What is this 12b-1 fee in my 401(k)?

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Key Takeaways

  • 12b-1 fees are paid out of mutual fund assets to cover the costs of distribution and other services

  • They’re typically broken down into marketing and distribution fees and service fees

  • While 12b-1 fees may not increase a fund’s performance, they’re not uncommon among mutual funds

If you haven’t heard of a 12b-1 fee and just discovered it in your 401(k) charges, you’re not alone. This charge, which earns mutual funds nearly $10 billion a year, is often folded into a fund’s prospectus. 12b-1 fees are often used to cover marketing and distribution expenses as well as commissions to brokers. 

In theory, 12b-1 expenditures can actually make a fund more attractive through economies of scale: more marketing means more investors, and more investors means less overhead per person. But in practice, 12b-1 fees can inflate the cost of a mutual fund with little return.

So what does a 12b-1 fee do, anyway? Do higher 12b-1 fees indicate better performance, or the reverse? And what’s a reasonable charge? We’ll break down 12b-1s and help you decide if you’re investing in the right funds.

What is a 12b-1?

12b-1 fees are typically broken down into two charges:

  1. Marketing and distribution fees: Marketing and distribution fees are often commissions paid to investment intermediaries (like financial planners, advisors, and brokers) and are capped at 75 basis points (0.75% of assets). 

  2. Service fees: Also called trailing commissions, service fees are paid to brokers for providing investment education, customer service, and other ongoing customer support, and are limited to 25 basis points (0.25%). 

Between the two, 12b-1 fees are limited to 1% of assets, but they’re typically charged as a flat rate rather than a percentage. 12b-1 fees were legislated into existence in 1980, under the premise that allowing mutual funds to advertise would increase their customer base and allow for economies of scale. However, in the nearly eighty years of its existence, opinion on the 12b-1 has soured. 

Investment analysts say that not only do 12b-1’s fail to improve performance, they also create a conflict of interest: for example, fund managers earn their paychecks based on assets under management, so they’re incentivized to try to bring in new investors through marketing rather than a solid track record. As a result, financial advisors generally recommend being vigilant about the asset-based charges allocated to 12b-1 fees.

Where exactly can I find my 12b-1 fee?

If you look at a mutual fund’s quick facts, you’ll typically see its performance, load, total assets, and overall expense ratio. The 12b-1 fee is an operational expense and is included in the expense ratio. But you’ll have to do more digging to isolate that specific charge.

Instead, you’ll have to look at the mutual fund’s prospectus under the shareholder fees section to see how much it’s charging for marketing and distribution or account service. You can find prospectuses on the Securities and Exchange Commission’s website, a fund manager’s website, or Morningstar’s fund overviews. They often break 12b-1 fees out of the overall operational expenses. Prospectuses are available to read whether or not you’ve bought shares in the fund.

Keep in mind that no-load funds, which don’t charge commissions when you buy or sell shares, can still charge 12b-1 fees (we’ll go into this more in the next section).

Front-end, back-end, and 12b-1

When you’re choosing a mutual fund, you’ll want to watch out for loads (commissions or sales charges that investors pay to the fund). 12b-1 fees are a type of load themselves (in fact, they’re sometimes called level loads), and their annual charges are included in a fund’s operational expenses.

There are two other load types to keep an eye on: front-end and back-end loads. Front-end loads are a one-time purchase fee paid when you first invest in a mutual fund, and are deducted from the investment amount. For example, if you invest $10,000 in a mutual fund with a 4% front-end load, the fund will keep $400 and your initial investment will be just $9,600. Typically, front-end loads range from 3.75-5.75%.

Back-end loads, as you might have guessed, are sales commissions applied when you redeem shares in the mutual fund. They’re often used as an incentive to keep investors’ assets for a set period of time, so back-end fees often decrease over time and can be waived entirely after the fund’s holding period ends. Back-end fees are charged as a percentage of the shares you redeem, so if a fund’s back-end fee is 3% and you redeem $10,000 worth of shares, you’ll only get $9,700 of that money.

Neither front-end nor back-end loads are included in a fund’s operating expenses, since they’re one-time charges rather than ongoing levies. Just to make things more confusing, funds that list themselves as “no-commission” can’t charge front- or back-end loads, but they can charge a 12b-1. You’ll need to watch out for all types of sales commissions when evaluating funds. However, some mutual funds waive front-end, back-end, or 12b-1 fees for investors purchasing through their employer-sponsored retirement program.

Is my 12b-1 fee reasonable?

While 12b-1 fees haven’t been shown to increase a fund’s performance, they are not uncommon among mutual funds. A 2018 Motley Fool analysis of 3,796 domestic stock funds(excluding ETFs) listed on the Morningstar Principia database found that just over 40% levied 12b-1 fees, with an average fee of 0.31% and an average overall expense ratio of 1.45%. 

According to the analysis, funds that charged 12b-1 fees had an average 15-year annualized performance–or the rate at which an investment grows over a defined period of time–of 6.96%, while funds that didn’t charge 12b-1’s had a lower expense ratio of 1% and had a higher 15-year performance at 7.49.% The analysis concluded that not only do 12b-1 fees charge more fees overall, but they failed to deliver better annualized performance over 15 years.

While it’s impossible to make hard-and-fast rules, typically, a fund with high costs must perform better to generate the same returns. We think this is especially true with long-term investment accounts like 401(k) plans when small fees can eat away at your returns over time.

Putting it all together

How do you choose a fund with lower fees? You’ll want to consider your investment objectives and personal financial situation. Human Interest is committed to making 401(k)’s affordable and transparent, and we’re focused on providing access to funds with low expense ratios.

At Human Interest, we believe our fee structure is more competitive than legacy providers—many of which charge 12b-1 fees. If a plan chooses funds with 12b-1 fees, Human Interest rebates those fees to the plan to offset plan expenses. In fact, we found that revenue-sharing fees could cost participants thousands in retirement savings over the span of a career. And we never charge transaction fees to participants.

Interested? Encourage your employer to sign up for an affordable 401(k) today.

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We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.

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