For years, regulators have considered altering the 12b-1 fees imposed on mutual funds. But despite hearings and public debate, no new rules have appeared. Now the SEC seems poised to issue a major proposal that would cap 12b-1 fees on C-shares and change disclosure rules. The reforms could be a real hassle for some broker/dealers and advisors, who say it will mean more paperwork, and make it harder for them to provide ongoing service to smaller clients.
According to the Investment Company Institute, the mutual fund trade group, 12b-1 fees generate $12 billion in annual revenue, a major source of income for many firms. And 12b-1 fees on C-shares account for 25 percent of that. “The fees make it possible for representatives to provide clients with ongoing support,” says Robert Hamman, president of First Asset Financial, a broker/dealer in Salina, Kansas.
The 12b-1 fees first appeared in 1980, and their original purpose was to pay for advertising and promotions aimed at attracting more shareholders for struggling mutual funds. By increasing assets under management, fee proponents argued, the industry could enjoy economies of scale and lower costs for investors. But since then, the role of 12b-1 fees has evolved, and it is now used primarily to compensate advisors.
Arguing that the industry no longer needs the extra income, some critics have called for abolishing 12b-1 fees altogether. But SEC staff members have made it clear that their aim is to reform the fees — not eliminate them. The commission's latest guidance came from Andrew J. Donohue, director of the SEC's division of investment management, who discussed the fees in a speech delivered in April. Donohue said that the rules must be changed so that the purpose of 12b-1 fees is communicated clearly to investors. “Many investors do not understand rule 12b-1, the services that 12b-1 fees pay for, or even the fact that 12b-1 fees are being deducted from their fund investments,” Donohue said.
Under typical terms, Class-A fund shares charge a maximum upfront load of 5 percent, which represents a sales commission paid to the broker. The broker may also receive an annual 12b-1 fee of 25 basis points as long as the investor holds the fund. Investors who choose Class-C shares pay no front-end load, but the fund charges an annual 12b-1 fee of 100 basis points. Class- B shares, meanwhile, are unpopular these days because regulators have frowned on them. SEC staff members have long worried that investors may not choose the share classes most appropriate for them. Many investors who buy C-shares would be better served by selecting A-shares, staff members have argued.
In his April remarks, Donohue focused on C-shares, saying that the 12b-1 fees should be divided into two categories, with 75 basis points treated as sales loads that pay brokers. The rest of the fee would be labeled as servicing costs. He also called for a capping of these fees. If Donohue's approach wins the day, C-shares could face rules that would resemble the system used for B-shares, which typically charge an annual 12b-1 fee of around 2 percent for a period of about five years. After that, the shares convert to A-shares, and investors pay an annual 12b-1 fee of 25 basis points.
If C-shares must convert to A-shares after five years, advisors would be forced to rethink how they sell funds, says John Robinson, a financial advisor with Hawaii Wealth Management in Honolulu. As it now stands, C-shares play an important role at many firms. Because of the trailing income from 12b-1 fees on the shares, advisors can profitably manage small accounts, talking to clients and making changes in investments. But without that income, many firms would be hard-pressed to provide personal attention for smaller clients, says Robinson. To cover costs, advisors would switch to fee-based brokerage accounts, or wrap accounts, which often charge more than C-shares do. “Changing 12b-1 fees would not serve the interests of advisors or clients,” Robinson says.
Changes in 12b-1 rules could also create additional administrative burdens for advisors and firms. If the fees are treated as loads, as Donohue suggests, then the disclosure documents would have to be changed. Prospectuses might have to spell out the impact that loads would have on returns. And fund companies would need to track exactly when C-shares must be converted to A-shares. While many advisors and fund companies oppose major changes that would result in increased costs and paperwork, there is one improvement that nearly everyone seems to support: devising a new name for 12b-1 fees. “The name itself leads to confusion,” says Mellody Hobson, president of Ariel Capital Management, a fund company. “Let's just call it what it is — a distribution fee.”