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Fidelity Proposes to Drop Destiny's Poor-Performance Penalty

The incentive-based fee arrangement has saved shareholders millions of dollars in the past few years.

Fidelity's

Destiny funds want to do away with a rare perk that has saved its shareholders a lot of money.

A performance-based fee adjustment forces the fund firm to lower fees when

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Destiny I and

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Destiny II underperform the

S&P 500

. Fidelity can raise fees when the funds outperform. Because both funds are trailing their benchmark over the past five years, the adjustment has saved shareholders a bundle -- $9.8 million on Destiny I and $5.6 million on Destiny II during 1998 alone.

Now Fidelity wants do away with the arrangement, and the funds' board of directors, which represents shareholders, has approved the move. But based on the funds' recent performance through Sept. 30, 1998, eliminating the fee adjustment would have significantly raised the cost to shareholders.

The firm's 138-page

SEC

filing containing the proposed change does not detail any explicit benefit to shareholders for giving up the performance incentive. And Fidelity representatives did not offer any specific ways in which the new fee structure would benefit shareholders.

The proposal to eliminate the performance incentive is just one part of a voluminous SEC proxy statement that details a host of proposed changes to the funds that must be approved by shareholders.

The fee adjustment was intended to keep shareholders' interests in line with management's -- a goal Fidelity has long claimed is close to its heart. In fact, the Boston-based fund firm is a "very strong believer of performance-fee adjustments," says spokeswoman Jessica Johnson.

Fidelity says the new fee structure is necessary because the firm has introduced a new class of Destiny shares that carry 12b-1 fees, which are used to advertise and market a fund to the public or to brokers. SEC rules require the cost of 12b-1 fees to be deducted from a fund's total return. That makes it harder for funds with 12b-1 fees to beat their benchmarks. Unless Fidelity can eliminate the Destiny portfolios' performance adjustment, the company faces a greater risk of paying a penalty for underperformance.

In the proxy, Fidelity argues that the SEC's position on 12b-1 fees is "inconsistent" with the agency's rule that allows funds to ignore sales charges -- or loads -- when calculating total return. Fidelity says Destiny's 12b-1 fee is, in effect, a sales charge.

"We believe that 12b-1 fees should not be considered in calculating performance adjustments," says Fidelity Vice President David Jones. "We think it's more appropriate to have no performance adjustment" rather than have one that is in error, he says.

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Why Fidelity's board agreed to go along with the changes is a mystery.

Fidelity would not make any of the funds' inside directors -- those who work for the company -- available for comment, nor would it provide contact information for the funds' nine outside directors. (Outside directors were paid between $220,500 and $273,500 in 1998 to oversee all of Fidelity's funds, including the two Destiny funds.) The only outside director who could be reached, Marvin Mann, chairman of

Lexmark International

(LXK)

, declined through a secretary to comment and referred

TheStreet.com

back to Fidelity.

Some brokers who sell Destiny funds say they are in favor of the current performance-based fee structure.

"In general, I prefer a performance-based kicker," says John Anderson, a broker with

USPA & IRA

in Brown's Mills, N.J. "The better the fund does, the better the payout," he says.

"The way it's currently structured is a benefit to shareholders," says David Miller, a broker for

Financial Network Investment

in Teaneck, N.J. "The

performance-adjusted structure shows Fidelity's belief that it's a quality product."

Destiny shareholders can vote on the changes through June 16. However, few shareholders bother to participate in proxy votes, making it likely that the changes will be approved.

Destiny funds, which are sold through brokers primarily to members of the military, can only be bought through a long-term (10 years or more) contractual plan, which takes 50% of the first 12 installments as a sales charge and 1.7% for each subsequent investment over the life of the plan.

The cost is high, but until recently, so was the reward. For many years, under the stewardship of manager George Vanderheiden, the funds posted market-beating returns. But Destiny I now trails the S&P 500 by 46 percentage points over the past five years. Destiny II, which was recently taken over by a new portfolio manager, Beth Terrana, trails by 36.6 points.