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Rating:Is There Life After 12b-1? Not Rated 2.8 Email Routing List Email & Route  Print Print
Friday, May 25, 2007

Is There Life After 12b-1?
Guest Column by: Louis Harvey

The writing is on the wall ... all you have to do is read it. 12b-1 is unlikely to remain intact in the face of regulatory and legislative concerns, imprudence of using high cost share classes, dollar and cents fee disclosures, level compensation requirements, class action litigation and availability of low cost investment alternatives.

While many advisers will wait for the axe to fall as it has on fee-based accounts, forward thinkers will protect their compensation by changing to fee structures that will survive past 12b-1. Alternatives are available today for advisers to avoid the 12b-1 execution.

The 12b-1 approach to compensation may be comfortable for an adviser since the cost is bundled into the price of a fund and most plan sponsors rely on the adviser to monitor costs, which includes their own 12b-1 compensation. While most advisers act in the best interest of participants, there is no assurance that all advisers do. As 12b-1 is exposed to close scrutiny, abuses are very likely to be uncovered that will only continue to energize reform.

The reform of 12b-1 could occur in four different ways:
1) Limit 12b-1 use to the original intended purpose*,
2) Add standards of accountability to define what advisers must do,
3) Repeal 12b-1 since its purpose has been served, or
4) Place statutory limits on fees.

Any of these reforms will compromise many advisers' current compensation and profitability.

The real issue with 12b-1 is not the amount of the fee as much as the opportunity for abuse. 12b-1 fees are actually an incentive for unscrupulous advisers to recommend high expense funds so as to secure compensation. As it stands today, the requirement to act in the best interest of participants is inconsistent with 12b-1 fees.

If you conclude, like I do, that the only question is when 12b-1 will cease to fund adviser services, the concerns are about what compensation methods will replace the legitimate use of 12b-1, and will new methods be as lucrative. In the ideal, those advisers who deliver value should see increases in compensation at the expense of those who do not.

Advisers can take action right now to protect their income from regulatory changes to 12b-1. Three alternatives are available today:
-Management Fee: Charge fees as a Registered Investment Adviser
-Mark-up: Mark up the prices of investments based on negotiation with plan sponsor
-Charge Participants: Charge fiduciary adviser fees directly to participants as permitted by the Pension Protection Act

Advisers, acting as Investment Adviser Representatives, can replace existing 12b-1 fees with direct compensation from plan assets or from employers. This alternative requires the adviser to be a fiduciary and enter into a formal agreement to take responsibility for the recommendations made. It is necessary for the adviser to set compensation with the plan sponsor that is independent of the platform provider or other investment managers. Advisers can make the case by switching to the lowest cost share class and illustrating the savings for the plan.

The second alternative permits advisers to add their own fee to the investment costs. Under this arrangement, the price of each investment includes the adviserís compensation but unlike 12b-1 the adviserís fee is based on services to be provided. Currently, this can be done for stocks and bonds, separately managed accounts and ETFs but are prohibited** in traditional mutual funds. Advisers would need to change investment line-ups to include only low cost investment options that permit a mark-up.

The third alternative takes advantage of the Pension Protection Act that provides for using plan assets to pay for level-fee advice. Under this alternative, an adviser shifts focus from selecting and monitoring a fund line-up to making recommendations to participants from any available investment. Under this alternative, advisers can act in the best interest of participants and relieve the plan sponsor of liability. Fees taken directly from participant accounts replace the 12b-1. This alternative is likely to be more lucrative than the 12b-1 since advisers can charge fees based on services rendered.

If 12b-1 compensation is taken off the table, investment product distribution will rely on each providerís ability to adapt to the alternatives that replace it. For the Management Fee alternative, providers must offer low cost share classes. For the Mark-up alternative, providers must offer products where advisers can add their own fees. The alternative to Charge Participants will require wholesaling in the traditional sense to bring product features to the attention of advisers.

The alternatives discussed here do represent a major shift in the way business is conducted today but in all likelihood the current business structure will go the way of the blacksmith after the introduction of automobiles.

Advisers may choose to fight the change but are not likely to prevail over the forces at play. The more productive course is to find alternative compensation methods for the excellent services that advisers provide to the retirement community.
*According to the Investment Company Institute, 52 percent of 12b-1 fees pay for ongoing services, while 40 percent compensate "financial advisers for initial assistance." Only eight percent goes to promotion, advertising and paying fund underwriters.

**Investment Company Act of 1940, section 22(d) requires that each fund (of a particular class) be offered to the public at the same price, thus precluding any mark-up for an adviser's services.
Louis S. Harvey is the president of DALBAR.

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