A suggestion to the SEC on 12(b)-1 fees

The goal of the Securities and Exchange Commission is to protect investors, but would the new 12(b)-1 fee proposal really accomplish that objective? Probably not. Essentially, the SEC wants to 0replace the 12(b)-1 charge with two fees. Mutual funds could charge an annual 25-basis-point “marketing and service fee,” as well as an “ongoing sales charge” that would disappear when the cumulative amount of the charge equaled the amount of any front-end load charged by a different share class of the fund. In issuing the proposal, the SEC appears to be attempting to protect fund shareholders from paying 12(b)-1 fees that they don't know they are paying and which — in the case of long-term investors — may add up to more than a fully disclosed front-end load. 12(b)-1 fees were introduced in the late 1970s when many funds were experiencing asset outflows that far exceeded inflows. The charge was intended to allow fund companies to recoup the marketing and selling costs necessary to increase inflows. Successful marketing, the prevailing wisdom went, would help the companies achieve economies of scale and thereby reduce expenses for fund shareholders, eventually paving the way for 12(b)-1 charges to be eliminated. Although fund assets have soared over the past three decades, 12(b)-1 fees are still with us, and the evidence of their having reduced fund expenses is sketchy. Instead, the fees continue to be used, in part, to pay continuing commissions to brokers selling the funds. Many financial advisers and brokers justify the 12(b)-1 fees as reimbursement for the services that they provide to investors who can't afford, or choose not to pay, fee-only advisers. The SEC proposal would bring the not-so-obvious total 12(b)-1 fee in line with the far-more-obvious front-end load. Furthermore, splitting the fee into a “marketing and service fee” and an “ongoing sales charge” undoubtedly would improve investors' understanding of the fees being deducted from their accounts. On the other hand, in comments to the SEC on the proposal, some advisers argued that changing 12(b)-1 fees could provide an incentive for them to sell only front-load Class A shares and provide no after-sales support to small accounts. That is because they think that the 25-basis- point annual “marketing and service fee” would be insufficient and because the part of any “ongoing sales charge” that they would receive from fund companies eventually would wind down. Worse, from an investor's perspective, is that the proposal could provide an incentive for advisers to switch clients in Class C shares into other funds when the continuing sales charge were about to end to start the meter ticking again. The SEC seems to have gotten its incentives wrong in its objective to protect investors. Surely it should be increasing the incentives for advisers to continue to guide small investors. That could be accomplished by increasing a renamed “ongoing service fee” to, say, 60 basis points a year for five years, declining to half that afterward, and requiring some specifics as to what the fee would pay for, such as an annual review of investment goals and regular risk assessments. The new name and enumeration of services would make the fee's purpose clear to advisers and clients. The “ongoing sales charge” should be capped at 50 basis points, regardless of a fund's front-end load, and disappear after three or five years. Given the size and profitability of the mutual fund industry, there is no reason that current clients should continue paying marketing costs for as long as they own a fund's shares. These are simply part of a fund's normal costs of doing business. Mutual fund companies should absorb any additional marketing costs not covered by these fees. These additional costs would be covered by the fund company's management fees or be reflected in lower profitability and borne by company shareholders. Either way, such a change would provide fund companies with the incentive to become more efficient.