Mutual Fund Distribution Fee Reform, Part III

The July rule proposal sets out to eliminate the old regime, governed under Rule 12b-1.  Rule 12b-1  became effective thirty years ago. Prior to 1980, investors were only charged “up front,” upon buying shares. This sales load could be used to compensate brokers and also pay for advertisements run by the fund family, for example. In 1975, the NASD set a 8.5% limit on sales loads. No-load funds charged no sales loads, so advertising and other distribution expenses were paid for by the fund adviser.

Thus, before 1980, fund advisers were not permitted to take money out of the fund assets to support marketing and sales expenses.

A business problem arose for fund advisers. Redemptions of shares outpaced investments. So, paying other brokers to more aggressively sell funds was necessary. For those funds that held themselves out to be "no loads," this would mean the adviser would have to pay more. So, many such fund advisers sought permission to take money from the fund to pay for advertisements and compensate sales forces for peddling shares. The 12b-1 rule was supposed to be a “short term solution” to a problem funds faced. The rationale was to support a struggling industry and thereby help investors. According to Chair Mary Schapiro back then:

“funds were losing investor assets faster than they were attracting new assets. And, self-distributed funds were emerging, in search of ways to pay for necessary marketing expenses.

“At the time, it was thought that investors would benefit if a fund could 'grow' by using some of its own assets to market itself and make distribution payments. This, it was believed, would result in improved economies of scale and, ultimately, lower expenses.”

However, over the past thirty years, the industry evolved, but the rules did not.  Indeed, shortly after the rule’s creation came another Congressional-assist for the industry. The creation of the tax-deferred 401k retirement plan transformed the industry. Mutual fund assets rocketed on a parallel course with the growth of these plans. This is documented in an early piece, “It’s a Wonderful Lie: Mutual Fund Advocacy for Shareholders’ Rights, Part I”:

“The growth and power of mutual funds corresponds closely to the initiation of the 401(k) and other defined contribution retirement plans. Since the launch of these vehicles, the percentage of U.S. household assets held in mutual funds has increased from 2.7% to 22%. As of year-end 2006, there were $2.7 trillion in 401(k) plan assets, 51.9% of which were invested in equity mutual funds. This is up from just $385 billion in 1990. Additionally, mutual funds of all types, account for 53% of the 403(b) market. Presently, nearly two-thirds of fund investors invest through employer-sponsored retirement plans.”

As assets grew, so did both the total amount of 12b-1 fees and the uses of these fees. Schapiro noted:

“[T]these fees evolved from payment for advertising and marketing to an alternate form of compensation—or sales load—paid to intermediaries selling fund shares. In addition, 12b-1 fees compensate broker-dealers and other fund intermediaries for ongoing marketing and related services including recordkeeping, transfer agency services and overall investor education and consultation . . .

“In essence, 12b-1 fees have become a means to pay broker-dealers and mutual fund intermediaries indirectly out of fund assets, rather than directly out of the investor's pocket. And as the use of 12b-1 fees has evolved, the aggregate dollars paid have ballooned. These fees amounted to $9.5 billion in 2009, nearly $12 billion in 2008 and exceeded $13 billion in 2007—compared to just a few million dollars in 1980 when they were first permitted.”

Beyond the sheer volume of fees, a concern of the agency is investor confusion. Or worse. Many simply do not even know they exist, notwithstanding the prospectus disclosure.