12b-1 Fee

A 12b-1 fee is an annual charge taken from a US mutual fund's assets to pay for marketing and distribution, such as commissions to the brokers who sell the fund, advertising, printing sales material and ongoing shareholder service. It is named after Rule 12b-1 under the Investment Company Act of 1940, which the Securities and Exchange Commission (SEC) adopted in 1980. The fee is expressed as a percentage of average net assets and is included in the fund's expense ratio.

Unlike mutual fund loads, which are charged on a purchase or a sale, a 12b-1 fee is deducted continuously from the fund and so reduces every shareholder's return. It is separate from the management fee paid to the fund's adviser. Funds outside the US cover distribution costs in other ways, such as initial charges or a share of the annual management charge, so the 12b-1 fee is a US-specific term.

A 12b-1 fee is like a small, permanent surcharge on a monthly subscription that goes to the shop that signed you up. You never see a separate bill: it is quietly built into the price you pay each month, and it keeps running for as long as you stay subscribed.

For a fund, the "subscription" is your investment. Each day, a tiny slice of the fund's assets is set aside to pay the people who sell and service the fund. Because it comes out of the fund itself, it shows up as slightly lower returns rather than as a separate charge on your statement.

Before 1980 the SEC's position was that a fund should not use its own assets to pay for selling its shares, because existing shareholders would be paying to attract new ones. During the heavy redemptions of the 1970s, fund companies argued that growth in assets would bring economies of scale that benefit everyone. Rule 12b-1 allowed a fund to pay distribution costs from its assets as long as the payments are made under a written plan approved by the fund's board of trustees, including a majority of the independent directors, and by shareholders. The board must review the plan at least once a year and may continue it only if there is a reasonable likelihood it benefits the fund and its shareholders.

Over time the fee came to be used less for advertising and more as a way of paying brokers over time instead of through a front-end load. This made possible Class B and Class C share classes, in which the investor buys at net asset value (NAV) and pays for distribution through the annual fee, often combined with a contingent deferred sales charge (CDSC).

The SEC rule itself does not set a maximum fee. The limits come from Financial Industry Regulatory Authority (FINRA) Rule 2341, which governs the broker-dealers that sell funds:

• Distribution (asset-based sales) charge. Capped at 0.75% of average annual net assets.
• Service fee. A separate fee for shareholder service and account maintenance, capped at 0.25% of average annual net assets.
• Total sales charges. Cumulative asset-based charges, together with any front-end or deferred charge, may not exceed 7.25% of new gross sales, or 6.25% if the fund also pays a service fee, plus interest.
• No-load label. A fund may not be described as "no-load" if its combined distribution and service fees exceed 0.25% a year, or if it has any front-end or deferred sales charge.

This is why the total 12b-1 fee on most share classes is either 0.25% (typical for Class A) or 1.00% (0.75% distribution plus 0.25% service, typical for Class C).

The yearly cost of the fee is:

Here $f$ is the fee rate written as a decimal and $\bar{A}$ is the investor's average account value over the year. On an average balance of $50,000, a 1% fee costs $0.01 \times 50{,}000 = 500$ dollars a year, against $125 for a 0.25% fee. Because the fee is charged every year on a growing balance, it compounds against the investor in the same way compound interest compounds in their favour. Over a long time horizon, a 1% fee can cost more than a one-off front-end load, which is why Class C shares tend to suit shorter holding periods. The fee appears under "Distribution and/or service (12b-1) fees" in the fee table of the prospectus and is reflected in the total return figures published on the fund fact sheet.

Critics argue that 12b-1 fees have drifted far from their original purpose: they are paid by long-term shareholders who receive little in return, and many investors do not realise that they are an ongoing sales charge. In 2010 the SEC proposed replacing Rule 12b-1 with a new framework that would have limited ongoing sales charges, but the proposal was not adopted. The fees also raise conflict-of-interest concerns when an investment adviser receives them. Under its Share Class Selection Disclosure Initiative, launched in 2018, the SEC settled with dozens of advisory firms that had placed clients in classes carrying 12b-1 fees when cheaper classes of the same fund were available without disclosing the conflict; by late 2019 the firms had agreed to return more than $135 million.

The industry has moved steadily towards share classes with no 12b-1 fee, including institutional and "clean" classes and exchange-traded funds (ETFs), which generally do not charge one. In the UK, the Financial Conduct Authority (FCA) ban on adviser commission from the end of 2012 had a similar effect on trail commissions.

• 17 CFR 270.12b-1: Distribution of shares by registered open-end management investment company
• FINRA Rule 2341: Investment Company Securities