Annuities swept up in SEC fund fee proposal

The SEC thinks mutual fund 12b-1 fees have gotten out of hand, and is proposing new rules to limit them and provide greater disclosure for investors.

The SEC’s 278-page 12b-1 proposal could also impact the use of distribution fees in the mutual funds in variable annuity subaccounts.

“When it comes to 12b-1 fees, there is a need for more fundamental change than merely disclosure reforms and a name change,” SEC chairman Mary Schapiro said last December.

The fees are deducted from mutual funds to compensate securities professionals for sales efforts and for services provided to the mutual fund investors. When 12b-1 fees were first charged in 1980, they amounted to just a few million dollars, the SEC said. But they have since escalated to $9.5 billion in 2009 — and to more than $13 billion in 2007.

That’s money that directly reduces the value of the investors’ shares in the fund — and the SEC says many investors are unaware that these fees are being deducted from accounts and are unaware who these fees are ultimately compensating.

“Despite paying billions of dollars, many investors don’t understand what 12b-1 fees are, and it’s likely that some don’t even know that these fees are being deducted from their funds or who they are ultimately compensating,” said SEC chairman Mary Schapiro. “Our proposals would replace rule 12b-1 with new rules designed to enhance clarity, fairness and competition when investors buy mutual funds.

“We must critically rethink how 12b-1 fees are used and whether they continue to be appropriate,” she continued. “For example, do they result in investors overpaying for services or paying for distribution services that they may not even know they are supposed to be getting?”

The rule would give investors a choice of paying a single upfront fee or fees paid annually, which would have new caps in place. There would be caps in place, and investors wouldn’t pay out more over time in annual fees than they would have paid with an upfront fee.

In another effort to lower costs, brokerages would be allowed to make their own deals with mutual funds and determine their own level of compensation. Funds determine that now, but the SEC hopes the competition would drive down mutual fund fees.

“This new approach is intended to increase competition of the sale of mutual fund shares,” said Andrew “Buddy” Donohue, director of the SEC’s Division of Investment Management. The SEC proposal would allow firms to charge a “marketing and service fee” of up to 0.25%. Anything above that amount would be deemed to be an ongoing sales charge, which would be limited to the highest fee charged by the fund for shares that have no ongoing fund sales charge.

As for variable annuity subaccounts, the proposed rule and rule amendments would apply to funds that serve as investment vehicles for insurance company separate accounts that offer variable annuities or life insurance contracts. Separate accounts are typically organized as unit investment trusts. They invest the proceeds of premium payments made by contract owners in one or more mutual funds (underlying funds) that manage the assets that support the insurance contracts.

Under the proposed rule changes, underlying funds would be treated like other mutual funds. Thus, an underlying fund could charge a marketing and service fee up to the NASD sales charge rule limit on service fees. Asset-based distribution fees in excess of the marketing and service fee would be deemed ongoing sales charges and subject to the requirements of the proposed amendments to rule 6c-10.

Like other mutual funds, to impose an ongoing sales charge, an underlying fund (or the insurance company sponsor) would have to keep track of share lots attributable to contract owner purchase payments, and provide for the automatic conversion of shares by the end of the conversion period.

“We understand that insurance company separate accounts may not currently track and age shares because they generally do not offer underlying funds with contingent deferred sales loads,” the SEC noted. “Under our proposal, insurance companies would either have to develop this capability or offer only shares of classes that do not impose an ongoing sales charge.”

Apparently, the SEC is maintaining an open mind about underlying funds, because it is asking for comment about whether it should treat them differently than other funds. Specifically, it is asking:

• Given that most distribution activities occur at the separate account-level, is it appropriate to permit underlying funds to impose the marketing and service fee or ongoing sales charges? JoNell Hermanson, writing in a July 9, 2007, comment letter, thought not. She urged eliminating 12b-1 fees for variable products because “12b-1 fees have become a ‘shell game’ for insurance companies and have allowed them to camouflage their profit margin as investment management fees.” • How would these fees be used? • Should we limit underlying funds to the marketing and service fee? • Should we consider some other structure for limiting fees charged by underlying funds?

Filed by Alan Prochoroff, editor and publisher of Insurance Compliance Insight. To subscribe, click here.

(07/29/10)