Contingent deferred sales charge

What Is Contingent Deferred Sales Charge?

A contingent deferred sales charge (CDSC), often referred to as a "back-end load" or "deferred sales charge," is a fee assessed when an investor sells or redeems shares of a mutual fund within a specified period after purchase. This type of fee falls under the broader category of mutual fund fees and expenses and is designed to compensate the broker-dealer or financial professional who sold the fund shares. Unlike a front-end sales load, which is deducted at the time of purchase, the contingent deferred sales charge is incurred at the time of sale.

History and Origin

The contingent deferred sales charge gained prominence as a way for mutual fund companies to offer shares that did not impose an immediate sales commission, making them appear more attractive upfront compared to funds with front-end loads. This structure emerged as the mutual fund industry evolved, offering investors different ways to compensate financial intermediaries for their services. The Securities and Exchange Commission (SEC) provides extensive information on various mutual fund fees, including these deferred charges, highlighting their impact on an investment portfolio.¹¹ The evolution of mutual fund distribution methods and regulatory oversight has shaped how these fees are structured and disclosed to investors. A report by the SEC's Division of Investment Management discusses the trends in mutual fund fees and expenses over time, indicating how sales loads have been assessed.⁹, ¹⁰

Key Takeaways

• A contingent deferred sales charge (CDSC) is a fee paid when mutual fund shares are redeemed, not when they are purchased.
• The charge typically declines over a specific period, such as five to seven years, eventually reaching zero.
• CDSCs are common with Class B and, sometimes, Class C share classes of mutual funds.
• The fee is designed to compensate the financial professional for their sales efforts.
• Understanding the CDSC schedule is crucial as it directly impacts an investor's net return upon early redemption.

Formula and Calculation

A contingent deferred sales charge is typically calculated as a percentage of either the original purchase price or the current net asset value (NAV) of the shares being redeemed, whichever is lower. The percentage usually decreases over time, often on an annual basis, until it reaches zero after a certain number of years (e.g., five to seven years).

For example, if a CDSC schedule is 5% in year 1, 4% in year 2, and so on, down to 0% after year 5:

Variables:

• Original Cost of Shares Sold: The cost at which the shares being redeemed were initially purchased.
• Current NAV of Shares Sold: The current market value of the shares being redeemed at the time of sale.
• Applicable CDSC Percentage: The percentage dictated by the fund's CDSC schedule based on the holding period.

Interpreting the Contingent Deferred Sales Charge

The contingent deferred sales charge is a mechanism that allows investors to invest in a mutual fund without paying an upfront sales commission. However, this convenience comes with a potential cost if shares are sold prematurely. Investors must consider the length of their anticipated holding period when evaluating funds with a CDSC. A shorter holding period increases the likelihood of incurring the charge, which can significantly reduce the overall return on investment. The presence and structure of a CDSC are important considerations for investors when making decisions about their investment planning.

Hypothetical Example

Consider an investor, Sarah, who buys \$10,000 worth of Class B mutual fund shares. The fund has a contingent deferred sales charge schedule as follows:

• Year 1: 5%
• Year 2: 4%
• Year 3: 3%
• Year 4: 2%
• Year 5: 1%
• Year 6 and beyond: 0%

Scenario 1: Sarah redeems all her shares after 2.5 years.
At the time of redemption, the shares are worth \$11,500. The CDSC would be based on the original cost or current NAV, whichever is lower. In this case, the original cost (\$10,000) is lower than the current NAV (\$11,500). Since she is in Year 3, the applicable CDSC is 3%.

CDSC Amount = \$10,000 (original cost) * 0.03 = \$300

Sarah would receive \$11,500 - \$300 = \$11,200 after the charge.

Scenario 2: Sarah redeems all her shares after 6 years.
Regardless of the shares' value, since she held them for more than 5 years, the contingent deferred sales charge would be 0%. She would receive the full current NAV of her shares. This illustrates how longer holding periods avoid the fee, making these funds more attractive for long-term investors.

Practical Applications

Contingent deferred sales charges are primarily found in certain classes of mutual funds, typically Class B shares, and sometimes Class C shares. These funds are often distributed through financial advisors or investment advisers who receive a commission from the fund company at the time of sale. The CDSC acts as a deterrent for early withdrawals, ensuring the fund company can recoup the commission paid to the distributor. Investors evaluating mutual funds should carefully review the prospectus to understand all associated fees, including the CDSC, expense ratio, and any 12b-1 fees. The Financial Industry Regulatory Authority (FINRA) provides resources to help investors understand the nuances of different mutual fund share classes and their varying fee structures.⁸ This knowledge is critical for effective retirement planning and ensuring costs do not unduly erode returns.

Limitations and Criticisms

While contingent deferred sales charges offer the appeal of no upfront sales charge, they come with significant limitations. The primary criticism is that they can penalize investors who need to access their capital before the contingent deferred sales charge period expires. This illiquidity can be problematic during unforeseen financial needs or market downturns when an investor might want to reallocate their diversification strategy. Critics also argue that these charges can obscure the true cost of investing, as the fee is not immediately visible at the time of purchase. Moreover, over longer holding periods, the combination of a deferred sales charge and ongoing 12b-1 fees can sometimes result in higher total costs than a comparable Class A share with a front-end load. For investors committed to low-cost investing, groups like Bogleheads advocate for no-load funds and emphasize minimizing all fees to maximize long-term returns.³, ⁴, ⁵, ⁶, ⁷

Contingent Deferred Sales Charge vs. Front-End Sales Load

The core difference between a contingent deferred sales charge (CDSC) and a front-end sales load lies in when the sales commission is paid.

A front-end sales load is a sales commission deducted directly from your investment at the time of purchase. If you invest \$10,000 in a fund with a 5% front-end load, only \$9,500 is actually invested. This means fewer shares are purchased initially.

Conversely, a contingent deferred sales charge (CDSC) is a fee paid when you sell your mutual fund shares, typically decreasing over a set number of years until it reaches zero. With a CDSC, the full \$10,000 is invested upfront. However, if you redeem your shares before the specified period, a percentage of your investment (usually the original amount or current NAV, whichever is less) is charged as the CDSC.

The confusion often arises because both are forms of "loads" or sales charges. The choice between them depends on an investor's anticipated holding period. Investors planning for short-term holdings might find a CDSC more punitive, while those with a long-term horizon might prefer it to avoid an initial reduction in their invested capital, assuming they hold past the declining charge period.

FAQs

What is the maximum contingent deferred sales charge?

The specific percentage of a contingent deferred sales charge varies by fund and share class, but the Financial Industry Regulatory Authority (FINRA) limits total mutual fund sales loads (including deferred loads) to 8.5% of the offering price.² However, the actual charge applied to an investor typically declines over time and depends on the specific fund's schedule and holding period.

Do all mutual funds have a contingent deferred sales charge?

No, not all mutual funds have a contingent deferred sales charge. Many mutual funds are "no-load" funds, meaning they do not charge any sales commissions, either upfront or deferred. Funds that do impose a CDSC are typically Class B shares and sometimes Class C shares, designed to compensate the financial professional over time.

How can I avoid paying a contingent deferred sales charge?

The most common way to avoid paying a contingent deferred sales charge is to hold the mutual fund shares beyond the specified declining charge period, after which the fee typically drops to zero. Another way is to invest in no-load funds from the outset, which do not impose any sales charges regardless of the holding period.

Is a CDSC the same as a redemption fee?

While both are paid upon selling shares, a contingent deferred sales charge (CDSC) is a sales load that compensates the broker for selling the fund. A redemption fee, on the other hand, is a fee typically paid directly back to the fund itself to deter short-term trading or to defray fund costs associated with frequent redemptions. The SEC limits redemption fees to 2.00%.¹

Why do mutual funds charge a CDSC?

Mutual funds charge a contingent deferred sales charge primarily to compensate the financial professionals or broker-dealers who sell their shares. By deferring the sales charge, the fund can pay the commission upfront to the intermediary, and then recoup that payment from the investor if they redeem their shares before a certain period. This structure aims to encourage longer-term investing and align the interests of the advisor with the fund's distribution.