3 Reasons the SEC’s New 12(b)-1 Stance May Increase 401k Fiduciary Liability
Since 1980, mutual funds have deducted “12(b)-1” fees from fund assets for “marketing and promotional” purposes. In theory, as funds gather more assets, economies of scale kick in and the expense ratios decline. On the face of it, this theory appears validated by actual practice, so the concept of using 12(b)-1 fees to increase fund assets does have merit.
But over the years, the definition of “marketing and promotional” has evolved, say some detractors, to include administrative expenses. According to the Securities and Exchange Commission Chairman Mary Schapiro, “We must critically rethink how 12(b)-1 fees are used and whether they continue to be appropriate.” (“SEC pushes to reform mutual fund fees,” Reuters, December 3, 2009)
Published reports indicate 12(b)-1 fees generated more than $13 billion in 2008 with much of them used to compensate brokers, who, not surprisingly, have argued against eliminating them (“SEC to consider putting an end to 12(b)-1 fees,” Investment News, December 3, 2009).
Here are 3 reasons why 12(b)-1 reform might increase fiduciary liability for every 401k fiduciary:
- The SEC has now unequivocally stated 12(b)-1 fees represent a conflict of interest. Mary Shapiro told the Consumer Federation of America’s Annual Financial Services Conference these fees present a conflict “that may be causing the adviser or salesman to steer the investor to a certain investment.” Clearly, the SEC sees the conflict of interest on the part of the adviser. We can therefore conclude every fiduciary must also possess this awareness – whether they realize it or not – and thus also possess a liability exposure should the plan use funds that contain 12(b)-1 fees.
- The use of 12(b)-1 fees within 401k plans have declined over the years. Few plans still buy traditional load (i.e., commission) based funds. According to a recent industry report, (“The Economics of Providing 401(k) Plans: Services, Fees and Expenses, 2008” Investment Company Institute, August 2009) the use of 12(b)-1 fees in 401k plans has been going down. From 2006 through 2008, the number of 401k assets subject to 12(b)-1 fees declined from 36% to 29%. As the “safety in numbers” argument dissipates, the fiduciary exposure in plans utilizing 12(b)-1 fees increases.
- If you think this is bad, just imagine if you use annuities in your 401k plan. Mutual funds have expressed concern about an “unlevel playing field” should the SEC outlaw 12(b)-1 fees. They claim annuities don’t have the same requirements regarding fee disclosure. While this is presently true, it has nothing to do with 12(b)-1 fees. More so, Shapiro promises the SEC is also looking into adding disclosure requirements for annuities.
Is Shapiro just blowing smoke like her predecessor Christopher Cox, who also claimed the reform banner regarding 12(b)-1 fees? Time will tell. And so will competing priorities. It’s possible the SEC could retain the 12(b)-1 structure in exchange for adopting a stricter fiduciary standard. Of course, a stricter fiduciary standard – one where any fiduciary cannot receive compensation from investments – may make the 12(b)-1 fee debate moot. In either case, 401k fiduciaries ought to carefully scrutinize their liability exposure in light of the new SEC stance on 12(b)-1 fees.