Deferred_sales_charge

What Is Deferred Sales Charge?

A deferred sales charge (DSC) is a fee that certain Mutual Fund investors pay when they sell or redeem their shares, typically within a specified period after the initial purchase. This charge, a component of Investment Fees, is also known as a contingent deferred sales charge (CDSC) because the fee amount is contingent upon how long the shares are held. Unlike a Front-End Load, which is paid at the time of purchase, a deferred sales charge is assessed at the time of Redemption. The percentage charged generally decreases over a set period, often five to seven years, eventually falling to zero³³. The primary purpose of a deferred sales charge is to compensate the broker or Financial Advisor who sold the fund shares, as they typically receive an upfront Commission from the fund company at the time of purchase³².

History and Origin

Sales charges, including deferred sales charges, have been a long-standing feature of the mutual fund industry, primarily serving as compensation for distributors. Historically, mutual funds compensated brokers through upfront commissions, known as front-end loads³¹. However, as investors became more sensitive to these visible upfront fees, the industry sought alternative compensation structures. The concept of the contingent deferred sales charge (CDSC) gained prominence as a way to "camouflage sales commissions" by spreading the cost over several years and making it payable upon early redemption²⁹, ³⁰.

This shift was closely tied to the evolution of mutual fund distribution, particularly following the adoption of SEC Rule 12b-1 in 1980. Rule 12b-1 allowed mutual funds to use fund assets to cover marketing and distribution expenses, which could include compensating brokers for selling shares²⁷, ²⁸. While initially intended to help funds attract new shareholders and potentially achieve economies of scale, it also enabled the development of deferred sales charges. The Mackenzie family of funds is credited with pioneering the DSC option in 1987²⁶. Over time, these charges became a common feature, particularly for Class B and sometimes Class C Share Class mutual fund shares, effectively deferring the sales compensation to the point of sale. However, the use of deferred sales charges has seen a decline in recent years, with some major investment firms eliminating them due to regulatory scrutiny and changing industry practices²⁴, ²⁵.

Key Takeaways

• A deferred sales charge (DSC) is a fee paid by investors when they sell mutual fund shares within a specified holding period.
• The fee amount typically declines each year the shares are held and eventually reaches zero.
• DSCs are also known as contingent deferred sales charges (CDSCs).
• They serve to compensate the broker or financial advisor who sold the fund, often through an upfront payment from the fund company.
• Investors can generally avoid deferred sales charges by holding the mutual fund shares beyond the specified declining period.

Interpreting the Deferred Sales Charge

A deferred sales charge is commonly structured as a percentage of either the original purchase cost or the current Net Asset Value (NAV) at the time of Redemption, whichever is less. This percentage typically starts at a higher rate (e.g., 5-6%) in the first year after purchase and decreases annually until it reaches 0% after a certain number of years, usually five to seven²³. For instance, a fund might charge 5% if redeemed in year 1, 4% in year 2, and so on, until year 7 when it becomes 0%.

When evaluating a mutual fund with a deferred sales charge, a prospective Shareholder should carefully examine the fund's Prospectus to understand the specific fee schedule and the duration of the charge. The presence of a deferred sales charge suggests that the fund's structure is designed for longer-term investors, as holding the shares for the full declining period allows the investor to avoid the fee entirely. Conversely, selling before this period expires will incur the charge, reducing the overall return on the Investment Portfolio.

Hypothetical Example

Consider an investor, Sarah, who purchases $10,000 worth of Class B mutual fund shares on January 1, 2024. The fund has a deferred sales charge schedule as follows:

• Year 1 (Jan 1, 2024 - Dec 31, 2024): 5% DSC
• Year 2 (Jan 1, 2025 - Dec 31, 2025): 4% DSC
• Year 3 (Jan 1, 2026 - Dec 31, 2026): 3% DSC
• Year 4 (Jan 1, 2027 - Dec 31, 2027): 2% DSC
• Year 5 (Jan 1, 2028 - Dec 31, 2028): 1% DSC
• Year 6 and beyond: 0% DSC

Suppose Sarah needs to sell her shares on October 15, 2026, which falls within Year 3 of her holding period. At that time, her investment has grown to $12,000.

The deferred sales charge calculation will typically be based on the lesser of the original investment amount or the current value at redemption. In this example, let's assume it's based on the original investment for simplicity, though funds may vary.

The applicable deferred sales charge rate is 3%.
DSC Amount = $10,000 (Original Investment) * 3% = $300

When Sarah redeems her $12,000 worth of shares, she would receive:
Redemption Proceeds = $12,000 - $300 = $11,700

If Sarah had waited until January 1, 2029, or later, to sell her shares, the deferred sales charge would have been 0%, and she would have received the full market value of her investment at the time of Redemption.

Practical Applications

Deferred sales charges are primarily found in Mutual Fund investments, particularly in certain Share Class structures like Class B or some Class C shares. These charges are a way for fund companies to compensate selling agents, such as brokers and Financial Advisors, for distributing their products without directly charging the investor an upfront Sales Load. Instead, the compensation is recouped if the investor sells the shares prematurely²¹, ²².

While the Securities and Exchange Commission (SEC) does not limit the amount of sales loads, the Financial Industry Regulatory Authority (FINRA) imposes caps on the aggregate amount of sales charges, including deferred sales charges¹⁸, ¹⁹, ²⁰. For investment companies with an asset-based sales charge that also pay a service fee, FINRA rules state that the aggregate of asset-based, front-end, and deferred sales charges should not exceed 6.25% of total new gross sales¹⁶, ¹⁷. If no service fee is paid, this limit is 7.25%¹⁴, ¹⁵. These regulations aim to protect investors from excessive fees.

However, the regulatory landscape regarding deferred sales charges is evolving. Some jurisdictions, like Canada, have moved to ban deferred sales charges on new mutual fund purchases, effective June 1, 2022, recognizing that these charges can create incentives for dealers that may not align with an investor's best interests¹³. This demonstrates a broader trend towards greater transparency and alignment of interests in fee structures across the investment industry.

Limitations and Criticisms

Despite their intended purpose, deferred sales charges (DSCs) have faced significant criticism from investor advocates and regulators alike. A primary concern is that they can create a "hidden" fee that investors may not fully understand at the time of purchase¹². While the Prospectus details these fees, investors may overlook the implications of early Redemption until they decide to sell. This lack of transparency can lead to unpleasant surprises if an unexpected life event necessitates early withdrawal, resulting in a substantial penalty.

Critics also argue that DSCs can incentivize brokers to sell mutual funds that might not be the most suitable for an investor's liquidity needs, especially if the broker receives a larger upfront Commission from certain fund families for selling DSC-laden shares¹⁰, ¹¹. This can create a conflict of interest for the Financial Advisor, potentially leading to recommendations that benefit the advisor more than the client's Investment Portfolio. Furthermore, DSCs can "trap" investors in funds with higher ongoing annual expenses, known as the Expense Ratio, because selling early to switch to a lower-cost alternative would trigger the deferred sales charge⁸, ⁹.

The debate over the appropriateness of deferred sales charges and other embedded compensation structures has prompted regulatory action in various regions. For instance, the Canadian Securities Administrators (CSA) has implemented a ban on deferred sales charges for new purchases of mutual funds, citing concerns about incentives for dealers and potential investor harm⁶, ⁷. This regulatory shift reflects a growing consensus that such fees can hinder investor flexibility and transparency.

Deferred Sales Charge vs. Front-End Load

The key distinction between a deferred sales charge and a Front-End Load lies in when the investor pays the Sales Load.

While both are forms of Sales Load designed to compensate the selling broker or advisor, their timing significantly impacts an investor's initial capital and liquidity. With a front-end load, less capital is immediately invested, potentially reducing the compounding effect. Conversely, a deferred sales charge allows the full investment to go into the fund initially but penalizes early Redemption. The choice between a fund with a deferred sales charge and one with a front-end load often depends on an investor's anticipated holding period and preference for how sales commissions are paid.

FAQs

What is a contingent deferred sales charge (CDSC)?

A contingent deferred sales charge (CDSC) is another name for a deferred sales charge (DSC). It emphasizes that the fee is "contingent" upon the Shareholder selling their Mutual Fund shares within a specific time frame, and the amount of the fee is also contingent on the holding period, typically declining over time.

How can I avoid paying a deferred sales charge?

You can generally avoid paying a deferred sales charge by holding your Mutual Fund shares for the entire period specified in the fund's Prospectus, after which the fee typically declines to zero⁵. Some funds also allow you to redeem a small percentage (e.g., 10%) of your holdings annually without incurring the charge⁴.

Are all mutual funds subject to deferred sales charges?

No, not all Mutual Funds have deferred sales charges. Many funds are "no-load" funds, meaning they do not charge any Sales Loads (either front-end or deferred). Exchange-Traded Fund (ETF)s also typically do not have deferred sales charges. Investors should always review a fund's Prospectus to understand its fee structure.

Does a deferred sales charge affect my investment returns?

Yes, a deferred sales charge directly reduces the amount of money you receive when you sell your shares prematurely, thereby lowering your net Investment Portfolio return³. Even if your investment grows, the fee takes a portion of that growth or original capital. Additionally, funds with deferred sales charges often have higher ongoing annual Expense Ratios compared to no-load or front-load funds¹, ².