The mutual fund fees known as 12b-1s have morphed into something few envisioned when the SEC created them 25 years ago. With regulators now poised to address that transformation, many reps are sweating about the future of a reliable income stream.
Originally created by the SEC as a way to help underwrite fund-marketing costs in a period of perilous outflows for mutual funds, 12b-1s have become a tool for encouraging advisors to sell certain funds. Today only 2 percent of 12b-1 fee income goes for advertising and promotions.
Critics argue that the fees should be banned because they no longer serve their original purpose, and now the NASD and SEC are weighing what action to take on these complaints.
What's Brewing
With some of its staff members questioning the value of the 12b-1 rule, the SEC called for comments about whether the fees should be changed or eliminated altogether. Meanwhile at the NASD, a task force is reviewing what changes should be made.
Industry observers say that a complete 12b-1 ban is unlikely because it would cause major disruptions for advisors. But some substantial changes could occur in the next year or so. Whatever happens, the stakes are considerable. In 2004, 12b-1 fees produced $10.4 billion in revenues, according to the Investment Company Institute, the mutual fund trade group. For advisors, needless to say, a decline in 12b-1 revenue could be painful. “Without 12b-1 fees, we couldn't afford to service many of our clients,” says Thomas Paron, president of Compass Capital Management, a registered investment advisor in Southbury, Conn.
In a typical arrangement, class-A shares come with a one-time front-end load of 5 percent, which goes to the brokerage as a commission for the sale. In addition, the brokerage receives a 12b-1 fee of about 25 basis points, an annual payment that lasts as long as the client holds the fund. With class-C shares, there is no front-end load, but the brokerage receives annual payments of 1 percent covered by 12b-1 fees. Class-B shares, which traditionally charge annual 12b-1 fees of 2 percent or so, have become unpopular as regulators complained that the shares are not the best choice for most investors.
Paron says that the C shares offer an effective way for billing small accounts. His firm oversees $400 million for about 4,000 clients. While Compass Capital oversees some sizable accounts, most clients have modest assets, including teachers who invest $25 each pay period. Because the 12b-1 fees are automatically subtracted from fund assets, there is relatively little paperwork. The fund knows the total assets; it can simply pay 1 percent of assets to advisors. Receiving a steady stream of payments, an advisory firm can afford to provide routine client services, such as monitoring accounts and taking phone calls to change beneficiaries.
“If we lost the 12b-1 revenue, we would have to work like an attorney and bill clients every time we talked to them on the phone,” says Paron. “Someone with a $5 million account might not mind getting invoices, but I don't think that model would work for the client with $50,000.”
Under the Covers
Under the current system, a client can look in a prospectus and see how much of the total expense ratio involves 12b-1 fees. But concerned that shareholders may not understand the true cost of 12b-1 fees, the SEC is considering proposals that would charge a client's account directly. In the revised system, a client with $10,000 might see in his statement that the account had been billed $100 to pay 12b-1 fees. This disclosure would leave little doubt about the impact of 12b-1 fees. But installing the extra system could be expensive. In some cases, clients might have to sell shares in order to pay the fees, creating additional capital gains-tax bills. “To charge each client, you would have to create new systems that can calculate the account's assets on a daily basis,” says Brian Reid, chief economist of the Investment Company Institute.
Many clients already receive adequate disclosure of 12b-1 fees, says Charles Haas, a registered investment advisor and principal of Haas Financial, a Linsco/Private Ledger-affiliated branch in White Bear Lake, Minn. Haas tells each new client exactly what their annual fees will be and gives them two choices — buying class-A shares or using an asset management account with an annual fee of about 1 percent. For example, a client who puts $500,000 into American Funds' Growth Fund of America would pay a 2 percent front-end load and an annual 12b-1 fee of 25 basis points. That means the upfront tab would be $10,000, followed by the ongoing annual fee of $1,225, assuming the account does not grow. In contrast, the client who opts for an annual fee of 1 percent would pay $5,000 every year. “We give people a choice, and most select the class-A shares because of the cost,” says Haas.
Even proponents of 12b-1 fees admit that some reforms are in order. For starters, it might help to simplify the name, says John Robinson, an independent financial advisor in Honolulu, who sells C shares. In talking to clients, Robinson lays out all the costs and uses the term “12b-1,” but it would be easier if he could refer to “advisor fees.” Robinson also worries about instances when 12b-1 fees may be excessive. He objects to funds in wrap programs that charge 12b-1 fees. “The client is paying the wrap fee and a 12b-1 fee,” he says. “Clients should pay for advice, but there is no reason to pay twice.”
Even if the SEC decides not to issue a ban, there seems little chance that the issues around 12b-1 fees will vanish. At a time when disclosure requirements are increasing, advisors will undoubtedly face new pressures to explain how they get paid and why.