ICI Tears Into 12b-1 Proposal

In a 32-page response to the request for comments from the Securities and Exchange Commission (SEC), the Investment Company Institute outlined a number of concerns.  

While acknowledging that “the SEC has a number of legitimate concerns with 12b-1 fees”, and that the rule, adopted in 1980, is “in need of an update,” the ICI bluntly stated that “we believe that the proposal places the agency in the inappropriate role of a ratemaker, and is far more extensive and intrusive than necessary.”  In fact, the ICI suggests that, “If adopted as proposed, the revisions could fundamentally alter the way intermediaries use funds in various distribution channels, significantly affect the lineup of share class options currently available to investors, necessitate major systems changes, and require the renegotiation of thousands of dealer agreements”.  This, in the ICI’s estimation “…would be done at a great cost that would be reflected in higher expenses borne by shareholders” – all for benefits that the ICI thinks are “uncertain and quite possibly illusory”. 

In fact, the ICI goes so far as to state that it thinks the SEC’s proposal falls short of a statutory requirement that the anticipated benefits of its rulemaking must be weighed against the resulting costs and burdens, and not only urges the SEC to take a “further and more careful look at its analysis”, but said it was “conducting our own economic analysis, which we expect to file by the end of the month” to “assist in this regard.” 

Alternative Views 

Turning its attention to retirement plans, the ICI stated that the current use of 12b-1 fees in the retirement plan context is “clearly not the functional equivalent of a front-end sales charge”, and that in its assessment, the SEC should take steps to permit funds to provide ongoing compensation for ongoing services rendered in the retirement plan context,” without having to treat that compensation as a form of ongoing sales charge”.  The ICI letter goes on to outline two ways that this could be accomplished: 

• by providing guidance to the effect that certain ongoing services provided to plans and their participants are not “primarily intended to result in the sale” of fund shares and therefore not “distribution activities”, and/or  
• by directing FINRA to craft a separate cap for retirement shares that would reflect “the unique nature of the ongoing services provided by brokers in that context”.  

The ICI went on to note that, in essence, the latter recommendation “would allow for a higher marketing and service fee for classes of fund shares used exclusively for retirement plans.” 

Impact on Small Plans  

Not content to lay out possible solutions, the ICI cautioned that, “if the rule is adopted as proposed, some funds currently used as investment options in retirement plans will be required to treat a portion of their 12b-1 fee as an ongoing sales charge and provide for a conversion period”, going on to note that “for reasons explained below, we think this requirement is misplaced and will serve as a practical prohibition on the use of mutual funds for the smallest retirement plans”.  

The ICI notes that the SEC has acknowledged that “many plan administrators currently do not track and age shares….Plan administrators would have to either develop this capability…or offer only classes of shares that do not impose an ongoing sales charge,” and that the SEC has gone further to note that developing that aging and tracking capability and eventually converting shares “may not be a viable option for retirement plans” and that “[t]hus, our proposal would likely make R shares a less attractive investment option for plans to offer” – a “grim assessment” with which the ICI concurs.  

“It is theoretically possible that recordkeepers would enhance their systems in light of the SEC’s proposal, but it would be a major undertaking requiring a retooling of core processing routines and a significant allocation of resources for the testing and implementation regimen necessary to put the share lot tracking into production,” according to the ICI, which goes on to suggest that those higher costs “…would be borne by retirement plan participants in the form of higher recordkeeping expenses, which could be quite significant in basis point terms because of the size of the affected plans”.  That said, the ICI thinks a more likely result is that those tracking systems would not be built for that small market, and instead “small employers may seek alternative investment options that allow them to continue to offset plan expenses”, specifically citing annuities or “less-regulated collective investment trusts”, or, they may simply, in the ICI’s estimation “simply forego offering retirement plans altogether because they cannot afford to bear the upfront expenses of starting a plan”.  

“…(S)adly, this appears to be collateral damage from the SEC’s core initiative to cap 12b-1 fees for C shares,” according to the ICI.  “The services provided by a broker to a plan are very different from those provided by a broker to a client in exchange for a front-end sales charge,” it cautions, noting that, “in the retirement plan context, the broker provides a variety of ongoing services that are unique to retirement plans, important to plan participants, and rendered over the entire life cycle of the plan”.  The ICI goes on to detail those services, including assisting the plan sponsor with the request for proposal (RFP), the participant enrollment process, as well as ongoing participant education, Section 404(c) compliance, annual investment and plan operational reviews, and even assistance at plan termination. 

“The ongoing nature of these services, and the use of fund assets to compensate brokers for them, is distinctly different from non-retirement plan contexts,” according to the ICI, which again calls on the SEC to “reconsider the application of the new distribution framework to classes of fund shares used exclusively for retirement plans”, specifically citing the ”…impact of the proposal on workers at small employers, who could lose, or never gain, the opportunity to contribute to a workplace retirement plan if this avenue for covering the costs of establishing and maintaining a plan is eliminated.”  

First Things First?  

That said, at a high level, the ICI also noted that this proposal “…comes at a time when the SEC is also actively considering the harmonization of standards of care for investment advisers and brokerdealers and contemplating new point of sale disclosure rules,” and that “in order most thoughtfully to address the entire range of distribution-related issues facing it, the SEC ought to first resolve the debate over the appropriate standard of care applicable to  broker-dealers, and then address point of sale disclosure, confirm disclosure, and Rule 12b-1”. 

The rest of the ICI response is online at http://www.ici.org/pdf/24689.pdf.