It's time to take action on 12(b)-1 fees

This is the year for the SEC to settle the 12(b)-1 issue. Securities and Exchange Commission Chairman Christopher Cox has pledged to examine the fee system, questioning whether the use of 12(b)-1 fees has moved away from the original intent, which was to cover marketing and distribution expenses. The SEC approved such fees in 1980 to encourage mutual funds to put more effort into marketing, believing that it generates economies of scale for fund shareholders, thus reducing the administrative and management costs for each shareholder. The most recent SEC study of mutual fund expense ratios found that although expense ratios, on average, have increased in the past two decades, they generally decline as the amount of assets in a fund increases. In other words, large funds generally have lower expense ratios than small funds. And although expense ratios on average have increased, this may be largely because many companies have greatly reduced front loads, which are not included in expense ratios, and replaced them with 12(b)-1 fees, which are included. Further, shareholders today have access to more-expensive services, such as telephone redemption and exchange privileges, consolidated account statements and check or wire redemptions. All of this suggests that 12(b)-1 fees are working as planned. So why the concern about the fees? There are several reasons. First, when the fees were approved, because sale commissions were paid out of front-end loads, the marketing and distribution costs envisioned involved primarily advertising and share issuance. Since then, many funds have reduced or even eliminated their front-end loads, while using 12(b)-1 fees mostly to compensate advisers to sell the funds. Up to 75% of such revenue is paid to investment advisers, financial planners and brokers, who are now important marketers of mutual fund shares. Also, some observers are concerned that 12(b)-1 fees represent a conflict of interest for these marketers. However, if those concerns led to 12(b)-1 fees' being abolished, either many individual investors would go without guidance, or mutual fund companies would have to find another way to compensate advisers and brokers. Some have proposed placing a cap on 12(b)-1 fees, either in terms of the dollar amount or the period for which they can be charged. This would present an incentive for less scrupulous advisers or brokers to switch clients into new funds when the cap were reached, thus starting the clock running again. Before 12(b)-1 fees are abolished — or, less drastically, a cap is imposed — we would prefer clear, simple, up-front, verbal and written disclosure of all fund fees, and what they mean to the investor, before a purchase is completed. This disclosure should be made on one sheet of paper, separate from the prospectus. The sunlight of clear, simple disclosure is the best disinfectant for any mold being fostered by 12(b)-1 fees.