If ever there were a time to kill 12(b)-1 fees, that time is now. The imminent extension via regulatory reform of the fiduciary standard to brokers who provide advice presents a fitting time to get rid of fees that create conflicts of interest, confuse investors and unnecessarily complicate the comparison of costs across competing funds.
Since they were introduced by the Securities and Exchange Commission 30 years ago, 12(b)-1 fees have been a source of controversy. Ostensibly, they were intended to support sales, marketing and distribution efforts that theoretically drive up demand for mutual fund shares and permit fund companies to drive down expenses through economies of scale, which has been promoted by the industry as good for the investor. However, there is scant evidence to suggest that investors have benefited from paying the fees.
While 12(b)-1 fees have survived previous regulatory reviews, the SEC once again is about to conduct a formal review. Whether it will find the will and the way to overcome industry support for the fees remains to be seen, but Chairman Mary Schapiro recently acknowledged in a speech before the Consumer Federation of America that better disclosures and a name change will not be enough; doing away with 12(b)-1 fees altogether may be appropriate.
From a fiduciary perspective, there are three particularly compelling reasons to eliminate the fees: conflicts, confusion and cost.
Conflicts of interest arise for both advisers and fund directors. The primary use of 12(b)-1 fees is to pay continuing compensation to those who distribute fund shares. The amount of the compensation, or trail commission, may vary among funds. This is an inherent conflict of interest for an adviser operating in a fiduciary capacity, because they are given an incentive to compromise the investors' best interests for their own financial gain. If trail commissions are replaced by an account-level fee assessed by the adviser, there is no conflict. Moreover, the adviser can charge a fee commensurate with his or her own level of service and skill rather than be captive to whatever the fund company chooses to distribute.
Fund directors also find themselves in a conflicted position with respect to the management of 12(b)-1 fees. They are fiduciaries charged with serving the best interests of the fund shareholders. Representatives of the fund industry acknowledge and use this fact to argue that regulators should leave it to the directors to establish the appropriate level and uses of 12(b)-1 fees. They know that if some funds can buy business by paying funded trail commissions from such fees, the directors of competing funds will be forced to pay trail commissions too, as it is difficult to withstand the counterfiduciary pressure to build in extra expense to shore up distribution outlets.
Confusion is the second compelling reason to eliminate 12(b)-1 fees. Most investors don't understand what they are, don't know who receives money from them and don't understand how indirect (hidden) 12(b)-1 fees compare with direct (overt) fees or sales loads. Funds that pay for distribution through 12(b)-1 fees sell better than those that involve direct fees, even when the hidden fees may be more damaging to investor returns over the long term.
When a fiduciary knows that a product feature is misunderstood in practice and, worse yet, misleading by design, as is the case with 12(b)-1 fees, the fiduciary should take action to correct the situation. For this reason, advisers, regulators, fund directors, and institutional investors such as retirement plan sponsors and foundation investment committees, should all advocate elimination of 12(b)-1 fee plans.
Finally, cost is another compelling reason to eliminate such fees. Investors currently pay about $13 billion annually in 12(b)-1 fees. Is that fair and reasonable? We simply don't know, because there is too much variability across funds with respect to how the fees are being collected and applied. Not knowing is a problem for a fiduciary who is obligated to evaluate expenses sufficiently to determine if they are fair and reasonable for the services provided.
The elimination of 12(b)-1 fees, coupled with requirements for all funds to report expenses in a few clear and consistent categories, would make expense analysis much more efficient and effective. With full transparency of well-defined expense categories, it's likely that the competitive pressure applied through thorough due diligence would drive down fund expenses. Compensation for legitimate expenses will continue, but the change would help to ensure that the expenses were fair and reasonable.
Blaine F. Aikin is chief executive of Fiduciary360 LLC.
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