Investors face a fund charges conundrum

This year was meant to be the start of a brave new world for investors, where advice would no longer be tainted by commission and charges on investment funds and individual savings accounts would be transparent following the implementation of the Retail Distribution Review (RDR) in January.

However, delays in the final regulation of platforms such as FundsNetwork and Interactive Investor, through which most advisers and investors nowadays purchase their investment funds, has left the situation still somewhat confused. The introduction of new "clean" share classes is also presenting investors with the conundrum of whether to switch existing investments or not.

What has become clear following RDR is that a large number of different parties receive payments from investment funds. The traditional charging structure on funds was "bundled" so that a single annual management charge (AMC) was deducted by the fund company, and this was used not just to pay the cost of managing the investments, but also for platform services and the annual commission payment to a financial adviser. An additional charge was taken by fund managers to pay for "backoffice" administration expenses as well. Latest available figures from Lipper show that these bundled fund charges averaged 1.49%, with additional expenses bringing the total to 1.7%.

Where selected fund groups deduct their annual charges from capital

Fidelity*

Fidelity MoneyBuilder Dividend, Enhanced Income, Global Dividend.

Jupiter*

Jupiter European Income, Global Equity Income, High Income, Income, Japan Income, Monthly Income, North American Income, Responsible Income, Merlin Balanced, Merlin Conservative, Merlin Income.

Invesco Perpetual

Invesco Perpetual European Equity Income, Asian Equity Income, Distribution, European High Income, Global Financial Capital, Monthly Income Plus, Global Equity Income, Managed Income, High Income, Income & Growth, Income, UK Strategic Income.

Newton

Newton Asian Income, Balance, Corporate Bond, Emerging Income, European Higher Income, Global Dynamic Bond, Global High Yield Bond, Global Higher Income, Higher Income, Real Return, UK Equity.

M&G

M&G Dividend, Episode Balanced, Episode Growth, Episode Income, Extra Income, Global Dividend, Global Leaders, Global Real Estate, Managed Growth, Pan European, Pan European Dividend.

Notes: * Exceptions: Fidelity Multi Asset Income - depends on share class. Jupiter Distribution and Growth & Income, where charges are taken 50/50 from income and capital. Source: Fund managers.

In recent years, investors have been able to reduce their charges by opting for platforms such as Cavendish Online, Alliance Trust Savings and Interactive Investor, which rebate annual commission to investors and charge fees instead. But generally there has been a lack of transparency, particularly with regard to platform charges.

Delays by the regulator mean the changes required to make charges fully transparent are still being phased in. It was not until the end of April this year that the Financial Conduct Authority (FCA) finally confirmed that cash rebates to advised and non-advised platforms will be banned from 6 April 2014. Thereafter, the cost of platform services will have to be paid for by a charge that is disclosed to, and agreed by, the investor.

The regulator says the changes are aimed at ensuring that investors can make fully informed choices if they wish to use a platform, and that they understand what they are paying for the service the platform provides. It wants to prevent cash rebates being used to disguise the costs of the platform charge. The platform rules will apply from April 2014 for new clients, but fund platforms will have until April 2016 to move existing customers to the new transparent charging model.

Consequently, most fund managers are now operating at least two "share classes" in their funds: an old-style share class with traditional bundled charging and a new, so-called "clean" share class where the only deductions are the charges for investment management and the ongoing administration expenses. But some of these clean share classes are not as low-cost as expected, and the regulator has warned managers not to use the introduction of clean shares as an excuse to increase their fees.

Some platforms are already offering clean share classes where they are available; other platforms are still working out their new pricing models. In the meantime, those that have provided commission rebates are having to deal with the taxman's decision to start taxing them from the beginning of this tax year, though it does not affect holdings within ISA accounts and self-invested personal pensions. Justin Modray, former financial adviser and owner of comparefundplatforms.com, explains: "It will be the responsibility of the fund platforms to deduct basic-rate tax at source, but they had very little time to prepare for this so they are still in negotiation with the tax authorities." Standard Life says it will pay the tax on its platform customers' behalf until the end of 2013.

Advised investors

In the meantime, investment advisers are starting to move their clients' investments into clean share classes. Although they can leave existing investments in old-style holdings and continue to receive commission for the time being, as soon as they advise on changes or rebalancing of portfolios they are obliged to move clients to unbundled pricing. Andy Merricks, head of investment at Skerritt Consultants, explains: "At the point when we are reviewing a client's portfolio or giving advice, we are switching to clean share classes. But it can be quite difficult. They are not always available."

Research by AXA Wealth has found that more than half (52%) of adviser firms questioned said they anticipated placing more than 75% of new platform business into clean share class funds during the next 12 months. A further 20% predicted that the level of new assets going into clean share classes will be above 50%.

David Thompson, managing director of AXA's fund platform Elevate, says: "The two main drivers encouraging advisers to use clean share classes are the greater transparency as a result of RDR and HMRC's decision to tax fund rebates. I think it is good news for investors. My view is that the greater transparency will also result in fund managers' charges coming down."

Independent financial advisers must now charge their clients a fee for advice. There have been fears that financial advisers may leave investors' holdings undisturbed and continue to collect commission on existing products for as long as possible. But a survey of financial advisers by Skandia has revealed that 62% intend to move all their clients to a fee-based model within the next 12 months. The survey also found that the vast majority of advisers' clients are choosing to pay the charge for ongoing service via their funds. Three-quarters of advisers said that more than 90% of their clients choose to pay for ongoing service in this way, rather than making a direct payment.

Investors who opt for the product-charging approach may notice very little difference from the old-style arrangements. Instead of fund managers making deductions from their funds, the platforms will facilitate the process and arrange for deductions to pay their own charges and those of advisers. However, an advantage for investors is that they should have greater flexibility in exactly how the charges are deducted, which we will discuss later.

As customers become accustomed to paying fees rather than commission, the trend may change. But only 10% of advisers believe a lot more of their fees will be paid directly by their clients rather than through funds in future.

Self-directed investors

If you are a self-directed investor making your own investment decisions, your choices with regard to clean share classes will vary according to which platform and funds you are using and how much you have to invest. Some platforms, such as Alliance Trust Savings' i.nvest, Interactive Investor and Charles Stanley Direct, are already offering clean share classes, while others such as Hargreaves Lansdown Vantage are still deciding on their charging models.

Self-directed investors may be able to save some money by switching their existing investments to clean share classes. If they ask their existing platform to convert their holdings, there will not be any capital gains tax liability. However, if this requires a switch between platforms, it could be costly if there are penalties for switching. And until all platforms have finalised their charging models, it is not possible to predict which will be most competitive.

Hargreaves Lansdown Vantage is the UK's largest platform for retail investors, and its dominance has enabled it to obtain a larger-than-average slice of the AMC from fund managers anxious to offer products via its platform. It is now putting pressure on fund managers to provide it with cheaper "super-clean" share classes to sell to investors. Its spokespeople say the aim is to get a better deal for investors. However, others have argued it may be more interested in preserving its own profit margins.

According to calculations by Justin Modray, Hargreaves Lansdown currently receives an average 0.77% annual commission (comprising both advisory commission and platform fee) from fund providers, out of which it rebates an average 0.17% via a "loyalty bonus" to clients, leaving it with a meaty 0.6% annual margin. He points out that charging 0.6% as an explicit fee may put investors off, if they can go to another platform provider such as Charles Stanley Direct and pay only 0.25%. But if Hargreaves Lansdown can provide clients with access to lower-cost share classes, investors' total costs may not be affected.

For many investors, paying any percentage-based platform fee may be the wrong strategy. David Linsley, head of products at Interactive Investor, asks: "If the fund you want to invest in is identical across all platforms, why would you pay a percentage fee on a significant holding when a flat fee would be far more economic? Investors with holdings of more than £10,000 are almost certainly going to be better off with a platform that charges a flat annual fee, rather than a percentage-based fee."

Until the platforms' charging structures are clear, Modray advises: "I think it makes sense to wait until the dust settles. You may pay a little bit more in the meantime (than if you switched to clean shares classes) but it will be easier to see where you can get the best deal after that."

How are charges deducted

One of the factors that will be worth taking into account when choosing a platform in future is how charges are paid and whether there is any flexibility. As the box above shows, leading fund managers often take their charges out of investment capital, usually when funds have an income objective because their aim is to maximise investors' income. There are varying views on this practice. Some managers argue that if an investor's prime objective is income then it makes sense to take charges from capital to ensure the investor receives as much income as possible. They point out that fund managers should be able to generate enough capital growth to make up for these deductions and still add value.

Others, such as Terry Smith, chief executive of Fundsmith, whom we quoted earlier this year, disagree with the practice. He says: "This sleight of hand allows them to boast about a high level of yield while depleting the value of your capital. Over time this has a significant compounding effect. Also, from a domestic tax perspective, charging costs to capital is inefficient, as capital gains are typically taxed at a lower rate than income and can be deferred by not releasing gains, thus allowing value to compound on what is in effect an interest-free loan from the taxman."

The leading fund managers we questioned say they will stick to their current practice with regard to their clean share classes. But the ways advisers or platforms take their payment may vary. It may be taken out of a cash account facility in which fund income and other cash is held, or the platform may deduct it from investors' capital. Alternatively, investors may be able to pay for these services separately.

It is worth considering your options. You may be happy to have the payments taken from your capital, but if you have ISAs it may be more tax-efficient to have them taken from funds held outside of ISAs. However, you may prefer not to see your capital eroded and therefore have it taken from a platform cash facility or pay by direct debit instead.

Skandia's adviser platform offers some choice. Spokesman Tim Skelton-Smith explains: "With regard to the adviser's charge, this can be taken from a nominated product as it's treated as a withdrawal. As for the platform charge, this is taken across all product wrappers, but the customer can nominate the fund from which it is taken within each product. So for example, you could hold a cash fund within each product and request that the charges are taken from that fund."

Bestinvest currently offers three options. Jason Hollands, business development and communications director, says: "We can either take platform and advice fees via direct debit or from cash held in a nominated investment account and, should there be insufficient cash, from selling units in the largest holding."

Will investors be better off?

The unbundling of investment charges will help to make investors more aware who they are paying for what service. However, making direct comparisons between the total costs of investing in different funds may not be so easy.

Ed Moisson, head of UK research at Lipper, comments: "RDR has accentuated the fact that greater transparency makes it a lot more difficult for retail investors - particularly if they aren't using an independent financial adviser - to know what they are being charged. For example the splitting out of platform and IFA costs from the costs of managing a fund can result in a Ryanair-style situation with all costs split out, but no figure pulling them all together."