Paper Cut to Death with 12b-1 Fees

September 3, 2010 at 1:21 am Leave a comment

Paying all these 12b-1 fees and other expenses found in the small-print can be a lot like getting paper-cut to death.  The Securities and Exchange Commission (SEC) is looking to put a Band-Aid on the problem by capping these nonsensical fees and proposing more disclosure, albeit three decades after these fees initially got introduced. According to InvestmentNews, the SEC has proposed a .25 percent cap on 12b-1 fees, which may save investors upwards of $857 million per year if the proposal is enacted. That’s all good and great, but aren’t investors already getting pillaged and plundered with load expenses and other investment management fees?

The Original Rationale

The original thought process behind the 12b-1 fee movement was designed to allow the little guys (small fund management companies) to compete on an even playing field against the big guys (think of Fidelity, Vanguard, and the American Funds) when it came to product distribution. The SEC says about 2/3 of the 8,000 mutual funds in the industry charge 12b-1 fees, which reached over $13 billion in 2008. These 12b-1 fees generally account for 18% of the total annual fund expenses (ICI – Investment Company Institute).

Source: ICI. The general trend in 12b-1 fees was upwards until the financial crisis hit.

 So are small fund management companies truly benefitting from the customer kickbacks after 12b1-fees were unveiled in 1980? It appears the small fry fund companies have indeed scraped up some extra fees as ammo to market products against the big guys, but the big guys are receiving the same 12b-1 fees. It’s like giving both me and Alex Rodriguez (New York Yankees) an aluminum bat in the game of baseball. There’s  a good chance I may be able to clear the infield now, but A-Rod will instantly have the power to hit one out of the stadium – I have effectively gained no advantage with my new metal bat.

The Investor Perspective

If I’m an investor, what do I care if my mutual fund company has one investor or one million investors? I just want the best products at the lowest price. Yeah, there are these special items used in other industries that help pay for marketing and distribution expenses…they’re called sales and profits. What a novel idea. 

Deciphering all the mutual fund class flavors is tough enough. Like trading in a used car when buying a new car, the juggling of prices, fees, and taxes can become a head-spinning exercise in discovering the true component costs. The cards become even more stacked against investors, if you consider alternative products like the shady world of annuities (see Annuity Trap article).  If translating 12b-1 and load fees is not challenging enough for you, try digesting a slice of legalese heaven by examining this 259 page annuity prospectus gem.

The Flawed Structure

Unfortunately, the financial industry is rife with conflicts and opacity, with the investor getting the short end of the stick. The industry’s main incentive is all about generating commissions for the broker (salesman) and financial institution – not about generating the best return for the client. Here is how I see a typical conversation playing out between a broker and prospect:

Broker A:  “This is a slam dunk investment with guaranteed returns.”

Prospect XYZ:  “Wow, that sounds great – guaranteed returns in a world that everyone is talking double-dip. How do I learn more?”

Broker A:  “You can sign here on the dotted line, or borrow this forklift and take two months to review this gargantuan 259 page prospectus that I don’t even understand.”

Prospect XYZ: “If I have questions about 12b-1 fees, administrative fees, up-front commissions, management fees, mortality charges, trail expenses, or other costs, can I give you call?”

Broker A: “Oh sure, but I’ll probably be in the Bahamas drinking umbrella-coconut drinks with all the commission dollars I’ve earned, so if I don’t answer, just leave a message.” 

Why do 12b-1 Fees Exist at All?

OK, now that I’ve returned from my annuity rant, let’s get back to the pointless value of 12b-1 fees. I mean honestly, what privileged status does the financial industry have in charging customers for a business’s operating expenses? Why stop at charging customers for marketing and distribution costs…maybe customers can start paying for new fund development expenses or for employee health benefits? What’s more, if the financial industry is going to nickel and dime clients with all kinds of fees, then why not have customers subsidize the marketing and advertising campaigns in other industries, like in the pharmaceutical, tobacco, beer, and junk food industries?

Not all 12b-1 fees are created equally. Many funds do not even carry 12b-1 fees, or many that do carry a much more modest punch. While I respect Mary Shapiro’s courage in addressing the useless 30-year 12b-1 fee structure institutionalized by industry lobbyists, putting a Band-Aid on this paper-cut is only hiding the wound, not healing it.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and mutual funds, including Vanguard and Fidelity, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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