“Hidden” 12b-1 Fees Can Pack a Punch!

The Basics of 12b-1 Fees

Let’s start by addressing the primary question: what, exactly, is a 12b-1 fee? To put it simply, a 12b-1 fee is a fee paid by investors to their mutual fund for marketing and distribution. This fee is considered an “operational expense”, which means it is included in the overall expense ratio for the fund. The fee is paid by fund managers taking client assets under management and using them to pay service providers.

The typical 12b-1 fee can be as high as 1% annually for most mutual funds that have these hidden fees. They are considered “hidden” because the unnecessary 12b-1 fee is included in the mutual fund expense ratio. Let’s use American Funds Capital Income Builder A fund (ticker symbol CAIBX) as an example. The total expense ratio of CAIBX is 0.58%. That is a reasonable expense ratio compared to the average expense ratio of about 1% for the entire mutual fund industry. However, 0.25% of that 0.58% expense ratio is a 12b-1 fee. That means it only takes 0.33% to run the mutual fund (pay staff, rent office space, computers, etc). The other 0.25% goes to paying for ads and marketing the mutual fund to investors. It is a waste of money for you to pay that fee every year, especially because it reduces your investment return by 0.25% every year!

The Theory

In order to understand the theory of how this fee is supposed to work, it’s probably best to understand how this fee came about in the first place. In the 1970s, mutual funds were struggling because many investors were withdrawing from them. The fund managers wanted a way to attract new investors, while also protecting existing investors and assets. That’s where the SEC’s new law in 1980 really helped out.

Rule 12b-1 of the Investment Company Act of 1940 set the precedent for this fee by granting mutual funds the ability to pay for marketing and distribution expenses directly from the investment assets of shareholders. However, the new law in 1980 really gave fund managers the ability to put this into practice with the theory that taking these expenses directly from the investors actually helps them in the long run. If the fees paid by current investors for marketing and distribution could bring in more investors, then over time these fixed costs would be brought down, benefitting everyone involved.

The Reality

Unfortunately, the theory behind the establishment of 12b-1 fees has not proven true. Instead of bringing the costs down, these mutual funds have actually become more expensive, and the benefits that were expected for current investors aren’t really seen at all. Essentially, current investors are paying money for new investors to join the fund – often to their own detriment! Let’s take a look at an example that shows how this 0.25% 12b-1 fee can affect your investments.

CAIBX has an average return of 3.33% per year over the previous 5-year period (May 2014 through May 2019). If you had invested $100,000 in CAIBX 5 years ago, it would now be worth $117,796. With no 12b-1 fee, the return would have been 3.58% (0.25% higher). Your $100,000 investment would be $119,228. That’s $1,432 of money that could have been yours.

In addition to negatively impacting an investor’s chances of retirement by lessening their portfolio growth, 12b-1 fees also create a big conflict of interest between investors and their advisors. Consider this: if your financial advisor has the option to choose between a lower-cost share class of a fund (which is good for you as the investor), or a higher-cost share class of the same fund (which allows them to make more money on the sale), how can you be sure the advisor will choose what’s best for you?

While we’d all like to trust that our advisors are acting with our best interests at heart, unfortunately this is not always the case. In fact, many RIAs were fined recently by the SEC for not properly disclosing to their clients that they were choosing to invest in higher-cost mutual fund classes specifically because these funds charged 12b-1 fees. Because the fee is “hidden” in the overall expense ratio, clients may not have realized that they were ultimately paying for the fund to acquire more customers, at the cost of their own potential earnings.

How can I avoid these 12b-1 fees?

There are a couple things you can do to protect your investments from being subjected to these “hidden” fees. For one thing, when researching mutual funds, look for those that have a low expense ratio. These will often be index or passively managed funds. If you aren’t exactly sure what constitutes a low expense ratio, you can also look into the mutual fund’s prospectus, which should be available to you. In the section for “shareholder fees”, it should indicate how much is charged for marketing and distribution. As a reminder, the typical 12b-1 fee is 0.25%, and the maximum charge for 12b-1 fees is 1% annually.

Of course, the easiest way to protect your investments is to work with a fiduciary financial advisor – or, even better, a fee-only fiduciary advisor. Fiduciaries are legally obligated to always act in their clients’ best interests. Fee-only firms do not earn commissions on any recommendations given to their clients. So, in this instance, a fee-only fiduciary advisor would not have any reason to recommend a higher-cost mutual fund class with a 12b-1 fee because there would be no benefit for them, or their client.

If you are not sure whether your financial advisor is a fiduciary, ask them! If they are not, consider switching to someone who is. You could save yourself a lot of money in the long run.