News, Vision & Voice for the Advisory Community


How the new 12b(1) fee restrictions could transform the financial advisory industry

Brokers selling 401(k) plans may have another nail driven into their coffin

Thursday, July 22, 2010 – 3:56 AM by Elizabeth MacBride
no description available
Jim Sotell: Fees that were hidden are coming to the surface. That will put RIAs on a more level playing field with brokers in the retirement plan business.

A new SEC proposal to cap, rename and force disclosure of infamous 12b(1) fees looks to be another gift to the fee-based world of advisors and another nail in the coffin of the commission-based brokerage business model.

The proposal, which is entering a 90-day comment period and is likely to be the subject of a tsunami of lobbying because the stakes are so high, caps the amount of fees that mutual fund companies can collect from their clients and use to compensate brokers who sell their funds.

The change could push more brokers to embrace the advisory business model, in order to be able to replace 12b(1) fees with AUM fees. It could put advisors on more of a level playing field with brokers in the 401(k) advice businesses – and might, at the same time, put many smaller retirement plans under strain.

The key details of the proposal are these:

The proposal limits the amount of asset-based sales charges that individual investors pay. The proposal would restrict “ongoing sales charges” to the highest fee charged by the fund for shares that have no ongoing sales charge. For example, if one class of the fund charges a 4% front-end sales charge, another class could not charge more than 4% cumulatively to investors over time. The fund would keep track of how long investors have been paying ongoing sales charges.

Separately, funds could continue to pay 0.25 percent per year out of their assets for distribution as “marketing and service” fees, for expenses such as advertising, sales compensation and services.

To read the rest of the SEC’s fact sheet about the proposal, go here.

Investor advocates were generally thrilled by the proposal.

“Based on our understanding of the proposal, we think it is a very positive step for investors,” said Barbara Roper, director of investor protection for the Consumer Federation of America. “It appears to take a reasonable approach that preserves the 25-basis-point administrative fee while applying appropriate limits to the portion of the 12b-1 fees used primarily to compensate brokers. If it is adopted and appropriately implemented, investors should get the best of both worlds, the choice of an incremental sales charge but without the risk of paying compensation fees above the legal limit.”

I talked to four experts in the RIA world to look more deeply into how this potentially transformative shift could play out. Here’s what I learned.

The impact in the 401(k) world

Jim Sotell, managing director of Comperio Retirement Consulting Inc., a Chapel Hill-based firm with $500 million of retirement assets under advisement, says he believes the change, combined with new rules from the Department of Labor calling for more disclosure, will ultimately play out to advisors’ advantage. See One down, two to go: Trio of important DOL regs reshapes 401(k) advice business.

The chief advantage of 12b(1) fees for brokers has always been that they were hidden – investors didn’t notice them or understand them if they did. By limiting the amount that can be charged via mutual fund accounts, the SEC is forcing retirement plans to find other ways to pay for plan services. Those other ways are likely to be out in the open.

RIA fees have always been out in the open – and RIAs have often been forced to justify them.

Now “everything is coming to the surface,” he says. “RIAs stand a good chance of benefiting.”

Some retirement plan sponsors may be in for a rude awakening as the fees come to the light of day. Sotell said he’s aware, for instance, a $20 million plan that a broker was charging $100,000 a year to advise on.

He said the most profound affects will be in the market of retirement plans of under $10 million. Those plans typically must pay brokers and advisors more than 25 basis points to manage the plans to convince brokers to take on the accounts.

Sotell added that he believes more 401(k) advisors – both RIAs and not – will eventually adopt a flat-fee system for advising retirement plans. His firm uses one.

Pushing more brokers to consider the advisory model

Ron Rhoades, RIABiz’s One-Man Think Tank columnist, sent us his thoughts on the implications of the rule change.

1. This will transform the existing business model of many brokerage firms, who came to rely upon the 1% (0.75% plus 0.25% combined) 12b-1 fees to pay compensation for their registered representatives.

2. Unless a similar rule is enacted for variable annuity trails, a lot of registered representatives will seek to sell VAs, instead, despite their generally higher costs of often-disadvantageous tax consequences to investors.

3. Mutual funds and/or brokerage firms will have to adopt systems to ensure that fees charged over time don’t exceed the maximums permitted.

4. One result which may occur is the acceleration of the move toward dual registration (as RRs/IARs) by registered representatives. Many registered representatives will become dually registered, and as investment adviser representatives they will begin charging AUM fees for managing a mutual fund portfolio for a client, rather than rely on the old 12b-1 fees to provide ongoing compensation.

5. If more “product sellers” become transformed into “purchaser’s representatives” – as BDs move to the RIA platform – then increased downward pressure on mutual fund fees will result. Not just “disclosed fees” reflected in the fund’s annual expense ratio, but also “hidden fees” resulting from transactions within the fund. Pressure would increase to abandon soft dollar compensation arrangements, limit portfolio turnover, and pay more attention to methods to control transaction costs within stock and bond funds. This would, in turn, likely lead to some further consolidation in the mutual fund industry. Additionally, since new funds rarely pass the due diligence tests performed by investment advisers, the barrier to entry for new funds (or new fund companies) may well increase, as well.

6. There is the possibility that, as asset-based fee payments end (at the end of the five-year period, or due to the maximum sales load amount being reached), that a broker-dealer and its registered representatives could engage in churning of mutual funds, by recommending to customers that they sell funds as the fund approaches the end of the fee payment period and purchasing new funds (thereby commencing a new up-to-five-year fee payment period). Rules will have to be adopted to prohibit such practice, and vigorous enforcement will be required. I continue to see this problem exist in the broker-dealer community, given the strong economic incentives present to generate a new commission (or ongoing sales charges, in this instance), rather than see a revenue stream disappear. Problems persist with both Class A mutual fund shares, Class B mutual fund shares (although they are now sold rarely), as well as with certain variable annuities.

7. In summary, this Proposed Rule could be transformational, as to both the broker-dealer industry and the mutual fund industry. But much will depend on subsequent SEC rule-making, especially as to when fiduciary duties are to be applied to BDs and the scope of the Advisers Act, generally. Future rules from the SEC could well diminish, or enhance, the ultimate impact of the significant proposals advanced by the Commissioners today.

The case of Edward Jones

Edward Jones is often cited as a brokerage that depends heavily on 12b(1) fees.

But when I called the company, Brett Campbell, principal, client solutions group for the St. Louis-based brokerage, laid out a powerful case for why the company doesn’t fear the proposal.

In fact, he said, “We like what we see. We think that the transparency and the disclosure is good.”

He said the firm’s 12b(1) revenue stream comes mostly from its sales of Class A mutual fund shares, which typically have a 25-basis point fee.
Under the new proposal, that is still permitted.

He said 90% of 90% of the its mutual fund shares sold have been Class A shares, with the remaining 10% split approximately equally between Class B and Class C shares.

“Firms that have relied on a C-share revenue stream may be more affected,” he said.

The law of unintended consequences (or is this one intended?)

David Hou, partner in Los Angeles-based Luminous Capital, which has $3.5 billion in AUM, spoke up for the trustworthy brokers of the world, saying the change could unfairly take away their revenue stream. And while the former Merrill Lynch advisor agrees that the shift may incentivize people to become RIAs “not everybody should be RIAs,” he said. He points out how difficult the RIA business is. For more on Hou’s epic move from top Merrill broker to top RIA, see: Merrill Lynch stars take a leap of faith to a new office — and independence.

He also pointed out a particularly interesting implication of the proposed change from the tax law standpoint. Hou often sees new clients with Class C shares in their portfolios. There are a variety of possible explanations – unscrupulous brokers and unnoticing clients, or clients who didn’t mind compensating a broker in that fashion. There’s one more: for high-income investors, there is a tax advantage to C shares vs. advisory fees.

An investor who pays 1% via a 12b(1) fee will never be taxed on that 1%. But, because advisors’ fees are not tax deductible, switching to a fee-based compensation system may well cost some investors a hidden tax break.

It’s more investors than you might think, says Harvey Bookstein, a partner with Los Angeles-based accounting firm RBZ, because investors subject to the AMT also cannot deduct advisory fees.

“Ninety percent of my clients fall under the AMT,” he said. “This is just another example of the government raising taxes without raising the rate.”

Related Moves

Oisín's Bits: Wealthfront drops old mission statement, declares war on institutions and emphasizes banking future • Seeking Utah charter, Edward Jones may become largest bank in US by branch count • After Advent chief leaves, Black Diamond head steps up

Andy Rachleff cans the old 'democratizing' mission statement at his robo; The 14,200 one-man Ed Jones branches may become branch banks; Steve Leivent consolidates power at SS&C.

July 3, 2020 – 1:12 AM

Chris Jalonen

Chris Jalonen

July 22, 2010 — 7:39 PM

Does anyone know if the pending and proposed changes to C share 12b-1 fees will affect existing shares that were already sold, (and the 12b-1 fees currently being paid to brokers, or if this proposal will affect new investments going forward?

Jeff Spears

Jeff Spears

July 22, 2010 — 1:22 PM

While this rule change will definitely hurt traditional B/Ds it will have a greater impact on dual registered “independent” wealth advisors. The people who are complaining the most are the people that have been bilking their clients with these hidden fees. This is a much needed and good rule change in my opinion.

Ron Rhoades

Ron Rhoades

July 22, 2010 — 6:32 PM

Jeff’s good comment, about the “weak rationalization” that “12 (b) 1 fees … allow [BD] firms to provide advice to smaller investors” – is interesting. Permit me to add some additional thoughts to this discussion:

First, I would posit my view that if ongoing financial planning or invesmtent advice is provided in return for an ongoing 12b-1 fee, as 12b-1 fees currently permit, then the 12b-1 fee is really an “investment advisory fee in drag” – and “special compensation” (which makes the broker-dealer exclusion from the definition of investment adviser inapplicable).

Second, I have heard and read repeatedly that “small investors” cannot be served by RIAs. Yet, $20,000 to invest, in a Class A mutual fund, usually results in a 5% or greater sales charge. For the $1,000 the investor would pay in a sales load, there are many RIAs who would prepare an investment policy and recommend specific low-cost investments for such a fee. And, if ongoing advice is requested, such as might occur with a 1% ongoing fee, there are many RIAs which charge hourly fees, who would be willing to provide a few hours of guidance for $200 a year. Not all RIAs are “wealth managers” – there are many good independent RIAs out there who serve small investors – and there will be many more in the years ahead.

Third, most prospective clients to our firm, who were served by B-D firms before, possess mutual funds with 12b-1 fees – yet were not aware of the fee, nor of the fact that their B-D (and the registered representative) were likely compensated by same. The real issue is that all fees and costs must be AFFIRMATIVELY and REPEATEDLY disclosed. And investors seeking guidance will need to get used to paying disclosed fees.

Fourth, in our due diligence analysis of mutual funds, we reject any fund that charges a 12b-1 fee, of any amount. We have never seen the shareholders of a fund benefit from any 12b-1 fee. In theory (but not in practice), mutual fund boards should ensure that 12b-1 fees paid for administrative expenses result in an expense reduction of the same amount (or greater) paid directly out of the fund – but this does not occur. For similar reasons, we reject the use of any mutual fund which makes payments in the form of soft dollars. As we move from a “sell side” securities industry to “buy side” financial intermediaries, more pressure will be put on mutual funds (by advisors) to abandon all 12b-1 fees, and all payment of soft dollar compensation. It will take time for the “market” to work in this fashion.

Brooke Southall

Brooke Southall

July 22, 2010 — 2:01 PM

Hi Jeff,

This seems like an important point.

Maybe you can explain in more detail why hybrid independents are the ones who are most likely to use C shares intensively — and why brokers at traditional BDs are not?

thank you,


Jeff Spears

Jeff Spears

July 22, 2010 — 2:14 PM

B/D’s definitely sell C shares and this will impact their business. My opinion is that it will have a much larger impact on the smaller wealth managers that are dual registered than it will on the LARGE B/Ds.

The objections I read about the 12 (b) 1 fees and how they allow firms to provide advice to smaller investors just strike me as a weak rationalization. Fees are a zero sum game.

Elmer Rich III

Elmer Rich III

July 1, 2011 — 3:27 PM

It is worthwhile looking at the experience in India with mutual funds when investors were asked to write two checks on a mutual fund purchase: – One for the fee for the fund – One for the investment

Mutual fund purchases didn’t just go down — they went to zero. Brain science and other advanced psychological sciences are teaching us that our brains will not pay today for long term benefits. Our brains, along with all animals, are hyperbolic discounters of future benefits.

RIABiz Directory

The Industry Sourcebook for RIAs

   |    LISTING

RIABiz Directory sponsored by:

Directory Sponsor Logo