Even if they want to, time is running out for mutual fund manufacturers and distributors to agree upon a common approach to commission payments ahead of the planned April 10 deadline for the Department of Labor’s new fiduciary rule. In fact, financial advisors are unlikely to see any commonality in share class offerings in the foreseeable future, experts say.
It's little wonder that mutual fund providers have not uniformly developed share classes for retail intermediaries. There is also no consensus on how broker-dealers and other wealth managers can continue to accept commissions once fiduciary responsibilities for retirement accounts are extended from RIAs to a wider spread of the advisory market.
“It’s a very fluid situation,” says Dan O’Lear, head of retail distribution for North America at Franklin Templeton. “Some broker-dealers have changed policy more than once.”
Three options are apparently being hurriedly discussed by fund providers, but with the approval process for new share classes taking 60 to 90 days, many are hoping for a delay under Andrew Puzder, President-elect Donald Trump’s nominee as new DOL secretary.
To date, broker-dealers and certain other intermediaries have funded their distribution costs via the varying sales loads or commissions attached to mutual fund share classes. The exact relationship between the fees and the services they support has become increasingly opaque, notwithstanding disclosure rules introduced in 2012.
And over the past decade, higher sales load share classes (ABCs) have gradually lost ground as both ‘no-load’ and retirement (R) classes have become more widely available (see chart below).
Under the fiduciary rule, advisors who continue to recommend share classes with high or complex commission structures risk the regulator’s wrath, even if operating under best interest exemptions, say securities lawyers.
But broker-dealers are struggling to adjust their business models. Some have publicly eschewed commissions, others intend to let retirees chose between commission-based and fee-based accounts, while still others may opt out of funds altogether. Three core options are emerging, but the precise path to lower (or even zero) mutual fund commissions remains unclear.
First, broker-dealers are hoping to exploit an exemption to Section 22(d) of the 1940 Investment Act, which forces broker-dealers to offer share classes in line with the fund prospectus, meaning the fund provider sets the sales load.
An exemption from the SEC would let a broker-dealer carve out a schedule for its own clients, requiring mutual funds to administer fee structures and other terms for the distributor. The broker-dealer might reduce sales loads and conflict of interest concerns, but at the fund manager’s expense.
“Even if you sold through 10-20 advisors, things could very quickly get out of hand,” says Dechert partner Jack Murphy.
In 2010, the SEC proposed an amendment to Section 22(d) to allow greater competition between broker-dealers on sales loads, and has issued “no action” letters several times in recent years. Broker-dealers are discussing disclosure implications with the SEC, suggesting charges be reflected in appendices to the main prospectus, say securities lawyers.
Second, a new share class could emerge which provides a single, level and transparent sales load to compensate advisors equally for costs of sales incurred. The existing T share class has been tapped as the starting point for this new share class, but at present there is no consensus on the commission level (with proposals varying between 2-3.5%) or other features.
Originally intended for short-term retail investors, the T share class could help to clarify operating expenses in the retirement sector, says Paul Ellenbogen, director of global regulatory solutions at Morningstar.
“We’re seeing a lot of talk about the development of clean share classes with no distribution or advice fees,” he says. “Broker-dealers are the price makers. If you want to be one of the funds left on their platforms as they reduce their range, you’ll issue the share classes they want.”
Third, existing low-to-no-load share classes are being modified and repurposed to provide lower fee levels and greater transparency. In the last six months, mutual funds have issued or migrated institutional (I) or retirement share classes which eliminate all but the most basic charges. In October, for example, American Funds filed a prospectus for an F3, which cuts out 12b-1 distribution fees and sub-transfer agency fees like R3 shares, but is aimed at the retail wealth management market.
The issuance trend appears well established. In the first 11 months of 2016, 58.4% of new share classes were classified as retirement or institutional shares by Morningstar, versus 19.8% in ABC share classes (compares with 55.4% and 23.7% respectively in the whole of 2015).
Brendan Powers, retail asset management research analyst at Cerulli Associates, expects lower A and greater I class use in the next 12 months.
“Mutual fund manufacturers will have to become more cognizant of the plans of the distributors they do business with. In the short-term, this would likely involve greater flexibility from manufacturers as they work with distributors who are adjusting their business models.”
While many expect a short-term increase in share classes, time is running out for broker-dealers to let their preferences be known. A new share class can be distributed 60 days after filing, but it can take an additional 30 days for internal hurdles to be overcome, says Ellenbogen, leaving scant time after the holiday period.
Until then, mutual funds must play a waiting game, according to O’Lear.
“If I create a new share class now, there is a risk I might not be able to offer it on certain broker-dealers’ platforms as it may not fit with their model,” he says. “We’re listening, we haven’t made any decisions, but we’re considering a lot.”