Deferred commission

What Is Deferred Commission?

Deferred commission is a type of sales charge or fee associated with certain investment products, predominantly mutual funds and annuities, that investors pay when they redeem or sell their shares, rather than at the time of purchase. This compensation structure falls under the broader category of Investment Fees and Compensation. Often referred to as a "back-end load" or "contingent deferred sales charge" (CDSC), a deferred commission is designed to compensate the broker-dealers or financial professionals who sold the product. Unlike a front-end load, where a portion of the initial investment is immediately deducted, a deferred commission allows the full amount invested to be put to work from day one. However, withdrawing the investment before a specified period, typically several years, incurs this charge.

History and Origin

The concept of deferred commission, particularly as a contingent deferred sales charge (CDSC) in mutual funds, emerged in the mid-1980s. Prior to this, mutual funds primarily used front-end load structures, where investors paid a sales charge upfront, sometimes as high as 9%¹³. The introduction of the deferred sales charge allowed investors to bypass these initial fees, making mutual funds appear more accessible and attractive by ensuring that 100% of the investor's capital was immediately invested¹². This innovation was a response to a competitive environment where financial advisors sought new ways to sell investment products while still receiving compensation¹¹. Regulatory bodies like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have since provided guidelines and disclosures for these fees to ensure transparency for investors¹⁰.

Key Takeaways

• Deferred commission is a sales charge paid by investors when they sell or redeem certain investment shares, such as mutual funds or annuities.
• It is often known as a back-end load or contingent deferred sales charge (CDSC).
• The fee typically declines over a specified holding period, often reaching zero after several years.
• It allows the full initial investment to be put to work, as the charge is not deducted upfront.
• The primary purpose of a deferred commission is to compensate the financial professional who sold the investment.

Interpreting the Deferred Commission

A deferred commission, usually expressed as a percentage, applies if an investor sells shares before a specific timeframe has elapsed. The percentage often declines annually over a set period, such as five to seven years, eventually reaching zero. For example, a mutual fund might impose a 5% deferred commission if shares are redeemed in the first year, 4% in the second year, and so on, until the charge is eliminated⁹. This declining schedule encourages long-term holding of the investment.

Investors typically determine the applicable deferred commission by consulting the fund's prospectus⁸. The calculation of the deferred commission is generally based on the lesser of the initial investment amount or the current net asset value at the time of redemption. This protects investors from paying a higher sales charge than their original investment if the fund's value declines. Understanding this fee schedule is crucial for investors assessing the total cost of their investment portfolio and making informed redemption decisions.

Hypothetical Example

Consider an investor, Sarah, who invests $10,000 in a Class B mutual fund that carries a deferred commission. The fund's prospectus outlines the following CDSC schedule:

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

Sarah's initial investment of $10,000 is fully invested into the fund, unlike a front-end load scenario.

Scenario 1: Early Redemption
After 20 months (in Year 2 of her holding period), Sarah needs to withdraw her money. At this time, her investment has grown to $11,500. According to the fund's schedule, the deferred commission is 4%. Assuming the charge is based on the lesser of the initial investment or current value, it would be calculated on $10,000 (her initial investment).

Calculation: $10,000 (initial investment) * 0.04 (4% deferred commission) = $400.

Sarah would receive $11,500 - $400 = $11,100 after the deferred commission is applied.

Scenario 2: Long-Term Holding
Alternatively, if Sarah held her investment for six years, the deferred commission would be 0%. If her investment had grown to $13,000 by then, she would receive the full $13,000 upon redemption, with no deferred commission deducted. This highlights how deferred commissions incentivize a long-term investment horizon.

Practical Applications

Deferred commissions are primarily found in specific share classes of mutual funds, typically Class B or Class C shares, and in certain types of annuities. In the context of mutual funds, these charges facilitate the compensation of financial professionals who sell the fund shares without deducting an upfront fee from the investor's principal⁷. This allows for the full investment of capital at the outset.

For investors, understanding the deferred commission structure is a critical component of effective financial planning. It influences decisions regarding the appropriate holding period for an investment and the overall cost analysis. While less common than in previous decades, deferred commissions remain a feature of some investment products, and their terms are always detailed in the product's prospectus⁶. The SEC provides extensive investor education on how these sales loads impact investment outcomes⁵.

Limitations and Criticisms

While deferred commissions allow for full initial investment, they are not without limitations or criticisms. A primary concern is the potential for investors to incur substantial fees if they need to redeem their securities before the deferred period expires. This can limit an investor's liquidity and flexibility, especially if unforeseen financial needs arise⁴.

Critics also point to the lack of transparency for some investors, as the fee is not deducted upfront and may be overlooked when comparing investment options, despite being fully disclosed in the prospectus³. Additionally, the presence of a deferred commission often correlates with higher ongoing annual expense ratios or 12b-1 fees for the associated share class, compared to front-end load or no-load alternatives². These higher ongoing fees can erode long-term returns, even if the deferred commission eventually disappears. Academic research suggests that while some share classes with deferred charges may align with longer investor horizons, the overall impact of fees on mutual fund returns is a significant area of study in investment management¹.

Deferred Commission vs. Front-End Load

Deferred commission and front-end load are both types of sales loads designed to compensate the party selling investment products, primarily mutual funds. The fundamental difference lies in when the fee is paid.

Confusion often arises because both fees serve the same purpose: compensating the selling agent. However, their impact on an investor's capital at different stages of the investment lifecycle is distinct. A deferred commission (or contingent deferred sales charge) can be advantageous for investors committed to a long-term holding period, whereas a front-end load is a one-time charge at the outset.

FAQs

What does "deferred commission" mean for my investment?

Deferred commission means you pay a fee when you sell your investment, not when you buy it. The fee typically decreases the longer you hold the investment, often becoming zero after several years.

Why would an investor choose a fund with a deferred commission?

Investors might choose a fund with a deferred commission because it allows their entire initial investment to be put to work immediately, unlike funds with a front-end load that deduct a fee upfront. This can lead to greater growth if the investment performs well from the start.

Is a deferred commission the same as a "back-end load"?

Yes, "deferred commission" is often used interchangeably with "back-end load" or "contingent deferred sales charge" (CDSC). All refer to a sales fee paid at the time of redemption, which usually declines over time.

How can I avoid paying a deferred commission?

You can generally avoid paying a deferred commission by holding your investment for the full specified period, as outlined in the fund's prospectus. After this period, the fee typically drops to zero. Always review the sales loads and fee schedule before investing.

Do all mutual funds have deferred commissions?

No, not all mutual funds have deferred commissions. Many mutual funds have front-end loads, while others are "no-load" funds, meaning they do not charge any sales commissions, though they still have ongoing expense ratios and other fees. Investors should carefully review the fund's prospectus to understand all associated costs.