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The GRABot BAG
by Sherrie E. Grabot, CEO

August 2010
Capping the Fees Debate

Many of us associated with financial services were somewhat ruefully thankful that our industry has lost its status as America’s least-popular sector. Financial crises may be bad, but massive environmental disasters are viscerally much worse.

Unfortunately, we seem to have a bottomless supply of potential criticism underlying our own industry: fees. In the last week the issue has come to the surface yet again. To stretch a metaphor, the latest controversy sheds light on a very murky region of the investment world, and may force us to reconsider how we do business down there.

12b, or not 12b? The Fee Question

The war of words about fees is on again.

Touching off the latest round is the SEC’s proposal to make big changes in the mutual fund marketing charges known as 12b-1 fees. These fees have come in for ample criticism in recent years, and the story has attracted a lot of coverage, from the Washington Post to this newsletter.

What the average reader may not realize is that while the term “12b-1” will disappear, the fee itself won’t. Investors will still pay a marketing fee, and will still have a choice of paying it up front or annually. But the annual option will be capped at 25 basis points (the limit for what is called a “no-load” fund), and the whole issue will be disclosed more clearly.

Opinions about this proposal vary. On the surface it does seem unfair to collect a “sales charge” on an ongoing basis. If fees help produce additional sales, it’s hard to see how that benefits the investor who’s already bought the shares in question. But many advisors, broker-dealers, and other financial professionals believe that the proposal could end up hurting investors.

Unintended Consequences
Like any sweeping reform, the proposal risks some unintended consequences. For example, if the advisory business moves to a fee-only model, small investors may not be able to afford access to advice and planning services. By eventually killing off some classes of shares, the proposal could harm investors looking for shorter-term investments. A cap on ongoing fees might even encourage advisors to churn investors’ accounts. The proposed rules for disclosure could also prove unwieldy.

So what will happen in the end? The SEC and others have been talking about a 12b-1 overhaul for quite a while without making any actual decisions. Perhaps that’s part of a subtle strategy. In the meantime, the Wall Street Journal points out that “some concerns have become less pressing” as disclosure and scrutiny increase, fund classes with high 12b-1 fees lose market share, and advisors increasingly choose institutional-class shares or ETFs that don’t include the fees.

Duty of Prudence
A recent court decision has provoked fewer headlines, but also provokes some interesting questions about fees. In Tibble vs. Edison International, a federal court found that Edison had failed in its “duty of prudence” to retirement plan participants by including retail shares of some mutual funds in the plan, rather than making available the lower-cost, institutional equivalents of the same investments.

A Daily Finance article about the ruling uses some very strong language, calling the case “the end of the great 401(k) rip-off.” The author describes the additional revenue-sharing costs in question, which are paid to plan advisors, as a way to “rob” or “steal” money from investors. The piece closes with a blanket statement that no retirement plan should contain actively-managed funds, retail or otherwise.

Is he really saying that everyone should choose the lowest-cost index fund and call it a day? This is simply nonsense. Depending on an individual’s specific situation, they might need the greater risk/return profile of an actively managed fund – or more likely, a balanced portfolio containing both higher- and lower-risk options.

For Every Free Lunch, A Fee
Even index funds are managed by someone. Or something – if the day-to-day activity is handled by a rack of servers, someone has to keep them humming, cover trading costs, licenses and insurance, file the paperwork, maintain the website, and so forth. In a retirement plan context, things get more complicated. For example, higher expense ratios are used to offset recordkeeping fees and other administrative expenses. Fees are just one piece of the whole compensation puzzle.

Inevitably it takes money to manage money. At GuidedChoice we’ve always run a very efficient operation, but to remain in business, we charge for our services. We just think it’s prudent – both in terms of a common-sense, good idea, as well as a fiduciary duty – to charge reasonably, do so transparently, and let the buyer decide.

In any case, the writing is on the wall for this type of “revenue sharing.” A similar decision stopped Caterpillar in its tracks last year, and it wasn’t the only one.

Bad News, Good News
The bad news in all this resides at an emotional level rather than a rational one. Rancor about fees helps stoke a widespread “financial companies are stealing our money” attitude among the public. You know and I know that the cowboys who brought down Merrill Lynch and AIG are not the people running your 401(k). But even today, with account balances largely recovered from their terrifying lows, the average investor is not feeling especially thankful to financial professionals. We would do well to move toward a more transparent way of doing business as gracefully as possible.

The good news is that we seem to be on the road toward much greater transparency regarding fees. Transparency is good. Economics 101 tells us that more complete information produces more efficient markets. Efficient markets are good for any consumer who wants to maximize the value they get from spending a dollar, and for any provider who is ready to compete by demonstrating value. Let the competition begin.

~~ Sherrie