A contingent deferred sales charge (CDSC) is a fee that a mutual fund investor pays when selling shares within a set number of years after buying them. It is "deferred" because nothing is deducted at purchase, and "contingent" because it is only charged if the shares are sold before the schedule runs out. The rate usually starts at around 5% in the first year and falls step by step to zero.
A CDSC is the most common form of back-end load, one of the mutual fund loads used to pay the broker who sold the fund. It has traditionally been attached to Class B and Class C shares, and is often paired with an annual 12b-1 fee. In the United States, deferred sales loads are permitted by SEC Rule 6c-10 under the Investment Company Act of 1940, and count towards the overall limit on sales charges in FINRA Rule 2341.
Contingent deferred sales charge in plain terms
A CDSC works like an early-checkout fee on a long hotel booking. You pay nothing when you arrive, but if you leave in the first week you owe a penalty, if you leave in the second week the penalty is smaller, and if you stay the full booking you owe nothing extra. The hotel uses that promise to pay the travel agent upfront, knowing it will recover the money either from your stay or from the fee.
The fund company does something similar. It pays the selling firm a commission at the start out of its own pocket, then earns it back through yearly fees while you stay invested. If you leave early, the CDSC makes up the shortfall.
How the schedule works
Each fund sets its schedule in its prospectus. A typical schedule for old-style Class B shares, shown here only as an illustration, looked like this:
| Year shares are sold | CDSC |
|---|---|
| 1 | 5% |
| 2 | 4% |
| 3 | 3% |
| 4 | 3% |
| 5 | 2% |
| 6 | 1% |
| 7 and later | 0% |
Class C shares normally carry a much shorter CDSC, often 1% if sold within the first 12 months, combined with a higher yearly distribution fee. Large purchases of Class A shares that qualify for a zero front-end load at a breakpoint are also often subject to a 1% CDSC if sold within 12 to 18 months.
Most funds apply common conventions that soften the charge:
- Lower of cost or value. The charge is usually applied to the original purchase price or the current value, whichever is lower, so investors are not charged on gains.
- Reinvested income is free. Shares bought by reinvesting a dividend or a capital gains distribution are not subject to a CDSC.
- Oldest shares first. When part of a holding is sold, shares that are free of the charge are normally treated as sold before those still inside the schedule.
- Waivers. Many funds waive the charge on death or disability, on required minimum distributions from an individual retirement account (IRA), and on small regular withdrawals.
Worked example
The charge on a redemption can be written as:
Here is the CDSC rate for the year in which the shares are sold. An investor puts $20,000 into Class B shares and sells them in year three, when they are worth $23,000. The rate in year three is 3%, applied to the lower figure of $20,000, so the charge is dollars. The investor receives $22,400. Had the shares fallen to $18,000, the charge would have been dollars.
Moving to another fund in the same family under the exchange privilege usually does not trigger the CDSC. SEC Rule 11a-3 requires the charge to be worked out later as if the investor had held the new shares since the original purchase date.
Class B shares were designed as an alternative to the front-end load: the full purchase amount is invested at net asset value (NAV), the investor pays a yearly 12b-1 fee of up to 1%, and the shares convert to lower-cost Class A shares after a set period, commonly about eight years. Because B shares carry no front-end load, they offer none of the volume discounts that rights of accumulation unlock on A shares, so large investors were often worse off in them, and regulators brought cases against firms that sold B shares in amounts where A shares would have been cheaper. Most large US fund families have since closed Class B shares to new investors, leaving Class C as the main share class with a CDSC.
CDSCs compared with other charges
The CDSC rewards patience, so its true cost depends on the investor's time horizon. Someone who holds for many years may pay no CDSC at all, yet the higher yearly distribution fee shows up in the fund's expense ratio and reduces total return every year. The charge is similar in spirit to surrender charges on insurance products and to the redemption fees some funds levy on very short-term trading, but those are separate charges with their own rules. In the UK and EU, exit charges on retail funds are uncommon; the sales charge on most European funds, where there is one, is taken on entry.