Mutual Fund Fee Reform: A Multibillion-Dollar Sleight of Hand?

Would 12b-1 reform truly make fund ownership cheaper?

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As the Securities and Exchange Commission looks to push through its reform of mutual funds' 12b-1 fees, one nagging question looms large: Will billions of dollars simply disappear from the mutual fund industry?

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Last year alone, 12b-1 fees, which cover everything from advertising to broker compensation, drained $9.5 billion from investors' accounts. In 2007, that number was an eye-popping $13.3 billion. While some of this money went toward funds' marketing and services needs, the vast majority was funneled to brokers. But earlier this month, the SEC voted in favor of an overhaul that would do away with the term "12b-1" and impose limits on funds' ability to charge ongoing sales commissions.

While this proposed change, which is still tentative until a 90-day comment period passes and the SEC can take into account public reactions, was drafted in the hopes of easing fund investors' financial burden, it's far from clear whether or not it can actually accomplish that goal. Simply put, brokers are unlikely to let billions of dollars slip through their fingers. Even if the SEC's proposal ultimately becomes the law of the land, brokers will find new ways to generate the revenue that once flowed from 12b-1 fees. That much we've known all along. What remains to be seen is how they will go about doing that—and whether the new fee structures will be any more favorable to investors than the old ones.

First, a bit of background. The SEC established 12b-1 fees in 1980 to help the mutual fund industry attract assets. In the early years, fund companies used the money they collected largely to fund advertising and distribution costs. Back then, the fund industry was struggling and asset levels were low. In the intervening years, though, funds ballooned in size, to the point where many have stopped accepting new investors. But even as their initial purpose became less relevant, 12b-1 fees continued to catch on. In a 2007 report, the Investment Company Institute said that roughly 70 percent of funds had 12b-1 fees for at least one of their share classes. Over time, these fees have gone from paying for printing and advertising to providing the brokers who sell funds with sales commissions.

Under regulations approved by the Financial Industry Regulatory Authority, funds can charge up to 1 percent (100 basis points) per year in 12b-1 fees. Of that, up to 25 basis points can be used for nuts and bolts "marketing and services" expenses. Meanwhile, up to 75 basis points can be used for asset-based sales charges, which are primarily code for ongoing sales commissions paid out to brokers.

Investors who pay the fees encapsulated in these 75 basis points are often invested in class C shares. Unlike A shares, which often have a front-end load, C shares allow investors to put their money to work immediately. But there's a tradeoff. Instead of paying one upfront sales charge, investors in C shares will often have their commissions spread out over time. Here's the catch: Investors who pay up to 75 basis points per year on their assets under management will, over the course of many years, often end up dishing out more than they would have had they elected to pay one lump sum upfront.

That's where the SEC's proposal comes in. It looks to prevent investors from paying more in continuing sales charges than they would have had they paid the maximum front-end load. In the case of investors in C shares, their investments would essentially convert to A shares after a set amount of time. Take, for instance, a fund that has its maximum front-end load set at 5 percent. Under the proposed regime, investors in C shares could, depending on the specific arrangements made by various fund companies, pay 1 percent per year for five years. After that period elapses, the investor's holdings would be converted into A shares with no continuing commission. This, of course, won't be an exact science. If the investor's holdings appreciate each year over the course of the five years, paying 1 percent per year would cost more than paying 5 percent upfront on the initial investment. Still, it's a relatively close approximation. Separately, funds would still be allowed to charge the 25 basis point "marketing and services" fee in perpetuity.