Contingent deferred sales load

What Is Contingent Deferred Sales Load?

A contingent deferred sales load (CDSL) is a type of sales charge assessed on certain investment products, primarily mutual funds and annuities, when shares are redeemed or withdrawn before a specified period has elapsed. This fee falls under the broader category of investment fees and is characterized by its deferred nature and its contingency on the holding period. Unlike a front-end load, which is paid at the time of purchase, a contingent deferred sales load is incurred at the time of sale. The amount of the contingent deferred sales load typically decreases over time, eventually reaching zero if the investment is held for a sufficiently long duration, often ranging from five to ten years.²⁷, ²⁸ This structure is designed to encourage investors to maintain their investments for the long term.

History and Origin

Sales loads have been a component of mutual fund fee structures for decades, serving as compensation for brokers and other intermediaries who sell fund shares. The concept of a deferred sales charge, specifically the contingent deferred sales load, gained prominence as an alternative to upfront fees. In 1995, the U.S. Securities and Exchange Commission (SEC) adopted Rule 6c-10 under the Investment Company Act of 1940, which permitted registered open-end management investment companies (mutual funds) to impose contingent deferred sales loads.²⁵, ²⁶ This rule allowed funds to offer investors an additional form of sales load, providing flexibility in how sales compensation was structured. Prior to this, deferred loads were not explicitly covered by the NASD Sales Charge Rule, which has since been amended to include them.²⁴ The introduction of the contingent deferred sales load provided a way for investors to put their entire initial investment to work immediately, with the sales charge only being applied if they exited the fund early.

Key Takeaways

• A contingent deferred sales load (CDSL) is a sales charge paid by investors when they sell certain fund shares or annuities before a specified holding period.
• The amount of the CDSL typically declines the longer the investment is held, eventually reaching zero.
• CDSLs are also known as "back-end loads" or "exit fees."²², ²³
• They are commonly associated with Class B and Class C mutual fund shares.
• The primary purpose of a CDSL is to incentivize long-term investing and compensate financial intermediaries.

Formula and Calculation

The contingent deferred sales load is typically calculated as a percentage of the lower of the initial investment amount or the redemption value of the shares. This percentage generally decreases over a set period.

Let:

• ( CDSL_t ) = Contingent Deferred Sales Load at time ( t )
• ( P_0 ) = Initial principal invested
• ( V_t ) = Current value of the investment at time ( t )
• ( r_t ) = Applicable CDSL rate at time ( t ) (which declines over time)

The formula for the contingent deferred sales load is:

$CDSL_t = \min(P_0, V_t) \times r_t$

For example, if an investor purchases $10,000 in mutual fund shares with a CDSL schedule starting at 5% in the first year and decreasing by 1% annually, and they redeem the shares in year 3, the rate would be 3%. If the investment value at redemption is $11,000, the CDSL would be calculated on the initial principal of $10,000. So, ( CDSL_3 = $10,000 \times 0.03 = $300 ). The remaining proceeds would be $11,000 - $300 = $10,700. This calculation demonstrates how the redemption value is affected.

Interpreting the Contingent Deferred Sales Load

The contingent deferred sales load should be interpreted as a potential cost that investors might incur if they do not adhere to the recommended holding period for a specific investment. A higher CDSL percentage in the early years indicates a stronger disincentive for short-term trading. As the percentage declines, the cost of early withdrawal diminishes. Investors should compare the CDSL schedule with their anticipated investment horizon to determine if this fee structure aligns with their financial goals. Funds with a contingent deferred sales load also often have higher annual 12b-1 fees and other ongoing expenses compared to funds with front-end loads or no loads.²⁰, ²¹ Understanding this trade-off is crucial for evaluating the overall cost of ownership.

Hypothetical Example

Consider an investor, Sarah, who invests $50,000 in a mutual fund with a contingent deferred sales load schedule as follows:

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

Sarah's initial principal investment is $50,000.

Scenario 1: Sarah redeems her shares at the end of Year 2.
At this point, the CDSL rate is 4%. Assume her investment has grown to $55,000. The CDSL would be calculated on the lower of the initial principal ($50,000) or the current value ($55,000), which is $50,000.
CDSL = $50,000 * 0.04 = $2,000.
Sarah would receive $55,000 - $2,000 = $53,000.

Scenario 2: Sarah redeems her shares at the end of Year 6.
At this point, the CDSL rate is 0%. Even if her investment has grown significantly, say to $70,000, she pays no contingent deferred sales load.
CDSL = $70,000 * 0.00 = $0.
Sarah would receive $70,000.

This example illustrates how the contingent deferred sales load penalizes early withdrawals but disappears for long-term holders, impacting the overall return on investment.

Practical Applications

Contingent deferred sales loads are primarily found in mutual funds, particularly those offered as Class B or Class C shares, and in certain types of annuities. They serve as a mechanism for financial advisors and brokers to receive compensation for selling investment products without charging an upfront fee to the investor. This can make the investment seem more attractive initially, as the full capital is invested immediately.

For financial planning, understanding the contingent deferred sales load is critical when evaluating the true cost of an investment, especially for individuals with a potentially shorter time horizon or those who might need access to their funds. Financial Industry Regulatory Authority (FINRA) Rule 2341 (formerly NASD Rule 2830) regulates sales charges, including contingent deferred sales loads, to ensure they are not excessive and that investors receive appropriate disclosures.¹⁷, ¹⁸, ¹⁹ This regulation aims to protect investors from unduly high fees. Investors can typically find the specific details of a fund's contingent deferred sales load in its prospectus or summary prospectus.¹⁶

Limitations and Criticisms

While designed to incentivize long-term investing, contingent deferred sales loads face several criticisms. One major drawback is that they can be an unnecessary expense for many investors, especially given the widespread availability of exchange-traded funds (ETFs) and no-load mutual funds which do not charge such fees. Critics argue that CDSLs add to the overall cost of an investment without necessarily contributing to higher returns.

Furthermore, investors may overlook these deferred charges when initially purchasing a fund, only to be surprised by the fee upon redemption. This lack of initial transparency can be a significant point of contention. Contingent deferred sales loads can also penalize investors who need to make early withdrawals due to unforeseen financial emergencies, forcing them to incur a fee on their own capital. The presence of higher ongoing expense ratios (including 12b-1 fees) often associated with contingent deferred sales load shares further reduces the net return for investors over time.¹⁵ Morningstar, an independent investment research firm, has often highlighted the impact of fees on investor returns, noting that higher fees can erode investment gains.¹⁴

Contingent Deferred Sales Load vs. Front-End Load

The primary distinction between a contingent deferred sales load and a front-end load lies in when the sales charge is incurred.

While a contingent deferred sales load allows the investor's entire principal to be invested from day one, it imposes a penalty for early withdrawal. Conversely, a front-end load reduces the initial investment amount, but no further sales charge is levied upon redemption. Both types of loads ultimately serve to compensate the financial professional who sold the fund shares.⁵

FAQs

What is the main purpose of a contingent deferred sales load?

The main purpose of a contingent deferred sales load is to compensate the broker or financial advisor who sold the mutual fund or annuity shares and to encourage investors to hold their shares for a longer period, typically to avoid the charge.⁴

How does a contingent deferred sales load decrease over time?

A contingent deferred sales load typically starts at a higher percentage (e.g., 5% or 6%) in the first year and gradually decreases by a set amount (e.g., 1% per year) over a specified period, usually five to ten years, until it reaches zero.², ³

Are all mutual funds subject to a contingent deferred sales load?

No, not all mutual funds have a contingent deferred sales load. This fee is commonly associated with certain share classes, such as Class B and Class C shares. Many no-load funds and exchange-traded funds (ETFs) do not impose sales loads.

Can I avoid paying a contingent deferred sales load?

Yes, you can often avoid paying a contingent deferred sales load by holding the investment for the entire specified period, after which the load typically drops to zero. Additionally, some transactions, like exchanges within the same fund family, may be exempt.

Is a contingent deferred sales load the same as a redemption fee?

While both are charged upon withdrawal, a contingent deferred sales load is a sales charge that decreases over time and compensates the seller. A redemption fee, on the other hand, is a fee charged by the mutual fund itself to discourage short-term trading and manage fund expenses, and it does not typically decrease over time in the same manner.¹