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The Securities Exchange Commission (SEC), which is the financial services regulator for the US has proposed a complete overhaul to the way mutual funds pay financial advisors. I have very little working knowledge of the US financial services since I’ve only ever dealt with Canadian products (and the occasional off-shore stuff) but I’ve done my best to interpret the proposals and am presenting this as I think there are many readers who would find the proposals of interest. Here are the highlights:

NOTE: DO NOT CONFUSE THESE WITH CANADIAN MUTUAL FUND SHARE CLASSES!

Now

Class A Shares can charge up-front sales commissions between 6.25% and 8.5%. This means that if you give your advisor $10,000 and the sales charge is 8.5%, $9,250 shows up on your first statement as being invested in the fund. The 12b-1 fees, which are charged annually to cover “marketing and distribution” costs, tend to be lower than other classes. For Class A shares, it might be 0.25%/year. The investment management fee might be 0.50%. So after paying the up-front sales charge, the annual expense ratio might be 0.75% per year.

Class B Shares are “rear-loaded” meaning you pay a sales charge (perhaps 2-4%) if you redeem within a certain period of time (say, the first 5 years). The 12b-1 fees tend to be higher than Class A shares and might be 1.00% per year (the maximum allowed). (These 12b-1 fees can reduce after a number of years (8 as an example) down to the A Class level.) The investment management fee is the same as Class A (0.50%), so the annual expense ratio is 1.50% per year, and in this case drops down to 0.75% per year after 8 years. So the ongoing costs are higher than Class A initially, but there is no up-front sales charge deduction.

Class C Shares are also known as “level-loaded”. There are no up-front sales charges, and a small rear-load sales charge (perhaps 1%) for a shortened amount of time – typically 1 year. The 12b-1 fees are usually at the higher end of the spectrum, and in perpetuity, as an example we’ll say it is 0.75%. Again the investment management fee is still 0.50% per year so the annual expense ratio is always 1.25%.

You can see that each class has a sweet spot as to reducing overall costs to investors: Class A is best for very long term investors with lump sums as the ongoing costs are the lowest. Class B is better for long term, monthly contributors who don’t consistently get dinged with up-front sales charges. They pay higher ongoing costs on contributions for 8 years, but then pay a reduced ongoing cost thereafter. Class C is better suited to shorter-term investors as the ongoing costs are relatively high and remain relatively high indefinitely.

The 12b-1Fee is essentially an ongoing payment to advisors, similar to trailing commissions for Canadian mutual funds.

Proposed

Limiting of Sales Charges

12b-1 Fees get “scrapped”. A new term, the Marketing and Service Fee, would be used and is capped at 0.25% per year. Anything over and above this 0.25% cap would be called an “ongoing sales charge”, which is also limited in how long it can be charged and this length of time is based on the maximum sales charge offered by any class of the fund that has no “ongoing” sales charge.

For example, let’s look at the current Class A shares with a 6.25% up-front sales charge and a 12b-1 fee of 0.25%: since the 12b-1 fee is 0.25% this full amount would be called a Marketing and Service Fee and qualifies as having no “on-going sales charge”. The up-front sales charge of 6.25% is the maximum amount of sales charges that a fund can charge an investor on any dollar invested over the life of the investment no matter the share class. This means that for a C Class Share, it could only charge the 0.75% “old 12b-1 fee” for 12.5 years. Remember, of this “old 12b-1 fee” of 0.75%, 0.25% qualifies as the new Marketing and Distribution Fee and the balance qualifies as the “ongoing sales charge”. It is this ongoing sales charge that cannot exceed the maximum sales charge of any class offered over the life of the investment. So in this case, the 0.50% ongoing sales fee cannot exceed 6.25%.

Transparency of Fees

Additionally, all reporting documents (including transaction statements), would have to disclose the Sales and Marketing Fee and the Ongoing Sales Fee. Further, the purchase transaction confirmations would have to detail the total sales charge rate that an investor would pay.

Allow Broker-Dealers to Set Fund Sales Fees, Not Fund Companies

Right now, a fund company sets the sales loads and no matter where you buy it, the sales loads are the same. From above, if a fund company sets the up-front sales charge to be 6.25% it will be 6.25% no matter where you purchase it. The proposal is to allow Broker-Dealers to set these sales charges in order to foster competition. The best analogy I can think of is May Day (May 1st, 1975) when set commissions for stock transactions were eliminated and the first discount brokerages were allowed to set the commissions. In this case, the Broker-Dealers could change that 6.25% to 4.5% (and this would reflect the absolute maximum sales charge allowed for any share class of that fund through this particular firm).

Conclusion

I’m not sure… civil war? ;)