A prolonged bear market is resulting in the loss of millions of dollars in fees each year to mutual fund companies. Fund firms have a particular problem recouping the commissions fronted to brokers who sell funds with back-end loads. In response, some fund companies are changing the formula for calculating the contingent deferred sales charge (CDSC) paid by investors who redeem Class B shares within five years of their purchase. And tracking multiple CDSC calculations within the same fund share class is a new challenge for recordkeepers.

Multiple share classes gained favor in the late 1990s because they allowed a variety of pricing schedules within a single fund to satisfy the needs of different types of investors and channels of distribution. Typically, Class A shares carry a front-end sales charge, or load, while Class B shares skip the upfront sales charge but carry an annual 12b-1 fee to cover sales and marketing expenses. A back-end load, known as a contingent deferred sales charge, is imposed if Class B shares are sold before a set number of years.

Class B shares allow fund companies to compensate financial professionals for their services, while helping investors put more of their money to work sooner. The fund company pays a commission up front to the selling broker, then recoups the commission through the annual 12b-1 fee. If the investor redeems shares before five years or some set period, the investor is charged a CDSC to pay the balance of the commission. The CDSC typically starts at 5% and is reduced by 1% per year until the deferred load is reduced to zero.

With the market falling for three years in a row, the popularity of deferred-load shares has created new economic pressure on fund companies. The value of shares at the time of redemption is often less than at the time of purchase. Most funds calculate the amount of the CDSC based on the lesser of two amounts: the value of the shares when they are bought or when they are redeemed. For example, if the shareholder initially invests $10,000 and at redemption the investment has appreciated to $12,000, the back-end sales load would be calculated based on the $10,000 initial investment. If the value of the investment has declined, the back-end sale load is assessed on the lower value of the investment at redemption, not the $10,000 initial purchase. This means the fund company cannot recoup the full amount previously paid to the financial intermediary.

CDSC Based on Purchase Price

Given the prolonged economic downturn, current methods of calculating CDSC are costing mutual fund companies millions of dollars each year. With more than $300 billion in assets under management in mutual fund deferred-load share classes, fund companies have provided an estimated $12 billion in commission advances that must be recovered through the collection of 12b-1 fees and CDSC charges. Some of those charges may never be recouped, due to the loss in investment value of shares. But an increasing number of fund companies are considering revising their prospectuses to calculate CDSCs based on market value at the time of purchase.

PFPC long ago noted the proliferation of multiple asset classes, pricing schedules and 12b-1 trailing schedules within the fund industry, and anticipated the future need of clients for a flexible fund recordkeeping. Aided by an open architecture system designed to interface and support various service capabilities on a single platform, PFPC's system can now capture the CDSC calculation methodology at the time of the purchase and store this information, along with other appropriate load and commission schedules, at the purchase lot level. This new functionality allows the systems to honor grandfathered shares according to the rules that were in effect when those shares were purchased and allows new shares to capture a different CDSC calculation methodology.

With the rough-and-tumble environment of today's market, mutual fund companies must seek a method to reduce the economic risk associated with contingent deferred sales charges and to meet ongoing market challenges. Fund firms that want to stay ahead of the competition need the right service provider with the right technology solutions to help them remain competitive no matter what the market environment.

James W. Nolan is SVP & managing director for PFPC with oversight and responsibility for product development, strategic distribution and client management in the transfer agency line of business.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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