Contingent deferred sales charge cdsc

What Is Contingent Deferred Sales Charge (CDSC)?

A contingent deferred sales charge (CDSC), often referred to as a "back-end load," is a fee incurred by investors when they sell or redeem certain mutual fund shares within a specified period from the original purchase date. This charge is a component of investment fees, falling under the broader category of mutual fund fees. Unlike a front-end load, which is paid at the time of purchase, a CDSC is deferred until the time of redemption, typically decreasing over several years until it reaches zero. The purpose of the contingent deferred sales charge is to compensate the broker-dealer who sold the fund shares for their services and distribution costs.

History and Origin

Historically, mutual funds primarily relied on front-end sales loads to compensate brokers. However, with the adoption of Rule 12b-1 by the Securities and Exchange Commission (SEC) in 1980, funds gained the ability to use fund assets to cover marketing and distribution expenses over time. This regulatory change paved the way for the introduction of various share classes, including those with contingent deferred sales charges. In 1990, the SEC specifically adopted a new rule to permit certain registered open-end management investment companies to impose contingent deferred sales loads, providing investors with an additional form of sales charge choice without requiring specific exemptive relief⁶. The Financial Industry Regulatory Authority (FINRA), through its rules (formerly NASD rules), caps mutual fund sales loads, including back-end loads, at specific percentages, often 8.5% of the purchase or sale, with lower limits applying if other fees are present⁵,⁴. This regulatory framework helped solidify the contingent deferred sales charge as a common fee structure in the mutual fund industry.

Key Takeaways

• A contingent deferred sales charge (CDSC) is a sales fee paid when certain mutual fund shares are sold within a specified holding period.
• The CDSC amount typically declines the longer the shares are held, eventually reaching zero.
• It is commonly associated with Class B shares and sometimes Class C shares of mutual funds.
• The charge is intended to compensate the selling broker for distribution services and discourage short-term trading.
• Understanding the CDSC schedule outlined in a fund's prospectus is crucial for investors.

Formula and Calculation

The contingent deferred sales charge is typically calculated as a percentage of the lesser of the original purchase price or the current market value of the shares being redeemed. The percentage applied decreases based on the length of time the shares have been held.

The calculation can be expressed as:

Where:

• (\text{Redemption Amount}) is the dollar value of the shares being sold.
• (\text{CDSC Rate}) is the percentage fee applicable at the time of redemption, which typically declines annually.

For example, a fund might have a CDSC schedule as follows:

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

If an investor redeems shares, the contingent deferred sales charge is applied to the amount withdrawn. This charge directly reduces the investor's net proceeds from the redemption.

Interpreting the Contingent Deferred Sales Charge

The contingent deferred sales charge serves as an incentive for investors to hold their mutual fund shares for the long term. A higher CDSC in the early years of an investment aims to dissuade rapid trading, which can incur costs for the fund and its shareholders. Investors evaluating a mutual fund with a CDSC should carefully consider their anticipated holding period. If an investor plans to hold the shares beyond the CDSC period, they may avoid the charge entirely. Conversely, for those with shorter investment horizons, the CDSC can significantly impact the overall return. Funds with a contingent deferred sales charge often have lower or no front-end loads and may carry ongoing fees such as 12b-1 fees to cover distribution and servicing.

Hypothetical Example

Consider an investor, Sarah, who buys $10,000 worth of Class B shares in a mutual fund with a contingent deferred sales charge schedule: 5% in year 1, 4% in year 2, 3% in year 3, 2% in year 4, 1% in year 5, and 0% thereafter. The net asset value (NAV) per share at the time of her purchase is $10.

• Scenario 1: Sarah sells after 2 years.
  Suppose after two years, the value of her investment has grown to $11,000. If she decides to redeem all her shares, the applicable CDSC rate is 4%.
  CDSC = $11,000 (redemption value) * 4% = $440
  Net proceeds to Sarah = $11,000 - $440 = $10,560

• Scenario 2: Sarah sells after 6 years.
  If Sarah holds her shares for six years, the contingent deferred sales charge would be 0%, regardless of the fund's value at redemption. In this case, she would receive the full market value of her shares, minus any other applicable annual fund operating expenses like the expense ratio.

This example illustrates how holding shares for the full contingent deferred sales charge period can result in avoiding the fee, thereby potentially enhancing investment returns.

Practical Applications

Contingent deferred sales charges are most commonly found in mutual funds, particularly those with Class B shares or certain Class C shares. These charges are structured to incentivize long-term investment by reducing or eliminating the fee over time. Beyond mutual funds, CDSCs are also a feature of some annuity contracts, where they are applied if the annuitant withdraws more than a specified percentage of their contract value within a certain surrender period. The underlying principle remains the same: to compensate the distributing entity and encourage sustained investment. Firms selling mutual funds and annuities must adhere to rules set by regulators like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) regarding the disclosure and limitations of these charges³,².

Limitations and Criticisms

While intended to encourage long-term investing, contingent deferred sales charges have faced criticism. One concern is that the complexity of varying CDSC schedules across different funds and share classes can make it challenging for investors to fully understand the total cost of their investment, especially if they need to access their funds sooner than anticipated. Such charges can significantly reduce an investor's net proceeds if they sell before the CDSC period expires¹.

Historically, there have been instances where broker recommendations of certain share classes, including those with contingent deferred sales charges, have led to questions about potential conflicts of interest, particularly when other share classes without such loads or lower overall costs might have been more suitable for an investor's specific financial situation. The Investment Company Act of 1940 and subsequent rules aim to provide a regulatory framework for these charges and ensure proper disclosure. However, investors are still encouraged to carefully read the fund's prospectus to understand all fees, including the contingent deferred sales charge, before making an investment decision.

Contingent Deferred Sales Charge vs. Front-End Load

The primary difference between a contingent deferred sales charge (CDSC) and a front-end load lies in when the fee is assessed.

While both are types of mutual fund sales charges, the contingent deferred sales charge defers the fee until the sale, incentivizing longer holding periods, whereas a front-end load is deducted upfront, reducing the amount initially invested.

FAQs

What is a contingent deferred sales charge (CDSC)?

A contingent deferred sales charge (CDSC) is a fee that some mutual funds levy when an investor sells their shares within a specific time frame after purchasing them. The fee usually decreases the longer the shares are held.

How does a CDSC work?

When you invest in a fund with a CDSC, your entire investment goes into the fund initially. If you redeem your shares before a set period (e.g., 5-7 years), a percentage of the redeemed amount is deducted as the CDSC. This percentage typically lessens each year you hold the investment.

Can I avoid paying a CDSC?

Yes, you can often avoid a contingent deferred sales charge by holding your mutual fund shares for the entire specified CDSC period, after which the fee typically drops to zero. Some funds also offer share classes without a CDSC, or you might qualify for certain waivers based on the amount invested or the reason for redemption. It's important to review the fund's prospectus for details.

What are the typical CDSC rates?

CDSC rates vary by fund and holding period but commonly start around 5% to 6% if shares are redeemed within the first year, declining by about 1% per year until it reaches zero, usually after five to eight years.

Why do mutual funds charge a CDSC?

Mutual funds charge a contingent deferred sales charge primarily to compensate the financial professional or broker-dealer who sold the shares for their distribution and servicing efforts. It also serves as an incentive for investors to remain invested for a longer term, which can help the fund manage its assets more stably.