False Advertising: The Truth About 12b-1 Fees

Mercer Bullard, a University of Mississippi securities law professor and founder of fundholder advocacy group Fund Democracy, doesn't believe 12b-1 fees are inherently wrong, but he would like to see greater disclosure on how they are used.

"When you pay distribution fees such as 12b-1 fees, it's essentially an ignorance meter," Bullard said. The flip side, he said, is that some people can afford to pay for advice and don't mind doing so. "There are conscientious brokers who are providing good advice, and some people need that advice." Other investors might not need that advice, and regulation should "make it clear exactly what people are paying for."

Buy American. Or, Are You Being Served?

While many brokers are indeed conscientious, many fund-industry watchers raise concerns that 12b-1 fees create a misalignment of interests that doesn't serve the individual investor well. At issue, in a nutshell, is cost: If brokers get paid to sell one fund and not another -- such as a low-cost index fund, for instance -- why should they sell the cheaper fund?

"The adviser has a lot to gain in selling funds that charge 12b-1 fees, so there's a conflict of interest right off the bat," said Jeff Kiel, vice president of Global Fiduciary Review at Lipper and point person on Lipper's ongoing study on 12b-1 fees and how reform might take shape.

Once investors understand that their brokers get a commission to sell a particular fund, "there's no way of knowing for certain whether they're selling you the fund for them or for you," said Larry Swedroe, director of research at Buckingham Asset Management and author of Rational Investing in Irrational Times.

Swedroe said the American Funds family has solid funds, but he notes that part of the reason it gets such prominent placement from brokers is that it typically charges front-end loads and 12b-1 fees. "American pays brokers more money to get the shelf space," Swedroe said.

12b or Not 12b?

Another major issue with 12b-1 fees is exactly what falls under the 12b-1 banner. "If fund assets are being spent for distributions, it clearly falls under 12b-1," said Lipper's Kiel. "If they're spending their own resources, then it comes out of profits. That is a very fine line."

It is a line that regulators say many in the industry are clearly crossing. The SEC says funds can use as much as 1% of their assets annually for 12b-1 fees, which typically run about 0.25% to 0.75%. However, under the rules set down by the National Association of Securities Dealers, the portion of the 12b-1 fee that goes to marketing and distribution costs can't exceed 0.75% of a fund's assets. Many funds are perilously close to that level and may be leaving items that are clearly related to distribution off the 12b-1 ledger.