SEC votes to scrap confusing ‘12b-1′ mutual fund fees, set new framework for fund sales costs

SEC votes to scrap mutual fund ‘12b-1′ fees

BOSTON — The Securities and Exchange Commission on Wednesday voted to revamp fees that most mutual funds charge to cover sales and distribution costs, and that have become a source of confusion for investors and industry insiders alike.

Revenue from so-called “12b-1″ fees can be used for a wide range of fund services beyond upfront sales costs, and an investor can pay the fees for years after they’ve gotten into a fund, eroding returns. Even industry pros find 12b-1s confusing, because funds can use the fee revenue in so many different ways beyond compensating brokers selling funds.

The commission voted unanimously in Washington to adopt changes proposed by the SEC staff to limit investor costs and improve fee disclosure. The rules are subject to a 90-day public comment period.

The proposals, SEC Chairwoman Mary Schapiro said, “are intended to provide clarity and fairness to a mutual fund distribution system that has become confusing and potentially anticompetitive.”

The new rules, she said, are aimed at “leveling the playing field for investors,” while also minimizing disruptions to the fund industry.

The proposed rules include reducing the cap on how much a fund can charge in 12b-1s, which can make up one component of a fund’s overall ongoing expenses. The 12b-1s are separate from the management fees that all funds charge for overseeing an investment portfolio.

About two-thirds of the industry’s 8,000 funds charge 12b-1s, which brought in $9.5 billion last year. That’s up from a few million dollars when funds were first permitted to charge the fees in 1980, according to the SEC.

Last year’s $9.5 billion was equal to 18 percent of all fund expenses, not counting upfront, one-time sales charges known as “loads” that some funds charge, according to the fund industry’s Investment Company Institute. The 12b-1 fees typically amount to around $2 a year for every $1,000 invested.

Increasingly, the fees have become revenue substitutes for the growing number of funds that draw investors by touting the fact that they don’t charge loads. Funds charging loads compensate brokers and other sales-and-distribution middlemen through fees paid directly by individual investors.

Funds charging 12b-1s cover sales and distribution costs through ongoing fees that all investors pay as long as they’re in the fund. But funds can also use 12b-1s to cover everything from advertising, to sending out fund reports to investors, to record keeping and other long-term services. They can range as high as 0.75 percent of a fund’s assets per year.

Under the SEC proposal, funds would be allowed to charge a “marketing and service” fee of up to 0.25 percent.

Funds could still charge loads to individuals at the time of purchase or cover sales costs on an ongoing basis. But the total amount an investor pays would be capped after a set number of years, so that the total wouldn’t exceed the amount the investor would have paid had sales costs been covered upfront. For example, a fund that charges a 4 percent sales load could deduct no more than 4 percent over time from an investor not paying upfront.

Funds also would be required to disclose what percentage of their assets are being paid to brokers as ongoing sales charges, and separately list costs for marketing and other services.

The proposal would also do away with the 12b-1 name, a legacy of the SEC rule that allowed funds to begin charging the fees. The fees were created to help a then-struggling fund industry recover from tough times in the 1970s.

But use of the fee revenue has often strayed from the original intent because of the varied arrangements fund companies use to compensate brokers. For example, some funds continue to charge 12b-1s although they’re closed to new investors, meaning they no longer have to market themselves or cover expenses for taking on new clients.

The Investment Company Institute has warned that scrapping 12b-1s would eliminate incentives for advisers to continue serving clients, for example, by giving them investment advice. A 2005 study by ICI found that only 2 percent of 12b-1 fees supported advertising and other promotions. About 40 percent went to advisers for initial sales, with 52 percent for ongoing support.

ICI spokeswoman Ianthe Zabel on Wednesday said 12b-1s “play an important part in the overall economics of mutual fund investing.” The fees, she said, “have proven over time to be a highly efficient and tax-effective method” for covering fund costs.

Zabel said the ICI expects to comment later on the SEC’s proposed changes, with a goal of ensuring that they “benefit fund investors while maintaining the ability to appropriately compensate service providers for valuable services to shareholders.”