12b 1 plan

What Is 12B-1 Plan?

A 12B-1 Plan is a written plan adopted by a mutual fund that allows it to use fund assets to pay for distribution and marketing expenses. This falls under the broader category of investment management and mutual fund operations. These expenses can include compensating brokers and other financial intermediaries for selling fund shares, advertising costs, and the printing and mailing of prospectuses to new investors.,²⁷ The name "12b-1" comes from Rule 12b-1 of the Investment Company Act of 1940, which permits mutual funds to finance these activities from fund assets.,²⁶ While these plans are designed to help attract new investors and potentially increase fund assets, the costs associated with a 12B-1 Plan are ultimately borne by the fund's shareholders.

History and Origin

Prior to 1980, the Securities and Exchange Commission (SEC) generally held the view that it was improper for a mutual fund to finance its own distribution directly or indirectly, despite Section 12(b) of the Investment Company Act of 1940 not explicitly prohibiting it.²⁵ The industry was largely reliant on front-end sales loads to compensate brokers.²⁴

However, by the mid-1970s, "no-load" mutual funds had gained significant market share.²³ In response to industry developments and a desire to provide funds with a mechanism to pay for distribution, the SEC reversed its long-standing position. In 1980, the SEC adopted Rule 12b-1, which permits a mutual fund to pay distribution-related costs out of fund assets, provided certain conditions outlined in the rule are met.²²,²¹ The introduction of the 12B-1 Plan was initially seen as a way to potentially benefit existing shareholders by growing fund assets, which could lead to economies of scale and lower overall expenses.

Key Takeaways

• A 12B-1 Plan allows a mutual fund to use its assets to pay for distribution and marketing expenses.
• These fees are disclosed in the fund's prospectus and are included in the fund's expense ratio.
• The fees generally range from 0.25% to a maximum of 0.75% for distribution and marketing, plus an additional 0.25% for shareholder services, totaling up to 1% of the fund's net assets annually.,²⁰
• The primary purpose of a 12B-1 Plan today is often to compensate financial intermediaries, such as brokers, for selling fund shares.,¹⁹
• Shareholders ultimately bear the costs associated with 12B-1 fees, which can reduce a fund's total returns.¹⁸

Formula and Calculation

A 12B-1 fee is calculated as a percentage of a mutual fund's average annual net assets. While there isn't a complex formula, the calculation is straightforward:

For example, if a fund has average annual net assets of $100 million and charges a 12b-1 fee of 0.50%, the fee collected over the year would be $500,000. These fees are deducted directly from the fund's assets.¹⁷

Interpreting the 12B-1 Plan

A 12B-1 Plan indicates that a mutual fund is actively allocating a portion of its assets towards marketing and distribution. For investors, understanding the 12B-1 fee is crucial because it directly impacts the total return of their investment. Funds with higher 12b-1 fees will have a higher overall expense ratio, which can erode returns over time compared to funds with lower or no such fees. When evaluating a mutual fund, investors should consider the 12B-1 fee alongside other costs like management fees and sales loads. A higher 12b-1 fee may suggest that a greater portion of the fund's assets is being used to attract new investors rather than being directly invested.

Hypothetical Example

Consider an investor, Sarah, who is looking to invest in a mutual fund. She finds two funds, Fund A and Fund B, both with similar investment objectives and historical performance before fees.

• Fund A has an expense ratio of 0.75%, which includes a 12b-1 fee of 0.25%.
• Fund B has an expense ratio of 0.50% and no 12b-1 fee (it's a no-load fund).

Sarah invests $10,000 in each fund. Assuming both funds achieve a gross annual return of 8% before expenses:

• Fund A's net return would be 8% - 0.75% = 7.25%.
• Fund B's net return would be 8% - 0.50% = 7.50%.

Over one year, Fund A would earn Sarah approximately $725, while Fund B would earn her approximately $750. While the difference from the 12b-1 fee (0.25%) might seem small, over many years, this consistent charge can significantly impact the long-term compounding of her investment. This example highlights the importance of scrutinizing all fees, including those associated with a 12B-1 Plan, when making investment decisions.

Practical Applications

12B-1 Plans are primarily seen in the context of mutual funds and are a key component of their fee structure, particularly for certain share classes. They are used to fund various activities aimed at promoting and distributing the fund's shares. These activities can include paying commissions to financial advisors and brokers who sell the fund, covering the costs of advertising campaigns, and distributing sales literature.,¹⁶ For instance, Class B and Class C shares of mutual funds often carry higher 12b-1 fees compared to Class A shares, as these fees may compensate for lower or absent front-end sales loads.,¹⁵ The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) require that 12b-1 fees be clearly disclosed in a fund's prospectus and other disclosure documents.¹⁴,¹³

Limitations and Criticisms

Despite their intended purpose, 12B-1 Plans have faced significant criticism over the years. One major concern is the potential for conflict of interest between fund advisors and shareholders. Advisors' fees are often based on assets under management, creating an incentive to grow the fund's size through marketing, even if the associated 12b-1 fees do not directly benefit existing shareholders.¹² Critics argue there is limited evidence that these fees lead to lower expenses or better returns for shareholders through economies of scale.,¹¹ Indeed, studies have suggested that while funds with 12b-1 plans may grow faster, shareholders may not receive benefits in the form of lower average expenses.¹⁰

The opaqueness of some fee structures and the difficulty for shareholders to monitor these conflicts have also been points of contention.⁹ The SEC has consistently scrutinized 12b-1 fees, launching initiatives to ensure proper disclosure and address potential conflicts where advisors recommend share classes with higher 12b-1 fees when less expensive options are available.⁸,⁷ This ongoing regulatory focus underscores the need for investors to carefully evaluate all fees associated with a fund.⁶

12B-1 Plan vs. Sales Load

The primary difference between a 12B-1 Plan and a sales load lies in when and how the fees are charged to an investor. A sales load, also known as a commission, is a fee paid directly by the investor either at the time of purchase (a front-end load) or at the time of sale (a back-end load, or contingent deferred sales charge). These are one-time charges that reduce the amount of money initially invested or received upon redemption. In contrast, a 12B-1 Plan involves ongoing fees that are deducted annually from the mutual fund's assets. While sales loads are direct, upfront, or deferred commissions, 12b-1 fees are ongoing operational expenses of the fund itself, continuously impacting the fund's net asset value (NAV). Investors often get confused because both are forms of compensation for distribution efforts. However, sales loads are explicit transaction costs, whereas 12b-1 fees are embedded in the fund's expense ratio and erode returns gradually.,,⁵

FAQs

What is the maximum 12b-1 fee allowed?

FINRA rules generally cap 12b-1 fees at 1.00% annually, which typically consists of a distribution fee (up to 0.75%) and a shareholder service fee (up to 0.25%).,⁴

Are 12b-1 fees tax-deductible?

For individual investors, 12b-1 fees are typically not tax-deductible. They are considered an operational expense of the fund and are already factored into the reported fund performance and your investment income.

How can I find out if a fund has a 12b-1 plan?

Information about a fund's 12b-1 plan and associated fees will be clearly disclosed in the fund's prospectus, usually within the fee table section.³,² This document is accessible before you invest.

Why do some funds have 12b-1 fees and others don't?

Funds that use 12b-1 fees typically do so to pay for marketing and distribution costs, including compensating brokers. Funds that do not charge these fees are often referred to as "no-load" funds and may be sold directly to investors without an intermediary.¹ The presence or absence of a 12b-1 fee can impact the fund's overall cost structure.