What 12b-1 Reform Means for Investors

A look at the SEC's vote

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The Securities and Exchange Commission has voted to get rid of 12b-1 fees as they currently exist, all but capping off a prolonged campaign by investor advocates to rein in mutual funds’ annual expenses. In a unanimous vote, the SEC came out against the fees, which in 2009 drained $9.5 billion from investors’ accounts. Still, no changes will take effect until a 90-day comment period has passed and the public’s input has been evaluated.

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Prior to Wednesday’s vote, most regulations regarding 12b-1 fees had handed down by the Financial Industry Regulatory Authority. Finra had previously capped 12b-1 fees used for “marketing and service” at 0.25 percent per year and additional 12b-1 fees, which typically have been used to compensate brokers, at 0.75 percent per year, for a total maximum charge of 1 percent per year.

Under the new language, funds can still collect the 0.25 percent “marketing and service” fee in perpetuity. As a result, the SEC proposal primarily affects the broker fees collected under the 0.75 percent cap. Essentially, these annual fees have served as an ongoing sales charge levied upon investors. In other words, whereas many investors who are in share classes with front-end loads pay their sales fees upfront, investors in other share classes have seen these charges spread out over time.

In many instances, investors have paid out more in these “ongoing fees” than they would have had they opted for a front-end load. Under the SEC’s proposal, there would be more parity. For instance, a fund where the highest front-end load is 5 percent would be barred from having ongoing sales fees add up over time to more than 5 percent. In other words, once the investor has paid, via ongoing sales fees, the equivalent of the maximum front-end sales load for a fund, the ongoing sales charges would stop. The SEC proposal would also do away with the term “12b-1.”

Todd Rosenbluth, an equity analyst for Standard & Poor’s, is encouraged by the SEC’s vote.  “Every step that the SEC can take to bring costs down is a positive one for mutual fund investors,” he says. The Investment Company Institute, the trade group for mutual funds, had a more reserved reaction. “Fees paid under Rule 12b-1 play an important part in the overall economics of mutual fund investing.  They have proven over time to be a highly efficient and tax-effective method for covering the costs of a range of services that are valuable and important for mutual fund investors,” the group said in a statement.  “We look forward to reviewing and commenting on the SEC’s proposed reforms to the 12b-1 rule, which will impact literally millions of investors, thousands of funds and myriad financial intermediaries.”

Wednesday’s vote follows up on a promise that SEC Chair Mary Shapiro made at a conference late last year. “The problem is that [investors] may have no idea these fees are being deducted or who they are ultimately compensating,” Schapiro said during the Consumer Federation of America’s annual Financial Services Conference. “We must critically rethink how 12b-1 fees are used and whether they continue to be appropriate.”