Financial services is the perfect example of an industry where enormous information asymmetry between businesses and consumers means that consumers are easily duped by those who might try and take advantage of them.
This information asymmetry is reinforced by a vast array of bewildering technical jargon has sprung up; jargon which, not accidentally, makes it even more difficult for people to understand what is happening to their money. Unfortunately, it’s also an industry that folks are all but compelled to interact with; after all, as everyone knows, we all must prepare for retirement, and that ultimately means saving and investment.
These facts were made painfully evident to me, recently, as I heard the story of someone who was duped by an FS Financial employee to engage in a dubious investment strategy that is likely to cost them thousands of dollars or more while enriching that employee.
So, below, I’m going to try and cut through a bit of the bullshit and explain what happened in this particular case and, along the way, hopefully illustrate some of the obvious ways that folks might get screwed by unscrupulous investment advisers.
Mutual Funds and deferred-sale charges
Have you ever wondered why the investment adviser exists? Why do these people do this job? How do they get paid?
Well, let’s start with the basic idea of an RRSP. An RRSP is essentially a registered account. When you “contribute” money into that account, what you’re actually doing is buying shares in some sort of investment vehicle. The account is then where those shares are held.
To make the business worthwhile, the investment adviser then collect some sort of commission.
These commissions can be taken as a percentage of the invested amount up-front, often up to 5% of the invested amount. But far more common, these days, is something called a “deferred-sale charge”. In a DSC setup, the mutual fund provider pays the commission to the investment adviser instead of taking it out of the amount of money being invested.
Sounds great, right?
Well, there’s a kicker: If you try to take that money back out of the fund, there’s a penalty! In the first year, that fee can be as much as 6, 7, or even 8% of the amount being withdrawn, then declining each year the money is held in the fund until the fee reaches zero, usually 6-8 years out.
Now, if you’re investing long and you can tolerate some risk of the fund doing poorly, this is fine. But if, for any reason, you need to liquidate your holdings (say, to put a down payment on a home), this can turn into many thousands of dollars in penalties.
Of course, this ain’t news. The DSC is a scourge on the industry and has been reported in many places and at many times.
But it gets interesting when you add something else to the mix…
Woah, wait, “leveraged”? What the hell does that mean?
Well, it’s more needless technical jargon. All it means is “borrowing money and then investing it”.
That should immediately make anyone nervous. Unfortunately, I suspect that the mortgage industry has trained people to think this is normal. How so? Well, folks think of a house as an investment.
They shouldn’t, but they do.
Viewed this way, a mortgage is actually a leveraged investment, as opposed to a lifestyle purchase decision like a car or a boat.
Now, in the case of leveraged investing, the basic idea is incredibly simple, and looks a lot like an interest-only mortgage (and we all know how great an idea those are):
- Borrow money using an investment loan.
- Invest that borrowed money in the market in a non-registered account.
- Pay only the interest on the investment loan.
There’s a couple of reasons why this might be appealing.
First, the interest paid on the investment loan is tax deductible. This means that investors who’ve hit their RRSP contribution limit can continue to purchase shares in a non-registered account while realizing some of the immediate tax advantages.
Second, lump some investing like this typically out-performs traditional investing for obvious reasons: there’s more time for compound interest to apply to the full amount.
And these days, due to rock bottom interest rates which makes borrowing a lot cheaper than it once was, a lot of folks are looking at leveraging as a way to increase their investment gains.
Sounds great, right?
Well, leveraged investing and mortgages share an important trait: in both cases, if the value of the asset purchased with debt drops lower than the borrowed amount, the borrower finds themselves “under water”.
We saw this in the 2008 crash, when millions of people found that the value of their home dropped below the value of the mortgage. If you were a house flipper, this suddenly meant you were forced to default on your loan, due to the inability to pay it back. The result was a rash of bankruptcy filings and mortgage defaults.
When it comes to leveraged investing, this means that, if the value of the investment drops below the amount of the loan, and the investor then finds themselves in the position where they need to liquidate their holdings-for example, if they lose their job and can no longer afford the interest payments on the loan-they’ll find themselves unable to pay back the loan.
As a result, leveraged investing carries with it a great deal of risk, and is absolutely not something for the faint of heart.
FS Financial - Worst of both worlds
So, what happened to this person I know?
Well, they were sold on the idea of borrowing a significant amount of money and purchasing shares in a mutual fund with, yup, you guessed it, a deferred-sales charge.
This greatly compounds their risk as, if they need to liquidate their holdings because they’re under water or can no longer support the interest payments, they’ll then have to pay a significant penalty, exactly when they can’t afford it.
Moreover, the jackass investment “adviser” who recommended this strategy did so at a time when markets are at an all time high and starting to look shaky (leveraging is typically a strategy you employ after a correction, not before, to take advantage of market gains when money is cheap).
This makes it very likely that, in the short run, a) the value of those investments will decline, and b) there’s a non-trivial chance of a lay-off due to a weak local economy.
But it gets worse.
Naturally, this person asked the investment adviser if there would be any risk associated with the value of the investment dropping below the value of the loan, to which the adviser told them that no, they would not be responsible for those losses.
That seems like a lie on it’s face, but it turns out it’s not. They were simply answering a different question.
A detour into margin loans
Oh god, more terminology, I know.
So, remember when I mentioned an “investment loan” earlier? Well, there’s another kind of loan out there that can be used for leveraged investment and it’s called a “margin loan”.
A margin loan is designed to reduce the bank’s risk that the investor could find themselves under water. Part of the loan’s terms is a loan-to-value ratio, basically the ratio of the value of the loan to the value of the investment. If that ratio drops below a certain level (due to the investment losing value), the investor must sell some of their investment to pay back part of the loan.
This is referred to as a “margin call”.
As you can imagine, if you’re a leveraged investor with a margin loan, if things go bad you may be forced to sell some of your position and realize immediate losses. This adds to the investor risk of leveraging but it means the bank doesn’t take on as much risk of the investor defaulting.
Back to FS Financial
So what our jackass investment “adviser” was actually saying was that our investor would not be subject to a margin call if the investment declines in value. This is technically true because the loan was a regular ol’ interest-only investment loan and not a margin loan.
But that wasn’t the damn question.
This does not mean that the investor isn’t responsible for paying back the loan and realizing losses if they can’t repay by selling off their mutual fund. They absolutely are.
Was the adviser being intentionally misleading or just stupid? I have to assume the former.
One more thing
Looking at the communication between the subject of this blog post and their FS Financial jackass investment “advisor”, I noticed something very interesting: they referred to the interest payments on the investment loan as “contributions”.
Except they’re nothing of the kind.
Remember, when leveraging to invest, you have a loan. In this particular structure, the investor then pays just the interest on that loan every month. But the “contribution”, that is the purchase of the mutual fund shares themselves, is done at the time the loan is granted and the purchase executed.
Every payment after that is just servicing the loan.
So when, later, this person indicated they wanted to “increase their contributions”, thinking of this like a traditional RRSP structure, the FS Financial jackass of course agreed! So they took the amount that the “contribution” was to be increased, calculated how big of a loan would be required to increase interest payments that amount, and promptly got the loan approved and the investment purchased.
It’s a clever little twist of language designed to do one thing: confuse the investor into forgetting that what they were actually doing was just increasing their leveraged position, and their associated risk, while earning the financial services guy a fat commission for a big purchase.
When you consider what actually happened here–the investor got a loan and bought an investment, then paid interest, and was subject to fees on early exit–it’s all actually incredibly simple. The complexity is all in the jargon.
So when thinking about this stuff, always try to peel away the language and get down to the nuts and bolts of what’s going on. What are you paying? What are your obligations? What can you do if you need to exit the deal? These are basic questions that a shady financial guy might not want to answer. So the job of the investor is to cut through the BS to get the answers they need.
And if all else fails, remember: you can always walk away. If your financial services guy seems to be dazzling you with jargon or giving you the run around, leave. Remember: you’re not stupid because you don’t understand their lingo. A good, smart adviser will know how to explain these concepts in a way you’ll understand, because ultimately, this stuff ain’t that complicated. If they don’t do that, or can’t, they’re not worth your time.