Even for financial advisors, the proliferation in recent years of different variable annuity and mutual fund share classes can be overwhelming. Some companies may have as many as 15+ share classes for a single investment strategy, all with unique advisor compensation, surrender charges, and fees. Yet by definition, not all of these share classes can possibly be the best for any particular investor. And in too many cases, it's simply a matter of the advisor choosing how they wish to get paid.
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss why there are only a few share classes necessary under a fiduciary rule, and why that means there's an impending fiduciary armageddon for (most) mutual fund and variable annuity share classes coming soon!
Because the reality is that the differences amongst most share classes ultimately boils down to the different ways that mutual fund companies pay distribution costs - i.e., commissions - across various sales channels. Those who preferred upfront commissions would sell A or B shares, while those who preferred levelized commissions would sell C shares, and those who got paid an advisory fee would charge their 1% AUM fee separately and use institutional or advisory share classes instead. Retirement plans and 529 plans cut their own deals as well, for their own share class alternatives. And the client got whichever share class happened to be sold by the broker or plan they were working with, and paid the associated cost, including embedded commissions, 12b-1 fees, and sub-TA fees, that may or may not apply.
But in a fiduciary world, the advisor is always expected to use the lowest cost share class for the client. Notably, the fiduciary rule doesn't actually require that advisors use the lowest cost fund, period; it's a myth that the fiduciary rule requires index funds to the exclusion of actively managed funds. However, if the advisor is going to recommend an actively managed fund... it better be the cheapest version of the fund available, because using anything different would represent a conflict of interest for the advisor enriching themselves at the expense of the client with an unecessarily-more-expensive product.
Yet taken to its logical conclusion, this means that most variable annuity and mutual fund share classes will be rendered entirely irrelevant under DoL fiduciary! At best, there may only be 2 share classes available - the uniform-commission T share for those who are paid some moderate upfront commission, and an institutional or advisory share class for everyone else (who separately charge their own advisory fee on top). And the other dozen or more share classes just vanish!
Of course, the transition may not happen immediately. Not only is there the potential that DoL fiduciary will at least be delayed, but given that it only applies to retirement investors, other share classes may still get used in non-retirement accounts for a while longer. But the key point is that under a fiduciary rule, there is only a legitimate need for one or two share classes at most. As a result, whether it's the Department of Labor fiduciary rule, or one that the SEC follows with in a few years, what we'll soon see is an armageddon that destroys most mutual fund and variable annuity share classes, as we complete the shift from being brokers who sell whatever products we can get paid to sell, into advisors who actually sell advice and implement the best solutions we can at the lowest cost they're available for!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces!
I want to talk today about mutual fund share classes... starting with some of my own experience starting out as a financial advisor.
When I started in the industry about 17 years ago, and was studying for my Series 6 and going through all the initial product training with the company, I remember feeling a little overwhelmed by all the different mutual fund share classes. There were A shares, and B shares, and C shares... and they all had different compensation, different surrender charges for the client, and different costs.
I was struggling to figure out when exactly you are supposed to use each one. For instance, when do I use an A share instead of a C share? Is there are right client situation for one versus the other? Or do I just basically choose whichever one aligns with how I want to get paid?
Because if getting paid was the deciding factor, it was actually pretty straightforward. The only thing I recommended was A shares. Because I had no clients, I had no revenue, and I wanted to qualify my contract and the salary draw I was receiving! I figured out how to play the game pretty quickly. You sell the version that lets you stay in the game. Which meant selling only A shares, and getting as much of the commission as I could.
Now, when I look back, I'm embarrassed about those days. Reflect back on it, I was selling whatever could get me the biggest up-front commission. I didn't think of it that way at the time. I wasn't trying to be greedy. I wasn't trying to screw my clients or anything like that. I was genuinely trying to help them. But I joined a firm that said I needed to meet a certain level of production to keep my job. And the fastest path to making my production requirements was to sell the mutual fund share class that got me there the fastest. Which meant A shares, where I could hit my targets at a 5% clip for every $1 that I moved.
Fortunately, the industry has changed a lot from when I got started. But if anything, I think when it comes to share classes, it's actually gotten more confusing, because the proliferation of share classes has gotten even worse. Now there are more than ever!
And so in today's Office Hours, I want to talk a about mutual fund and variable annuity share classes, and the explosion of all the different share classes, and how I think the industry's shift to fiduciary is basically going to be Armageddon for most of these share classes!
Mutual Fund Share Classes: Different Ways To Get Paid For Fund Distribution [Time - 2:17]
The starting point is just to look at the three classic types of mutual fund share classes.
First there were A shares, that paid an upfront commission to the broker who sold them. The payment came straight out of the fund's NAV price, with breakpoints for larger dollar amounts.
Then there were B shares, which had the so-called "contingent deferred sales charge," or CDSC, which was basically a surrender charge to recover commissions. Because B shares paid a similar commission to the broker as an A share, but it didn't come out of the NAV up front. Instead, the fund advanced the commission to the advisor, and had an ongoing expense ratio that was higher to recover the commission over time. The broker might be paid 5% up front, while the fund charged an extra 1% per year to make up for it. After five years, the fund had made all its money back. If the client left within those first five years, the CDSC surrender charge recovered the unpaid amount. In other words, the broker got paid 5%, and if the investor left after three years, the investor had to pay a 2% penalty, which recovered the last 2% that was already paid as a commission to the broker but hadn't been recovered by the fund company through the higher expense ratio.
Last, there were the C shares, which simply paid 1% a year, and had no upfront commission to the broker beyond the first 1% paid immediately. But the expense ratio was typically about 1% higher to compensate for it. That was the deal.
So to summarize, the options were: paid up front with A shares, paid up front but no upfront hit with B shares, or just the levelized commission of C shares.
In practice, B shares have largely wound down, due primarily to a lot of sales abuses. They're still out there, but the problem was that since the upfront commission for A shares is reduced for large purchases investors receive at breakpoints, while B share commissions were generally fixed, some unscrupulous brokers sold B shares at higher commissions instead of A shares that would've paid lower commissions with breakpoints. And regulators caught on. Effectively, for what was otherwise the exact same fund, the client just got charged more for no reason, even or especially if they planned to hold for the long term. So brokers still have a choice to sell an A share with an upfront or a C share with levelized commission, but B shares have been getting squeezed out.
In addition to A, B, and C shares, it's worth noting that most mutual funds also have some kind of institutional or advisory share class. These typically have no commission payments at all. They might include just the 25-basis point servicing fee portion of a 12b-1 fee. Although, that itself is optional. So currently, in addition to A, B, and C shares, most companies also have "I Class" shares for institutional funds.
American Funds calls them "F Class" shares. They've got the F-1 share class and the F-2 share class. The difference between F-1 and F-2 shares is whether they have the 25-basis point 12b-1 fee, that's paid either to the advisor, or in some cases, to the platform that offers it. This 12b-1 fee is how a lot of platforms offer no transaction-fee-funds (NTF) no-load mutual fund purchases. Because the platform actually is getting 25 basis points of compensation in the form of the 12b-1 fee, that the client is paying for to get that "no transaction fee" purchase.
In addition to these share classes, American Funds actually recently introduced a new F-3 share class as well, similar to the F-2 share class with no 12b-1 fee, but it also has no sub-transfer agent (sub-TA) fee.
For those who aren't familiar, Sub-TA fees are another kind of fee paid by the investors, through the mutual fund, to the investment platform. Technically, it's to compensate the platform for all the work it has to do keeping track of investor purchases and sales, related recordkeeping, capital gain dividend distributions, and so on. All those things that have to be tracked when the investor doesn't actually buy directly from a mutual fund company and instead buys through a brokerage platform. Fund companies often pay sub-TA fees, but the F-3 share class is now the cheapest of all for American Funds, because it strips out both the 12b-1 fees and the sub-TA fees.
American Funds is actually a good case-in-point example, because they're advisor-sold and they have a lot of these advisor share classes. In addition to the A, B, and C, and F share classes, they also have a 529-plan version of A, B, and C, and F-1 share classes. They also have retirement account share classes (R-1 through R-6), which again, vary in the payments they provide either to the broker selling the funds, the plan to support recordkeeping, or just to incentivize the use of their funds.
I'm not trying to pick on American Funds in particular, at all. They're just a good example here.
Because, if you add them all up... A shares, B shares, C shares, F-1, F-2, F-3, the alternative 529 versions of A, B, and C, and F-1, the R-1 through R-6 share classes... you end out with about 16 different share classes. For the same fund, for the same investment manager, for the same portfolio of securities! In fact, the only substantive difference across all 16 is the distribution cost - the amount of money that's paid from the fund's assets from the investor, either as a commission, a servicing fee to the broker, a servicing or transfer agent, recordkeeping, or some similar fee to either the retirement plan or the investment platform that the fund is being sold through or made available on.
And with the rise of DoL fiduciary, we're actually seeing the emergence of a 17th share class – the T share. The T share is like a hybrid of A share and C shares. It'll have a 2.5% upfront commission – like an A share, with breakpoints for larger purchases – but a 25-basis point 12b-1 fee on an ongoing basis. And then no other revenue sharing deals to platforms, to reduce some of the conflicts of interest that otherwise might run afoul of DoL fiduciary requirements.
How The Fiduciary Rule Will End Most Mutual Fund Share Classes [Time - 7:33]
Here's why all this matters.
The end result is that we have all these different ways that mutual funds get sold and distributed to the public. And all the different distribution deals have led to this massive proliferation of mutual fund share classes. Because each different share class is basically a different sales distribution deal. That's why we've got A shares with one kind of selling deal, C shares with another, F-1 with another, F-3 with another, and R-1 through R-6 all with another, all the way down the line.
But in the end, if we're going to get shifted to a fiduciary duty, the reality is you really only need one share class: whichever one is the cheapest. Not the other 16. Just that one!
There is a common point of confusion about the fiduciary rule: the belief that it would require advisors to always recommend the single lowest-cost investment solution that exists. As though everyone is just going to be required to use a handful of Vanguard and BlackRock ETFs at a cost of about three basis points each.
But that's actually untrue. There is not a requirement under the fiduciary rule to always find the one lowest-cost investment on the planet to the exclusion of all others. Nor is there any requirement to use low-cost passive funds in lieu of active ones. That's a myth.
What the rule does require, though, is that for any particular investment you're going to use, you better use the cheapest version of it available!
There's no requirement that you have to use, say, an S&P 500 Index fund over a large-cap, actively managed fund. If you can validate that the active fund provides value to justify its cost, that's fine. However, if you're going to use an S&P 500 Index fund, you damn well better use the cheapest one that's out there. Because by definition, all S&P 500 Index funds are trying to replicate the same index. So unless there's some underlying fundamental flaw in how the index fund is constructed – meaning you think it's not going to deliver on providing the S&P 500 Index returns – there's really no excuse to take a completely commoditized solution, like an S&P 500 Index fund, and buy anything except the cheapest version of it.
And here's the key point: the same is true for mutual funds.
In other words, in the context of a company like American Funds, there's no requirement to use an S&P 500 Index fund instead of Growth Fund of America, despite the fact that the American Funds actively managed fund does cost a little bit more, because they have active managers who get paid. However, if you're going to implement Growth Fund of America instead of the S&P 500 Index fund, there's no fiduciary justification for using a higher-commission A share version of the fund when you could've use the T share version. There's no justification for using the C share of the fund if you had access to the F share instead. There's no excuse to use an F-1 share with the 12b-1 and sub-TA fees if you could've used the F-3 share instead.
Because again, by definition, it's the same fund. It's the same manager. It's the same investments. The only functional difference is the distribution cost packed into the fund paid by investors to either the broker or the platform. As a fiduciary advisor, we will now have an obligation to find the lowest-cost version of that solution. Again, not necessarily the cheapest mutual fund, but the cheapest share class of that mutual fund for the client.
I realize that, in some cases, finding the lowest cost institutional share class can entirely obviate our compensation as an advisor. If you use the F-3 share class instead of the C share, you don't get paid the way that you would for a C share. That doesn't mean you have to work for free. It simply means you will need to form an advisory relationship with the client, in order to get paid the advisory fee directly from the client, and then you use the cheapest share class you can to populate the account while you get paid for what you're going to get paid for.
The end result is that the total cost to the client might actually be the same. But now, we all use the same F-3 share class. No more F-1 share, F-2 share, C share, B share, and potentially no A share or T share. In other words, we'll be going from a half a dozen different share classes, all the way down to one!
Variable Annuity Share Classes Will Collapse, Too [Time - 11:25]
Now, it's also worth noting that this discussion is not exclusive to mutual funds. Variable annuities are also legendary for multiple share classes. Historically, they had a very similar A share upfront, B share surrender charge, C share levelized commission option. Although amongst variable annuities, it's the B shares that remain the most popular, in part because A share variable annuities typically don't have breakpoints like A share mutual funds do (so there's no disincentive to use the B share, even for large purchases).
But now, there are also institutional class variable annuities, known as I shares. Then, we have a few other alternatives that are unique to variable annuities, including: L shares, which have shorter surrender period but higher M&E expense charges to recover the commission paid to the agent; O shares, which don't pay an upfront commission like A shares might, but do have a surrender charge like B shares (usually with declining M&E expenses over time); and there are X share variable annuities, which are the so-called "bonus" annuities, because it pays a bonus to the investor, but then has longer surrender charge periods and higher ongoing costs which allow the annuity carrier to cover the bonus paid up front (as there's no such thing as free money).
But here, again, all of these differences in variable annuity share classes boil down to how many different ways can we pay the selling broker an upfront or ongoing trail commission, and then adjust all the annuity contract provisions, surrender charges, ongoing expenses, and the rest, to make the math work.
Yet in a fiduciary world, you don't need all of those variable annuity share classes. You don't even want them! They just bring out conflicts of interest and potentially get the brokerage firm in trouble!
And we've seen some of that already. In recent years, lots of scrutiny has been placed on bonus annuities, and whether brokers are using the bonus to induce people to swap out of old annuities with surrender charges in order to buy a new annuity, and then use the bonus to replace the surrender charge (without recognizing the bonus itself is effectively going to get repaid over time with higher expenses in the new annuity). There has also been a lot of scrutiny on L share annuities and whether they're also inducing brokers to share a higher-cost product where there's an equivalent, though lower cost option, that would've fit better for the long-term investor. Especially when the annuity is sold with guaranteed income or death benefit riders that, by definition, would've only been relevant for long-term investors, though the L share annuity has a higher-cost for a long-term hold.
As a result, in a fiduciary world, all of these alternative annuity share classes will also start to vanish, because for a particular investor buying any particular variable annuity, the expectation is that you would sell the one version of the contract that has the lowest cost. At that point, all the other share classes of the annuity become irrelevant. You can't sell them. And if you do, it becomes an instantaneous fiduciary breach!
The Coming Armageddon Of Annuity And Mutual Fund Share Classes [Time - 13:57]
Because of these fiduciary dynamics, I think we're about to see a total collapse in the confusing number of share classes that exist today in the mutual fund and annuity arenas. At least, once DoL fiduciary actually goes through. I know it's still up in the air about whether it's just going to get delayed. But it currently looks like even if it does get delayed, it's probably going to be modified or softened a little bit, but not necessarily repealed or rescinded. And as long as that core fiduciary requirement remains, every share class besides the cheapest one will quickly become irrelevant. Or become a lawsuit waiting to happen!
My guess is that we'll find within just a year or two, mutual funds are probably going to come down to maybe two share classes. T shares for those that still do some kind of upfront commission business – so they can still get paid their 2.5% commission – and then some kind of institutional class advisory share, such as an I share or an F-3 share in the case of American Funds... with no commissions, no 12b-1 fees, and no sub-TA fees. The cheapest version of the raw investment that you can get, and then the advisor layers their advisory fee on top as appropriate. Because, if it's meant to be an advisory share class, it's virtually assured to be a fiduciary breach to use a share class with all of those additional costs when there's an alternative that doesn't have them.
Again, this doesn't necessarily mean a collapse in advisor compensation, because you can still use advisory accounts with institutional share classes and charge your own advisory fee, instead of getting paid, say, 1% through C shares. And at least for some period of time, I suspect we're going to continue to see T shares in place as well.
But I do think we're going to see A shares quickly vanish in lieu of T shares. I also think we'll see C shares quickly vanish in lieu of institutional class shares. And I think we'll see similar scrutiny on retirement share classes and 529 share classes. Variable annuities will probably also come down to a core of two alternatives: one with a moderate upfront commission, and the other one that's simply a fee-based contract.
It's worth noting that the share classes probably aren't going to vanish right away, in part because while DoL fiduciary is the catalyst that drives this, it still only applies to retirement investors. Which means, it only applies to retirement accounts, and advisors will still be able to use all those other share classes in non-retirement, taxable investment accounts, as well as for nonqualified annuities. But ultimately, I think it's only a matter of a few years before eventually the SEC acts with its own fiduciary rule – if only to bring parity to the DoL fiduciary rule and get a level playing field. Then, the same rules really will apply for retirement and taxable accounts.
And there have already been a lot of broker-dealers saying they're putting their changes in compensation in place uniformly across the whole platform now. As a result, the share classes that'll be available are going to be the same for both DoL fiduciary retirement accounts and the rest. Because, otherwise, you're kind of begging for a lawsuit against you if a lawyer ever sees that the client's non-retirement accounts have more expensive versions of the exact same fund that you're already using in their retirement account in a lower-cost alternative. For your own protection, it behooves you to be consistent across the board!
Which means, I think it's only a matter of time (and it may not even take that much time), to see a total collapse in the huge number of share classes that exist today. Fund companies that have 16 share classes will probably be down to probably just two: a version with some upfront commission for brokers who sell them – like the new mutual fund T shares – and then the lowest-cost possible institutional or advisory share class, where the advisor would be expected to layer their own advisory fee on top.
Which, effectively, will complete our transition from getting paid 1% as levelized commissions, into getting paid 1% as an advisory fee for advisory services – in essence, the shift from being brokers who sell products, into advisors who actually sell advice.
In any event, I hope this provides some food for thought about how the proliferation of mutual fund and annuity share classes that has been underway for the past decade is probably soon going to go through a very sharp reversal and decline!
This is Office Hours with Michael Kitces, 1:00 p.m. East Coast time on Tuesdays. Thanks for hanging out with us, everyone, and have a great day!
So what do you think? Are there too many variable annuity and mutual fund share classes out there? Which one(s) do you think will survive, or not? Is this a positive change for the industry? Please share your thoughts in the comments below!