Clear as Mud
by Tom Cock
President, Aging Options Financial Services
Clear as Mud
With almost any product, transparency benefits consumers. Clarity means better understanding and fewer surprises. This is particularly true in the investment business. The more you know about an investment vehicle, the more informed your decision.
For some in the financial services industry, transparency not only benefits clients, it also creates a bond of trust between the investment advisor and client that can lead to long-term, mutually beneficial relationships. For many others, the less you know about the product being sold the better.
This has been particularly evident in the commissioned mutual fund business. Prior to the 1970s (which just happens to coincide with the emergence of the first no-load funds from Vanguard), mutual funds were offered to investors with exorbitant initial sales charges (called “loads”). These sales loads instantly deprived investors of, typically, 8.5% of the money they invested.
With growing competition from funds that allowed you to buy directly from the fund, without expensive “middleman,” traditional mutual fund companies (and the brokerage industry which supported them) started scrambling to find a way to compete with these no-load “upstarts.”
They started by reducing the “front end load” from 8.5% to 5% or 6%.
Even then, no-load funds remained much more attractive.
The industry then turned to the Securities and Exchange Commission
(SEC) for help. It was provided in the form of a new rule, rule 12b-1, that allowed mutual fund companies to add an extra fee to pay for “marketing.” This new 12b-1 fee allowed stockbrokers and insurance agents to continue selling funds that paid them a hefty commission without the customer noticing an instant decline in the value of their portfolio. Instead of chopping off a big chunk of change to pay the salespeople, mutual funds went ahead and paid the commission upfront and then, slowly, carved out a bit of extra money every year to replenish those advanced monies.
These neatly hidden commissions were rarely mentioned to customers by those selling the funds. In fact, brokers and insurance agents were, and are, quietly encouraged to make it seem that the client is buying a no-load mutual fund. After all, how many people actually read prospectuses? And of those, how many understand what they read? Even a former chairman of the SEC referred to 12b-1 fees as “sales loads in drag.”
Now, the SEC has finally decided to make some changes to these sneaky, hidden fees. Under proposed rules, the fees would remain, they would just get new names to make their purpose a bit clearer. The portion of the fee that actually went to marketing the fund would be shown as such. The larger part of the fee, used to pay commissions, would be shown as an “ongoing sales charge.”
This minor tweaking of the terminology (attempting to help consumers better understand their purposes) may seem relatively benign, but it has the mutual fund industry and brokerage firms up in arms, as their ability to either keep you in the dark or outright lie to you is being threatened, which imperils their potential income.
The new 12b-1 fee rules would would allow no more than a 0.25% fee for “marketing” efforts. Any part of the old 12b-1 fee that exceeds that amount would have to be shown as a “sales charge” in the prospectus and would also be listed as such on the purchase confirmation that clients receive. In other words, an investor might actually know how much they’re paying in the form of a hidden commission.
It seems that the commissioned mutual fund sales industry is worried that, once you realize that you have been paying almost $10 billion per year in sales commissions, you might decide that you would be better off using true no-load funds to build your investment portfolio. With that kind of money at stake, you can see why they might want to keep these investments as “clear as mud.”