class C shares incur $1,757 of expense for the same time period. The difference is primarily added compensation to the broker.

While the additional expense of class C shares is high and for investors with $25,000 or more to invest, they will receive a discount on the front-end commission for class A shares. The initial commission is reduced starting with $25,000 with additional breakpoints at various levels up to $1 million. Investing larger amounts and getting these discounts makes owning class A shares even more important because of the added savings on expenses.

I have seen too many investors with class C shares in retirement accounts or other long-term investments. It is unfortunate there are brokers more interested in creating income for themselves than long-term profits for their clients.

One way to avoid this issue is to find a broker/advisor that truly manages your holdings. Not someone that once your account is opened disappears until they know you have additional funds to invest. Have your account reviewed by a CFP
or qualified advisor to see if your accounts are being handled properly.

Would you like a response to a financial question? Send your question to Doug Horn, 115 W. Broadway, Maryville TN 37801. Be sure to mark your envelope Money Matters.

Doug Horn, CFP, is an area financial planner with more than 24 years financial experience and founder of Quality Financial Concepts, located in downtown Maryville on Broadway.

Doug Horn, CFP, Registered Investment Advisor in Tennessee and Texas and Registered Principal, Branch Office of and Securities offered through CUE Financial, Member NASD, SIPC.

© 2007 All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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