SEC Proposed Action Will Slash Costs Paid By Retail Mutual Fund Investors

July 2010

12b-1 fees compensate mutual funds for marketing and selling costs. These fees are primarily a means of paying brokers for selling "no-load" funds that don't have upfront sales costs charged at the time of purchase. Some investors were pleased to have saved money by purchasing a “no-load” fund, only to have an even greater amount of fees paid out over time. In 2009, these fees amounted to $9.5 billion (and exceeded $13 billion in 2007).

As background, a front-end sales charge can be charged when the investor buys mutual fund shares. These front-end charges cannot exceed a range of 8.5 percent to 6.25 percent, depending on other fees charged by the fund. The sales charge is separate from (i) annual management fees and (ii) annual fees for sales efforts, which are referred to as 12b-1 fees.

In most financial transactions, only a small percentage of investors spend the time necessary to learn the real costs of transactions and services. Although there is disclosure of what is being charged in the voluminous detail of a prospectus, few actually read (and even fewer understand) all this disclosure. The SEC seems to have finally focused on this situation and plans to require more straightforward pricing of financial services. Last December, SEC Chairman Mary Schapiro stated:

“When it comes to these fees, there is a need for more fundamental change than merely disclosure reforms and a name change. We must critically rethink how 12b-1 fees are used and whether they continue to be appropriate. For example, do they result in investors overpaying for services or paying for distribution services that they may not even know they are supposed to be getting?”

Consistent with this statement, the SEC unanimously approved a proposal that drastically changes what is allowable. The SEC's proposal came the same day President Obama signed legislation requiring massive financial regulatory changes. Because of the attention given to these other financial regulatory changes, the importance of the SEC’s mandated fee changes was generally overlooked by the press.

Although a 90-day comment period exists, there appears little doubt that substantial change will occur. The current SEC proposal makes the following changes:

1. The proposal would limit the annual amount charged for a “marketing and service fee” to 25 basis points (0.25 percent). Anything above that amount would be deemed “an ongoing sales charge,” which would be limited to the highest fee charged by the fund for shares that have no ongoing fund sales charge (see next point).
2. Currently, an asset-based sales charge paid out of the fund's assets is limited to 0.75% per year, but there is no limit on how long a fund can pay these charges. The proposal would limit the cumulative amount of asset-based sales to the highest fee charged by the fund for shares that have no ongoing sales charge. For example, if one class of the fund charges a 4 percent front-end sales charge, another class could not charge more than 4 percent in total to investors over time.
3. Because these annual sales charges are obscurely referred to as 12b-1 fees, these charges are not well understood. Under the proposal, sales charges will no longer be called 12b-1 fees. Instead, mutual funds would need to identify and more clearly disclose the nature and amount of any ongoing sales charges, marketing and/or service fees in the fund's prospectus, shareholder reports, and investor transaction confirmations. Transaction confirmations also would have to describe the total sales charge rate that an investor is paying.
4. Currently, all broker-dealers who sell shares in a fund shares must sell those shares under terms established by the fund and disclosed in its prospectus. The proposal (i) enables broker-dealers to lower their own sales compensation, as would occur under normal marketplace competition, and (ii) prevents additional charges by any broker above what is established by the fund.

The SEC also unanimously approved rules requiring investment advisers to give clients narrative brochures containing "plain English descriptions" of the advisers' businesses, services and conflicts of interest.

In her opening comments during the hearing that approved the proposal, Chairwoman Shapiro provided a good summary of the background of 12b-1 fees and why the SEC intends on making this significant change. Her comments included the following:

“Rule 12b-1 was borne of a period in the late 1970s when funds were losing investor assets faster than they were attracting new assets. And, self-distributed funds were emerging, in search of ways to pay for necessary marketing expenses.

At the time, it was thought that investors would benefit if a fund could "grow" by using some of its own assets to market itself and make distribution payments. This, it was believed, would result in improved economies of scale and, ultimately, lower expenses.

…Very quickly these fees evolved from payment for advertising and marketing to an alternate form of compensation—or sales load—paid to intermediaries selling fund shares. In addition, 12b-1 fees compensate broker-dealers and other fund intermediaries for ongoing marketing and related services including recordkeeping, transfer agency services and overall investor education and consultation….

In essence, 12b-1 fees have become a means to pay broker-dealers and mutual fund intermediaries indirectly out of fund assets, rather than directly out of the investor's pocket. And as the use of 12b-1 fees has evolved, the aggregate dollars paid have ballooned. These fees amounted to $9.5 billion in 2009, nearly $12 billion in 2008 and exceeded $13 billion in 2007—compared to just a few million dollars in 1980 when they were first permitted.

I think that, despite paying billions of dollars, many investors do not understand what 12b-1 fees are. It's likely that some don't even know that these fees are being deducted from their funds or who they are ultimately compensating. In addition, investors may not realize they are paying the equivalent of sales loads or commissions—at a rate of ¾ of 1 percent a year—over the lifetime of their investment. Nor do investors realize that 10, 15, 20 or more years down the road, they may still be compensating the sales person who sold the fund.”

By placing a cap on how much mutual funds can charge through annual 12b-1 charges, there will be no motivation for the continued use of Class C mutual fund shares that pay higher ongoing sales charges for as long as the shares are owned. As noted above, such charges will be limited to 0.25% annually, which many sales representatives will not consider adequate for lower-balance accounts. The likely result is the new rule will lead to unbundling of services under a fee-for-service model. Investors will have a better of idea of the cost of offered services, and will be able to not purchase what is not desired. The overall cost to investors will certainly decrease, since most investors will not write a check to the salespersons who now make believe that their services are “free”.

If this approach occurs, less affluent investors need not feel abandoned because their small accounts do not warrant paying fees. Study after study has shown that a passive investing approach generates results (after consideration of costs) that are superior to what is achieved through expensive advice. For additional information, see Investing Made Easy. This article explains how one can implement the asset allocations that are identified in our online risk tolerance questionnaire and related investment allocation calculator.

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