fees will go on and on

Let’s face it.  Very few people have a clue how much money gets deducted from their mutual funds and then used to pay sales, marketing and service expenses.  These ongoing, “hidden” deductions are above and beyond management fees that also reduce investors’ returns.  And these fees can be in excess of the out-of-pocket, front-end sales load or deferred sales charge. Depending upon the “class” of a fund an investor is sold, these fees vary significantly.

Each mutual fund prospectus discloses the percentages of these deductions. But disclosure is not transparency.  One problem is that the name given to the sales-marketing-distribution-service charges refers to the SEC rule that created them 30 years ago — the “12b-1” fee. Very, very few investors know that 12b-1 fees exist, nor what they are used for.

Here’s one example. If you purchase fund shares through a broker or investment adviser who charges you an annual account fee of 1 ½ % or perhaps no account fee at all, you might not know that the adviser is also earning another ¾% per year on the mutual funds he suggested you purchase years ago.  Some investors believe that their brokers charge no fees at all. According to columnist, Bill Schmick:

“I’ve heard those words countless times before. I said nothing but took a copy of his statements to review. After analyzing his portfolio, I discovered that not only had he paid that broker $16,000 in sales charges (called loads) but he was also paying $5,000 a year in 12(b)-1 fees. He was dumbfounded, although I quickly explained that many mutual fund investors were in the same set of circumstances.”

This anonymous investor is not alone. According to SEC Chair, Mary Schapiro, investors unwittingly paid a total of $13 billion of these “hidden” fees in 2007 and about $12 billion and $9.5 billion in 2008 and 2009 respectively.

What we don’t know can hurt us. As New York Times writer, Jeff Sommer, explained:

“[o]ver a lifetime, expenses can have a devastating effect. Just 1 percent annually will eat away more than 40 percent of your nest egg over 60 years. That steady drain might well sink you.”

The good news is that the SEC announced in July that it hopes to patch the slow leak. The agency has issued a rule proposal for which comments are due in early November. I wrote about this in Mutual Fund Distribution Fee Reform over at the Race to the Bottom blog – click on the following numbers for parts 1, 2, 3, and 4. For another overview, see this K&L Gates memo.

After posting that piece, I took a peek at the comment letters that have been submitted to date. I was curious what the defenders of the status quo would have to say. Many investment advisers were unhappy that the SEC planned to limit ongoing “administrative and service” fees to 25 basis points (1/4 of a percent). Many were accustomed to having the fund operator deduct from their clients’ mutual fund, a full 1 percent of assets and quietly passing that along to them. For these investment advisers losing access to 75 basis points (3/4 of percent) was very troubling.

Keep in mind that a separate “ongoing sales charge” is still permitted. But under the new rule it could max out fairly quickly. So, the only fee that goes on and on and on will be the 25 basis points “administrative and sales fee.”

These professionals claimed that they needed those extra 75 basis points on an ongoing basis to provide services to clients who need hand holding when markets get turbulent and who need their accounts and investment choices closely monitored. For example one advisor wrote:

“12b1 fees are the only means for brokers to be compensated for ongoing service and advice given to clients on smaller accounts belonging to individuals that do not have the resources required to pay hourly rates for advice and service.”

And another person told the SEC:

“I am opposed to your amendments of 12B-1 fees. Investment Advisors need to be compensated for ongoing service to mutual fund shareholders. Would you expect a yard service to plant grass in your yard and come back and mow it forever without compensation?”

It seems reasonable to be paid for advice and service. However, why not be open and honest about those fees? It was startling to read comment letters in which these fiduciaries actually claimed that if they charged the fee directly it would be too much for their less affluent customers to afford or the customers would object. Really? Why wasn’t it too much when the fee was hidden?

What was also astonishing, was the comment that if they could not openly charge this to clients (either because they would balk at paying hourly rates for services or because they might not qualify for an account that charged directly 1 – 2% on all assets), many advisers would take drastic measures. If they did not drop small account clients, they suggested some would have to churn accounts so as to be able to collect upfront sales loads. For example, one advisor who was not alone in this sentiment wrote:

“BE CAREFUL. If you eliminate or curtail the 12b-1 fees, advisors will start “moving” money around so as to get paid again.”

Wow. With fiduciaries like that, who needs fraudsters.

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Tags: 12b-1, fees, mutual funds, SEC