Don't panic yet, but in case you haven't heard, the SEC is taking a hard look at a major source of pay for reps: 12b-1 fees. Sure, the subject of 12b-1 reform has been bandied about for more than a decade. But SEC director of investment management Andrew Donohue has said that an examination of the 12b-1 rule, written 27 years ago, is a big priority for the remainder of 2007.
The battle over 12b-1s is sure to be fought at a fever pitch. After all, there are billions of dollars at stake. Last year, asset management companies deducted $11.8 billion from fund assets to pay 12b-1 fees, according to the Investment Company Institute (ICI). Of course, for registered investment advisors and their reps, the debate is of little concern. Because they charge clients an ongoing fee on assets and are fiduciaries, most of them rebate any 12b-1 fees they receive back to clients. But many broker/dealer reps claim that 20 percent or more of their revenues come from 12b-1 fees each year.
In June, the SEC convened a roundtable packed with industry executives, a handful of analysts and a few consumer advocates, to examine possible avenues of reform. Jeffrey Keil, principal at Keil Fiduciary Strategies, who participated on the panel, says Donohue has made it clear that “all options are on the table,” but the broad consensus among industry experts is that the rule will not be repealed.
What's more likely, say several industry sources and investor advocates, is greater disclosure and tighter rules on what can and can't be paid for with 12b-1 fees. “You are likely to see much greater disclosure of 12b-1 fees at the point of sale,” says Burt Greenwald, a fund consultant with Greenwald & Associates. “Secondly, you're going to see a much more detailed description about the safe harbor for using 12b-1 fees. Today it's pretty much wide open. That's what the independent directors [on mutual fund boards] are having most trouble with.”
Old Fee, New World
The problem with 12b-1s is that the way the industry uses the fees has changed in the past 27 years. Originally intended for marketing purposes back when the industry risked suffering crib death, today they go to pay primarily for “advisor services” (which under the 12b-1 rule can only account for 25 basis points per year), as well as any number of other administrative and distribution costs. “Most investors don't know what the 12b-1 fee means,” says Christine Benz, an analyst with Morningstar. “The industry has taken advantage of that lack of focus, and shoved a lot of things under that umbrella that might not necessarily belong there.”
According to the ICI, in 2004, of the $10.3 billion paid out of fund assets in 12b-1 fees, some 40 percent was used for compensation to financial advisors (for initial assistance in picking the funds), another 52 percent went to ongoing shareholder services (account services and account management), 6 percent to fund underwriters and 2 percent to advertising and promotion.
Typically, 12b-1 fees range from 25 basis points on A-shares and some no-load funds, to 100 basis points (the maximum allowed under 12b-1 rule) on B shares and C shares. Investor advocates complain that because the fees are rolled up in a fund's expense ratio, they essentially serve as additional commissions (for advisors) in disguise. What's more, says Barbara Roper, director of Investor Protection at the Consumer Federation of America, they create conflicts of interest: Advisors have an incentive to pick funds that pay higher 12b-1 fees-whether those funds are best for clients or not. (See page 66.)
The brokerage and fund industries are fighting to keep the rule very much intact. The industry has evolved, the b/d industry association SIFMA wrote in a comment letter to the SEC, and 12b-1 fees now pay for services that weren't even available when the rule was first created. “The need for investment guidance is greater than ever given that mutual funds are the core investment of most retirement accounts,” wrote SIFMA general counsel Ira Hammerman in a comment letter to the SEC.
The fund industry also argues that if you strip out 12b-1 fees on mutual funds only, or even increase disclosure, and don't do the same with similar charges on other products, brokers aren't going to be as eager to sell mutual funds. “I think that is a completely legitimate point,” admits Roper. She says that advisors might turn to separately managed accounts, wrap accounts and structured finance products where they could be paid more.
One option that was considered by the roundtable, says Roper, who participated, was externalizing the portion of the 12b-1 fee that is used to pay brokers and advisors: in other words, charging it at the account level rather than taking it out of fund assets. But even Roper admits that while this measure would do the most to make the fees transparent, it might result in higher fees for smaller investors. Big investors, who, in effect, subsidize the cost of managing smaller accounts, would balk at the charges, and demand they pay less. Small investors would make up the difference, she says. For now, brokers are holding their breath until the SEC issues guidance, hopefully by the end of 2007.