SEC ponders scrapping 12(b)1 fee

The Securities and Exchange Commission said Tuesday that it would look into eliminating a type of mutual fund fee that costs investors nearly $12 billion a year.

Agency officials said they also would consider just scaling back the so-called 12(b)1 fee or merely renaming it to better reflect what investors are being charged for.

“Everything is on the table,” SEC spokesman John Nester said.

Named after a section of federal securities law, 12(b)1 fees were authorized in 1980 to help a slumping mutual fund industry pay for advertising the sale of fund shares. The 12(b)1 fees average 0.25% of a shareholder’s fund assets each year -- enough to take a big chunk out of a portfolio over the long term.

A 12(b)1 fee is separate from a fund’s management expense ratio, which tends to be more prominently reported in fund literature than a 12(b)1 fee is.

The SEC’s thinking in sanctioning 12(b)1 fees was that if a fund company could lure more customers through advertising, economies of scale would generate cost savings and bring down the asset management fees that fund investors also pay. Under that scenario, all the investors who paid the 12(b)1 fee would eventually reap benefits from the marketing expenditure.

But 12(b)1 charges are in fact rarely used to pay for advertising. Instead, they mainly pay for commissions to financial advisors and for a fund’s administrative costs.

“When the [SEC] adopted rule 12(b)1 more than a quarter century ago, the idea was that 12(b)1 fees would be a temporary solution to address specific distribution problems as they arose,” SEC Chairman Christopher Cox said in a statement issued Tuesday. “It is time for a thorough reevaluation.”

The Investment Company Institute, the mutual fund industry’s primary trade group, says only 2% of 12(b)1 fees now pay for advertising and promotion. Forty percent are used to pay financial advisors who sell the funds, according to the institute. But not all investors paying the fees even use financial advisors.

“There is a disconnect. With any other service, you pay the person providing the service and you pay for the level of service that you receive,” said Andrew Gogerty, an analyst with Morningstar Inc., a mutual fund research service based in Chicago. “Here, investors pay the fee regardless of the level of service that they get from their financial advisor or broker.”

Indeed, investors even pay 12(b)1 fees on holdings in some funds that are closed to new investors -- and so don’t need to be marketed to new investors

A mere 0.25% annual fee may not sound like enough to make a fuss over, but it can cost a fortune over time. Let’s say you invest $100,000 in a stock fund that generates an annual return of 10% before 1% a year in management expenses are sliced off. If you also pay a 0.25% annual 12(b)1 fee and hold on to the fund for 30 years, the 12(b)1 fee would end up costing you $94,285 in fees and forgone earnings, according to the SEC’s mutual fund cost calculator. Notably, although many investors avoid funds that impose sales charges, or “loads,” on share purchases, you would be better off paying a 5% upfront load, instead of a 0.25% annual 12(b)1 fee.

The SEC said it would hold a round-table discussion next month to determine whether the fee had outlived its usefulness. The agency is soliciting written comments in the meantime. This is the first review of 12(b)1 fees since they were launched 27 years ago, agency officials said.

“What we are trying to do is bring 12(b)1 up as an issue, and gather information from a widely divergent group of constituents to figure out where there have been problems, where there are benefits,” said Andrew Donohue, director of the SEC’s division of investment management. “This rule has been chugging along for a while. It’s time we look at it and see if it needs a new engine, a tune-up or should be scrapped.”

The fund trade group has not taken a position on whether the rule should be changed, but it applauded the SEC for taking a look at it.

“We understand that the use of 12(b)1 fees has evolved and commend the SEC for taking a fresh look at the rule,” institute spokesman Edward Giltenan said. “We look forward to participating in that discussion in hope of helping investors better understand these fees and their role in providing fund services.”

kathy.kristof@latimes.com