July 28, 2010
Thank you for your hard work in taking up this issue. I am confident that smaller investors will benefit from your final product, and that uncertainty in the mutual fund industry will be removed for the next generation.
I'm a CPA who has been preparing tax returns for money since 1974, and first started working with mutual funds in 1985. Now I'm a branch manager with Foothill Securities, Inc. My focus has always been to strive to give my clients a good deal, and help them avoid those salesmen who only ask how they can make the most money off of this prospect?
SEC, you seem to be stuck on C shares, and you're ignoring what's best for the smaller investor. With the average savings of Americans below $100,000, you should be concerned that they get good advice at a reasonable cost. That means you should not arbitrarily limit choices. You should see what goes on in the real world, and allow the fund companies more, not less flexibility.
The investor needs an advisor who knows all about them on an ongoing basis to be able to properly answer life changing questions when they arise. A recent article in Barrons about Dalbar showed that, while the gap is closing, do it yourself investors still trail those with advisors. The difference in fees between different distribution channels is dwarfed by that one time, when the market is down 50 percent, and the advisor convinces the client not to sell low.
Your job, SEC, is to make sure that the small investor has a chance to get a good advisor at the best deal, including the tax savings. I read the transcript of your day long discussion, and it seems that whenever the tax issue was brought up, no one else was interested That is a big deal. Everyone is up in arms about load funds, but when the tax will add 30-45 percent on the after tax cost of fees in taxable accounts, no one cares.
Also, don't forget the exceptional value of the mutual fund. They are far more efficient than the popular alternatives, the wrap account, and the variable annuity. For example, weren't Bernie Madoff's clients in wrap accounts? That could not happen in a mutual fund, where the funds are segregated from the fund marketing and management companies.
Based on my many years of experience of steering my clients away from the unethical salesmen among us, here is my idea for what constitutes a great deal for the small and medium size investor:
You should allow a true advisor class of funds with differing amounts of service fees within the funds, such as classes C1, C2, C3 which would charge 25, 50, or 75 bps for the advisor. That way, you could start off with smaller accounts, and when they become large, you could transfer them to the lower fee funds, or retain a blend of these funds. Each share class would carry it's own expense burden. The client could leave you at any time, and move his money without CDSC.
That will keep the current tax treatment of those fees. Once they are moved to the broker, they become after tax expenses, an up to 45 percent increase in the real cost of advice counting both federal and state income taxes. At the very least, you should obtain a tax opinion that this could work to the benefit of small investors.
C shares which you describe as an unending sales charge, are really service charges on a pre-tax basis. They are even described as service fees in the prospectus. That is why they are so popular. It is a much better deal for a small investor to pay the additional 75 bps on a pretax basis, than to have the wrap account with a one percent after tax fee. (Most investors get no tax benefit for miscellaneous itemized deductions because of the 2 percent floor or the AMT.)
That wrap fee could be higher than one percent for smaller accounts. Wrap fees added to Schwab supermarket "no load" funds carry the 40 bps charge, as noted in your roundtable discussion, to be allowed in the supermarket.
Now, let's talk about variable annuities. It seems that the largest sales of these products go to the companies that pay the most to the brokers. The C share version of these annuities usually pays 2 percent up front with 1.25 per year. And the poor client, has a seven year surrender charge, locking in the total of all those years fees. Then, after seven years, the salesman tells the client, "You have an old outdated version of this product. I can put you into a new, improved vehicle with all these new bells and whistles." The salesman can then get a new upfront sales charge, usually 6 percent, or the C share alternative with the 1.25 per year. Then any gains in unqualified annuities are taxed as ordinary income on the first dollars to come out of the annuity.
You may ask what does this have to do with 12b-1 fees? It shows that done correctly, mutual funds still could be, by far, the best choice for the small and medium size investor.
It's your job, SEC, to make sure investors have this choice. My mutual fund wholesaler told me yesterday that some people in the industry are saying that we should all take our clients' funds and convince them to go to separate accounts. That would not help my clients, only me. Therefore, that would be a dark day for me and my clients. Please make sure that does not happen.
Thank you all for your service.