Broker Fees Decline as New SEC Rules Approach

The costs to invest in certain broker-sold mutual funds have started to come down in anticipation of new regulations taking effect in July.

The rules will limit what fund companies can impose in the form of 12b-1 fees and “service fees.” They also tighten the definition of which portfolios can be described as “no-loads” by brokers.

A main purpose of the regulations is to rein in “asset-based sales charges,” or 12b-1 fees. Originally, 12b-1 fees were intended to help no-load companies promote their products, under the rationale that larger funds would be more cost-efficient, to the benefit of investors.

But increasingly, the fees have been levied by load groups merely as a less-obvious way to compensate brokers.

“This establishes a tighter limit than has been the practice,” says Erick Kanter, a vice president at the Investment Company Institute, the Washington-based trade group for the fund industry. “It’s a positive step forward in limiting what can be charged.”

The regulations, proposed by the National Assn. of Securities Dealers, were approved by the Securities and Exchange Commission last July.

From the standpoint of shareholders, the most noticeable effect is that 12b-1 fees will be capped at 0.75% a year, or $7.50 for every $1,000 investment. Funds can now extract as much as 1.25% annually in this manner. About half of all funds charge 12b-1 fees.

Some groups have already started to shave their 12b-1 expenses, either in anticipation of the new rules or because of competitive pressures.

“This not only brings us into compliance with the new regulations but also is more equitable for shareholders,” says Bill Chapman, who, as executive vice president at Kemper Financial Services, heads the company’s marketing department.

Kemper has been able to retain a higher percentage of investors after it decided to cut 12b-1 fees from 1% to 0.75% in 1991, Chapman says.

The problem with 12b-1 fees is that they’re ongoing. The higher the charge, the greater the possibility that investors could wind up paying more over the years than if they simply forked over 8.5%, the maximum allowable front-end load.

Many groups also impose back-end loads to discourage near-term withdrawals on funds carrying 12b-1 fees. Back-end charges typically phase out after three to six years.

The new regulations attempt to ensure that investors don’t pay more in 12b-1 fees than the “economic equivalent” of 8.5%, adjusted for the time value of money.

However, there’s no guarantee that people won’t pay more than 8.5%--either in absolute dollars or in time value-adjusted dollars.

“This is an attempt to achieve rough justice,” says Richard A. Silver, a senior vice president at Colonial Management Associates in Boston and controller of the group’s mutual funds.

“Most shareholders wouldn’t pay more than the equivalent maximum front-end load, although it’s possible some long-term investors would,” says Silver, who also heads an accounting committee for the institute.

If you were in a portfolio with an ongoing 12b-1 fee, you would continue to pay this expense as long as you remained invested and the fund continued to charge it.

Depending on the level of new sales and other factors, a fund that levies a 12b-1 fee could continue to collect this charge for perhaps 15 to 25 years or more, according to some sample projections developed by Silver.

The typical fund shareholder stays in only five years or so, says Kanter. As a rough rule of thumb, cumulative 12b-1 expenses would tend to exceed the economic equivalent of an 8.5% load after 10 to 12 years, he says.

If there is a possibility you might pay more than 8.5%, the fund must disclose this information in the prospectus, near the fee table, says Elliott R. Curzon, a senior attorney for the National Assn. of Securities Dealers.

Service fees, by contrast, are limited to 0.25% a year, payable to the broker or financial planner who handles your account. The new rules clearly distinguish these fees from asset-based sales charges.

So what sort of service should you expect to get in return?

“First and foremost, the broker should be able to answer any questions you have on investments and provide you with information updates,” Chapman says.

The service fee should also encourage a broker to keep in touch with you over the years and to place you in funds with solid, long-term potential, Kanter says.

Another part of the new regulations prohibits brokers from describing funds with 12b-1 fees greater than 0.25% a year as being no-load portfolios--either verbally or in writing.

Brokers who break this rule will be subject to NASD disciplinary action, which could range from a fine or suspension to expulsion from the industry, Curzon says.

Fund Fee Rules at a Glance New regulations governing mutual fund charges and expenses, which take effect in July, can be summarized as follows: Funds can’t charge more than 0.75% a year in 12b-1 fees, down from the current maximum of 1.25%. Funds can’t charge more than 0.25% a year in “service fees.” Brokers and financial planners can no longer describe funds as “no load” if they carry 12b-1 fees in excess of 0.25% a year. If a fund has an “asset-based sales charge” such as a 12b-1 fee, its combined sales charges cannot exceed 7.25%. If it also imposes a service fee, sales charges are limited to 6.25%. Otherwise, a load of up to 8.5% may still be allowed.