Business - Of Mutual Interest SEC: Out with 12b-1s, in with clear fund fees

By Mark Jewell AP Personal Finance Writer BOSTON (AP) -- If you're like most mutual fund investors, you don't have a firm understanding of the fees you're being charged. And you may justifiably worry that you're paying more than you should. Such anxiety may soon be eased for the most vexing type of fees that fund investors pay. They're called 12b-1 fees, and they can cover everything from compensation for brokers selling the fund, to advertising and promotions, to services like mailing quarterly fund disclosures. For starters, the Securities and Exchange Commission wants to do away with their clunky name, a legacy of the 30-year-old SEC rule that allowed funds to begin charging the fees. But that's the least of the changes that the SEC envisions. If it grants final approval after a 90-day public comment period, the rules will fundamentally change how investors buy funds. The key changes: -- Many long-term investors will no longer be stuck paying ongoing sales fees for decades, racking up higher costs bit by bit. This is critical, because now they can end up paying more than if they had paid an upfront sales charge, or "load," when they bought into the fund. --Brokers could begin to compete on pricing by charging lower fees, much as they now compete on stock trade commissions. --Fund disclosures will be required to separate out what investors are paying brokers as ongoing sales charges, and what they're paying for marketing and services. The proposed changes, SEC Chairman Mary Schapiro says, are intended to provide clarity and fairness to a mutual fund marketplace that has become "confusing and potentially anticompetitive." The five SEC commissioners voted unanimously last week in favor of 12b-1 changes recommended by the agency's staff. Schapiro isn't the first SEC chair to talk about overhauling 12b-1 fees. Some industry pros even find them confusing, because the fee revenue can be used in so many different ways beyond compensating brokers and other intermediaries like financial advisers. "These rules are a bold proposal that was long overdue," says Jay Baris, an attorney with the firm Kramer Levin Naftalis & Frankel, who represents investment professionals. It's been difficult to design a fee structure that will allow for plenty of mutual fund choices without being overly complex. Then there's the need to fairly compensate the brokers who help investors choose and buy funds. They're paid by the fund companies, which collect their own fees along with the broker commissions. This system was put into place in 1980, when the SEC devised a new way to compensate brokers by allowing funds to charge 12b-1 fees. Increasingly, the fees have become a key source of revenue for the growing number of funds that attract new investors by not charging upfront, one-time sales charges known as loads. Most funds charge 12b-1 fees, amounting to a total $9.5 billion last year. Even though some investors buy directly from fund companies without paying loads, most buy through intermediaries, such as brokers or financial advisers. The fees for the sale can be paid in a variety of ways, which are typically designated by the share class of the fund being purchased: Class A shares: Typically charge 3 to 5.75 percent of the amount to be invested upfront, and assess lower annual expenses and 12b-1 fees. Class B shares: Usually allow investors to avoid paying upfront fees. Expenses are covered through a combination of 12b-1 fees and a back-end load. That's a sales fee that becomes due if you sell before a specified number of years, typically six or seven. If you stick around that long, your shares may convert to a class charging lower expenses. Class C shares: Generally don't charge upfront, but assess higher 12b-1 and overall fees. Typically, an investor's C shares won't be converted to a cheaper share class after a specified number of years. The SEC's proposal targets C shares because they tend to be the most costly for long-term investors, who can end up paying high 12b-1 fees year after year, sometimes for decades. The SEC says those shareholders end up subsidizing the sales costs of short-termers who sell their C shares within a few years, and don't shoulder their fair share of commissions. To address that, the SEC proposes capping ongoing sales charges so that the total paid over the years won't exceed the amount investors could have paid had they chosen to pay upfront. For example, a fund that charges a 4 percent sales load could deduct no more than 4 percent over the years from an investor not paying upfront. The SEC also wants to let brokers compete on pricing, rather than being stuck with the commission that the fund company sets for them. Brokers could offer varying levels of service, geared toward fee levels. It's been that way since the mid-1970s for stock purchase commissions. "You can go to electronic brokers now, and pay very little," Baris notes. "But if you want more service, you go to a full-service broker. And that's essentially what the SEC is proposing here for funds." Another key component of the SEC's proposal: Requiring funds to clearly show investors the ongoing sales charges they may be paying, and separate them from fees covering marketing and shareholder services. Disclosures must include totals for "ongoing sales charges" and any "marketing and service" fees. The SEC also wants to cap marketing and service fees to 0.25 percent of the fund's assets per year. Anything above that amount would be considered a sales charge. If the changes are to truly benefit investors, shareholders will need to pay closer attention to the sales fees that erode returns year after year. "I don't even think many people know what a 12b-1 fee is," says Kristina Fausti, director of legal and regulatory affairs with Fiduciary360, a firm that advises financial professionals. "Now, I think people will start asking more questions than they have in the past." Published: Mon, Aug 2, 2010

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