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No Break Points

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

B Share mutual fund pricing is hardly ever a good thing for the investor, but it’s a great thing for brokers. Brokers seem to be born with a special gene. They instinctively know the benefits of NO BREAK POINTS, but in case they were born defective or missed that day in class, much of the internal advertising to the brokerage community that scream in huge type the magic phrase, “NO BREAK POINTS!” Perhaps investors should understand what it means, too.

The traditional load mutual fund (A Shares) charges commissions up front, investing the balance. As the dollar amount invested rises to fixed points, called “break points” the applied commission rates fall. Worse yet from the broker’s point of view is that the lower commission rates are applied to the total investment. This decreases the all important YTB (Yield to Broker) for larger accounts. Fortunately, for commission driven brokers another class of funds, B Shares have NO BREAK POINTS!

Let’s look at how the math works. Here is a typical A Share pricing schedule. In this case from the Massachusetts Financial Services Prospectus:

Amount of Purchase Sales Charge* Offering Price As Percentage of: Net Amount Invested
Less than $50,000 5.75% 6.10%
$50,000 but less than $100,000 4.375 4.99
$100,000 but less than $250,000 4.00 4.17
$250,000 but less than $500,000 2.95 3.04
$500,000 but less than $1 M 2.20 2.25
1,000,000 None** None**

* Because of rounding in the calculation of offering price, actual sales charges you pay may be more or less than those calculated using these percentages.

** For class A shares only, a 1% CDSC will apply to such purchases, as discussed below

Let’s say that you invest $500,000 in the fund. The commission is 2.2% or $11,000. This amount is clearly a disappointing YTB. The amount invested is $489,000. Annual expenses deducted directly from the account (Expense Ratio) are 1.23%.

On the other hand, the broker might have recommended B Shares. He might indicate that there is no “up front sales charge” and that all your money goes to work at once. It almost sounds like “no-load”, doesn’t it? On the face of it, it sounds pretty good so far. And you can trust your broker, right?

Not disclosed is the commission paid to the broker of 4% or $20,000, a far more satisfactory YTB. Buried deep in the prospectus is the following expense comparison:

Class A Class B
Management Fees 0.75% 0.75%
Distribution and Service (12b-1) Fees 0.25% 1.00%
Other Expenses 0.30% 0.30%
Total Annual Fund Operating Expenses 1.30% 2.05%
Fee Waiver (0.07%) (0.07%)
Net Expenses 1.23% 1.98%

Line two shows an increase of 0.75% for “Distribution and Service (12b-1) fees” which continue for 8 years. Presuming no growth in the account, that’s a tax of 6% on the fund in additional expenses. In this case the additional operating expenses amount to $30,000!

So, the investor has avoided an initial charge of 2.2% in return for additional operating expenses of 6%. Now, even the severely math challenged among us will agree that this is not a good tradeoff. The investor is unlikely to be pleased to learn that the broker earned an additional $9000 by directing him to the more expensive share class.

But, it gets worse. Should the investor wish to redeem his shares, he will encounter the dreaded “Back End Load” or Contingent Deferred Sales Charge (CDSC).

The CDSC is imposed according to the following schedule:

Year of Redemption After Purchase Contingent Deferred Sales Charge
First 4%
Second 4%
Third 3%
Fourth 3%
Fifth 2%
Sixth 1%
Seventh and following 0%

While the CDSC declines over time, it is cleverly designed so that at every point along the way the total costs to the investor (Additional operating expense plus CDSC) are higher than if they had purchased the A Share.

Notice that if the account grows over time, the penalties for higher operating expenses and back end surrender charge are both magnified. And, recurring deposits each start their own clock running when computing the back end load. Finally, smaller accounts would still be better off in A Shares even if they don’t qualify for a breakpoint. But, because the commissions are higher for A Shares than B Shares for small accounts, they might actually get the appropriate product for once.

By now you are probably asking: “You mean that brokers can sell me the highest commission products when lower cost products are available?” The answer is a resounding YES! Salesmen have no legal obligation to recommend low cost solutions to your problems. In fact, they are actively encouraged through incentives to select high expense, high commission products. There is no way these conflicts of interest can be properly managed. As long as brokers can pick and choose products to maximize their own paychecks, investors can never be sure of receiving objective advice. If you are looking for advice from a financial professional, your best bet is always to choose a fee-only advisor.

So, what should you do if you find these turkey funds as you comb through your brokerage statement? First, fire your broker. It’s unlikely he had your best interest at heart. But, what then? Paying the surrender fee to clean up that mess is painful. But, when you compare the remaining surrender fee with the additional expenses you will bear before the surrender fee goes away, in most cases you will be far better off to bite the bullet.

Coming up next: Mutual fund pricing abuses of A Shares is a new hot topic for the State Regulators and the SEC. Find out how unscrupulous brokers and brokerage houses further manipulated the system.