Speaking at the Mutual Fund Directors Forum on Friday, SEC Chairman Christopher Cox cautioned that the rationale underlying 12b-1 fees had long outlived its intended purpose – and said that the SEC was undertaking a broad initiative focused on the industry’s fee disclosures to 401(k) participants.
Noting that when the SEC adopted 12b-1 “…our premise was that 12b-1 plans would be relatively short lived”, Cox recalled “…a very real concern that if funds were not permitted to use at least a small portion of their assets to facilitate distribution, many of them might not survive.”
In fact, Cox said that in 1980 the SEC thought that requiring current investors to subsidize the sale of fund shares to new investors “…could be a good thing – even from the standpoint of the current investors – because increasing overall fund size could help better diversify their holdings, and also proportionally reduce the burden of administrative costs that might now be spread over a wider pool of investors”.
Sales Load in Drag
Cox noted that “very quickly, however,” the 12b-1 fees became a substitute for front-end loads,” describing that transformation as turning those fees – some $11 billion last year – into a “sales load in drag.’
“Now, with nearly three decades of experience under our belts – and with today’s uses of 12b-1 fees barely recognizable in the light of the rule’s original purpose – it is high time for a thorough re-evaluation,’ Cox said – and he challenged the independent mutual fund directors in the audience “to take a fresh look at the way this use of investors’ funds has evolved’.
Specifically since, as Cox noted, the 12b-1 fee must be approved each year – and that it “may be terminated at any time by vote of a majority of the independent directors.’
In prepared remarks, Cox specifically cited the use of 12b-1 fees to pay for administrative expenses in connection with existing shareholders as an example of how they had “veered away from their conceptual basis as distribution subsidies.’ Moreover, he noted the example of funds that were closed to new investors, but that continued to collect 12b-1 fees.
As for how this had evolved, Cox said, “If the size of the fund is increasing, but the expense ratio isn’t falling, then using a 12b-1 fee for marketing and distribution expenses is very likely harming, not helping, the current investors,’ he said. Moreover, Cox said that collecting an annual fee from investors that is supposed to be used for marketing is “no more consumer friendly than forcing cable TV subscribers to pay a special fee of $250 a year so the cable company can advertise HBO and Showtime to lure potential new customers.’
Not surprisingly, Cox said that Rule 12b-1 is an issue the SEC plans to address this year.
Cox also cited a “broad initiative” to examine the adequacy of investor disclosures by mutual funds and other investment vehicles in a typical 401(k) plan. “With an emphasis on both the disclosures by the constituent investments in the 401(k), and the aggregate disclosures by the plan, we aim to make it far easier for busy Americans to understand the expenses they’re being charged in connection with their investments,’ he said.
Acknowledging that this would require collaboration with the Department of Labor and other investment regulators, he said “we’re confident we can achieve a great deal in the coming months – and that the effort is supremely worthwhile, given what’s at stake.’ Cox said the coming months would include roundtable discussions with the nation’s leading experts, a concept paper outlining the issues and solutions, and a formal rule proposal later this year.
Additionally, Cox said the SEC would be examining the various disclosures that 401(k) participants receive – and continue working to “purge all of the legalese from these disclosures.’
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