Letter of Intent (Mutual Funds)

A letter of intent, in the mutual fund sense, is a written statement in which an investor says they plan to invest a set total in a fund family over a fixed period, usually 13 months, in return for paying the lower front-end sales charge that the total would qualify for. Each purchase during the period is charged at the reduced rate from the start, even though the investor has not yet reached the breakpoint.

This is a narrow, fund-specific meaning. In business and deal-making, a letter of intent (LOI) is a preliminary document setting out the main terms of a proposed transaction before a final contract is signed. The fund version is a discount arrangement built into the fund's prospectus. It works alongside rights of accumulation (ROA), which count shares already owned, as one of the main ways to reduce mutual fund loads.

A letter of intent is like a gym that offers the annual-membership rate to someone paying monthly, as long as they sign up for a full year. You get the cheaper price on every payment from day one. If you quit early, the gym takes back the discount you were not entitled to.

With a fund, you tell the company you will invest a certain amount over the next year or so. Every purchase in that time gets the lower charge. To make sure it can collect if you fall short, the fund holds back a small slice of your shares until the promise is met.

The investor signs the letter, usually as part of the account application, naming the target amount. The usual steps are:

1. Set the target. The investor chooses a total that reaches a breakpoint, such as $100,000. Some funds let existing holdings count towards the target, combining the letter with ROA, and some let the letter be backdated to cover recent purchases, often up to 90 days.
2. Buy at the reduced rate. Each purchase during the period, usually 13 months, pays the sales charge that applies to the target amount rather than to the single purchase.
3. Escrow. The fund's transfer agent holds a portion of the shares bought, commonly up to 5% of the target, in escrow. The investor still owns them and receives their dividends.
4. Settle at the end. If the target is met, the escrowed shares are released. If not, the fund collects the difference between the charge actually paid and the charge that applies to the amount actually invested, normally by redeeming some of the escrowed shares.

The letter does not oblige the investor to buy anything. The only consequence of falling short is losing the discount. If purchases exceed the target and reach a higher breakpoint, many funds apply the lower rate to the whole amount.

A fund charges 5.75% on purchases under $50,000, 4.50% from $50,000 and 3.50% from $100,000. An investor signs a letter of intent for $100,000 and makes four purchases of $20,000. The adjustment owed at the end of the period is:

Here $A$ is the amount actually invested, $r_{\text{actual}}$ is the rate that amount qualifies for on its own, and $r_{\text{LOI}}$ is the reduced rate paid under the letter. The investor paid $0.035 \times 80{,}000 = 2{,}800$ dollars. The $80,000 actually invested only qualifies for 4.50%, which would cost $0.045 \times 80{,}000 = 3{,}600$ dollars. The adjustment is $(0.045 - 0.035) \times 80{,}000 = 800$ dollars, paid from the escrowed shares. Had the investor reached $100,000, nothing more would be owed: the whole amount would have been bought at 3.50%, for a total charge of $3,500.

US fund prospectuses must describe the letter of intent along with other breakpoint arrangements, a requirement the Securities and Exchange Commission (SEC) added to Form N-1A in 2004 after examiners found that many investors had missed discounts they were owed. The Financial Industry Regulatory Authority (FINRA) describes the usual period as 13 months, but the period, escrow percentage and backdating window are set by each fund, so the prospectus and statement of additional information (SAI) are the authority. Brokers are expected to tell customers when a letter of intent could lower their costs.

A letter of intent suits investors who know a larger sum is coming but cannot invest it all at once, such as someone moving money from a maturing deposit, receiving a bonus in instalments or investing on a schedule through a systematic investment plan. It only matters for Class A and other share classes with a front-end load, and only for purchases bought at the public offering price (POP). It has no role for no-load funds or exchange-traded funds (ETFs).

• FINRA: Breakpoints