Insights & Advice


12(b)-1 Strikes again

My regular readers know how much I despise 12b-1 fees. Those are the fees that mutual fund companies kickback to your broker or investment advisor for putting you into their funds. You never see the charge in your statements but it can be as much as one percent annually if you own a certain class of these funds called “C” shares.

“My broker doesn’t charge me anything,” protested a recent local investor “I just want better performance.”

I’ve heard those words countless times before. I said nothing but took a copy of his statements to review. After analyzing his portfolio, I discovered that not only had he paid that broker $16,000 in sales charges (called loads) but he was also paying $5,000 a year in 12(b)-1 fees. He was dumbfounded, although I quickly explained that many mutual fund investors were in the same set of circumstances.

Mutual fund companies normally have several classes of shares, for example, A, B and C shares. Each category may pay different fees and sales loads depending upon the category. C shares normally charge a 1% fee annually for as long as an investor owns the fund while “A “ shares may charge a 4.75% sales charge up front but a lower 12(b)-1 fee of about 0.25% going forward. The fee structure is intentionally complicated and rarely if ever appears on your statements.

Last week the Securities and Exchange Commission (SEC) announced a proposal to revamp these 12(b)-1 fees and require that these fees be disclosed to the investor. The SEC also suggested that broker-dealers should be able to set their own sales charges for mutual funds. The proposed rule change would cap the amount firms would charge for “marketing and services” (12(b)-1 fees) to 0.25%. Anything above that would be labeled an on-going sales charge and would be limited to the highest fees charged by the fund for shares without a sales charge.

For example, if a fund charged a 4% front-end load to an investor for buying one “A” share of its mutual fund, other classes of the same fund couldn’t charge more than that amount to the buyer over time. Since “C” shares charge investors 1% a year, the new rule would eliminate any 12(b)-1 fee after four years. Separately, the SEC proposal would create a new share class whose pricing would be determined by broker dealers.

This would be another important rule change and one that many broker-dealers don’t like. Most investors fail to realize that sales charges on mutual funds are fixed by the mutual fund companies. That means that brokers can’t compete with each other for your mutual fund business by reducing those charges. In comparison, commissions charged for stocks have been open to competition since the 1980s.

It is understandable, from the financial community’s point of view, why they oppose these changes. Last year 12 (b)-1 fees generated $9.5 billion for fund companies. Put another way, you the individual investor paid that much in addition to what you paid your broker or financial consultant in sales charges, which is several times that amount.

The financial services industry protests that there is already enough competition in the business with 4,600 broker –dealers vying for your business. They argue that if the SEC had it their way, brokers would only sell their clients the fund with the lowest possible price, with performance a secondary concern. Lacking only a sickle and black cowl, lobbyists warn that this would only encourage unscrupulous brokers to exploit their power to control prices and fleece the general public. Others lament that making this all about price devalues the counsel of the financial consultant or wealth manager to his/her clients. Finally, they say it would result in less, not more, competition as price wars developed and small firms would be forced out of business.

These were the same arguments used when the SEC de-regulated fixed commissions on stocks in the early eighties. Sure, some firms did go out of business because they couldn’t survive without gouging their customer base but it actually encouraged dozens of new discount brokers to open their doors. As for the advice of your investment advisor, after the financial crisis very few investors value their advice anyway.

My own experience in reviewing thousands of portfolios is that most advisors/brokers seek to place their clients in the highest fee-generating securities they can find while performance appears to be a secondary consideration. At least from the SEC’s point of view, why pay more when you can pay less for the same crappy funds.

Posted in Financial Planning, The Retired Advisor