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3 Reasons the SEC’s New 12(b)-1 Stance May Increase 401k Fiduciary Liability

December 08
15:32 2009

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.

14652_9039_Caution_Washingon_D_C_stock_xchng_royalty_free_300But 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:

  1. 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.
  2. 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.
  3. 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.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


  1. Tim Friday
    Tim Friday December 27, 11:41

    Should not a financial professional deserve to be compensated for the services it renders? In many cases, 401(k)s, like other types of accounts, benefit greatly from the professional guidance that perhaps only a licenesed expert can bring to the table. You have two options to pay for such service: explicit fees on all assets under an RIA agreement, or through commisions as generated by the underlying assets. Who is to say one is better than the other?

    Many wire houses, for example, do not allow their registered representatives to operate under the first scenario. Does this mean that they should be completely excluded from providing guidance in the 401(k) marketplace? The only way that they can be compensated through assets is vis-a-vis 12b-1s or dealer concessions. In fact, one can make an argument that through the proper selection of funds, the plan and its participants can actually pay less by using funds at NAV that also pay a trailer. Alternatively, a plan can use institutionally based funds and other types of assets and be charged a “wrap” fee which in some cases may be equal to or greater than the average cost of 12b-1.

    Therefore, in my mind, the more important option the various regulatory bodies should looking towards is full disclosure! Regardless of the type of asset used, require the plan providers to disclose ALL fees associated with the management of a 401(k) plan. With full disclosure, let the plan sponsors and trustees determine what is best for meeting the requirements of its employees and their retirement future.

  2. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author December 27, 15:21

    Tim, thanks for the comment.

    I think you bring up a great issue and one at the center of this growing debate. Current laws allow brokers to do exactly what you say. The laws also allow financial service providers to receive asset based fees.

    There presently exists two conflicts: 1) As you state, some sponsoring firms do not permit registered reps to offer advisery (i.e., fee-based) services outside their corporate model; hence, forcing those individuals to only be paid via commission; and, 2) There is no requirement that brokers serve as a fiduciary to ERISA plans when providing services; hence, are allowed to be compensated in a manner (i.e., via commission) that would normally be considered a prohibited transaction under standard fiduciary law.

    These existing conflicts seem to be the center of the debate which the regulators are now attempting to tackle. Unfortunately, there appear to be no easy answers.

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