Last month the Securities and Exchange Commission (SEC) proposed making big changes to how mutual funds structure fees related to sales and distribution, referred to as 12(b)-1 fees. Adopted by the SEC in 1980, Rule 12(b)-1 gives mutual funds the ability to charge a fee to investors, much of which is used to compensate financial intermediaries (i.e. brokers). There are approximately 8,000 mutual funds and about two-thirds of them include this fee in their annual operating expense. Revenue from 12(b)-1 fees has grown exponentially since the fee was introduced, generating $9.5 billion in 2009.
Not all mutual funds charge a 12(b)-1 fee, but those that do are typically “load” funds. As an investor of a load fund, you generally have an option of buying class “A” or “B” shares, which have a sales charge and a relatively lower annual 12(b)-1 charge. However, you can choose to purchase class “C” shares and opt for a lower sales charge, but you will have a higher annual 12(b)-1 charge that continues until you sell the shares.
According to the SEC, new rules are being drafted with three primary objectives: limit the amount a mutual fund can charge as a sales charge, create more fee transparency, and open the door for increased competition among commission-based financial advisors.
The new rules will eliminate the use of the term 12(b)-1 fee and replace it with a “marketing and service fee” that is capped at 0.25%. In addition, the new rules will likely lead mutual funds to create a new class of shares by which brokers would determine their own commission rate, creating a more competitive pricing environment.
While supporters of the new rule say that cutting costs, providing more information and increasing competition can only be good for the investor, opponents of the rule change argue that there will be unintended consequences. Chief among their concerns is that it will ultimately result in fewer choices for investors. Some speculate it will lead to the demise of class “C” shares because brokers are no longer incentivized to sell it.
Much of the debate is being stirred from the commission-based investment advisor faction. Fee-only registered investment advisors are less vocal on the issue because they typically advise clients to use funds that do not have a 12(b)-1 fee.
The proposed rule changes are currently in a 90 day comment period, allowing industry participants to weigh in. If the rules go into effect, investors holding class “C” shares should benefit immediately as the fees deducted from their holdings are capped. Everyone benefits when fees are more transparent, and greater competition is always good for the consumer. Only time will tell if the opponents to the rule changes are correct in their logic.