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New Share Classes in a DOL Fiduciary World

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Regardless of the outcome of the Department of Labor’s fiduciary rule, investment management companies’ adoption of new share classes to comply with the rule may reduce conflicted advice, resulting in more money in investors’ pockets.

That’s the conclusion of research performed in April by Morningstar on the new share classes that have cropped up in order to comply with the rule — including T, Z and P shares. The Chicago-based fund research group probed the potential of these new share classes to help investors save for retirement.

The first new share class to show up was T shares (or “transactional” shares), which are designed to help financial advisors maintain their traditional business model — selling mutual funds on commission — while complying with Labor’s rules.

(Related: DOL Fiduciary Rule Inspires New Alphabet Soup of Fund Shares)

The second new share class, Z, or “clean” shares, may help financial services companies that wish to shift to a “level fee” model in which advisors’ compensation only comes from a level charge on clients’ assets and not from any varying third-party payments.

The Securities and Exchange Commission released guidance in early January to help mutual funds streamline the process of offering certain fee structures associated with the new fund classes that are designed to achieve level compensation consistent with Labor’s fiduciary rule.

The seven-page guidance was issued by the Division of Investment Management and focuses on disclosure issues and certain procedural requirements for offering variations in mutual fund sales loads and new fund share classes.

David Blass, general counsel at the Investment Company Institute in Washington, noted when the guidance was released that the SEC “will receive a large number of share class filings from funds offering variations in fund sales loads or new fund share classes in connection with the implementation” of Labor’s fiduciary rule.

Indeed, Janus filed in late January with the SEC to launch P and Z share classes for all of Janus’ intermediary funds except money markets. Both share classes “give lower sales charge options to our intermediary partners,” according to Janus.

Because DOL’s rule is designed to mitigate conflicts of interest, particularly in regard to fees charged to their retirement clients, including retirement plans and IRAs, DOL “is focused on sales commissions and other fees that may not be considered to be in the best interest of the client,” Janus said in filing the shares.

While Janus received SEC approval to launch the new share classes, the firm has yet to do so.

Paul Ellenbogen, head of global regulatory solutions at Morningstar, told me in a mid-April interview that Janus is likely among the firms in “limbo” as to whether to officially start allowing money to flow into the new shares given the uncertainty over Labor’s fiduciary rule.

Labor postponed the rule’s April 10 compliance date by 60 days, to June 9, and took comments until April 17 on President Donald Trump’s directive that Labor review the rule and consider potentially revising or rescinding it. The industry is awaiting Labor’s next move once R. Alexander Acosta is officially approved by the full Senate as the next Labor Secretary. He was approved by the Senate Banking Committee in late March.

As it stands now, according to Ellenbogen, “active” T shares that have money in them and are available for purchase are being offered by four fund complexes (with a total of 54 different funds): Calamos has 16; Transamerica offers 34 (called T1 and T2); Columbia has three; and American Beacon offers one fund.

Seven other companies have filed to launch T shares and have received SEC approval, Ellenbogen said, but are also “hedging their bets” regarding Labor’s rule, and “you can’t buy them” yet. “We expected they’d be launched by now,” he said. Those companies are: Federated, Cohen & Steers, Hancock, Allianz, Wells Fargo, BNY Mellon and Dreyfus.

ICI’s Blass noted in a comment letter to Labor in late March regarding potential delay of the rule that the launch of a new share class “is complex and costly,” and that “direct costs incurred by funds related to a share-class launch generally include legal consultation, audit work, system modifications and establishment of product parameters (e.g., account minimums, shareholder eligibility, rights of accumulation calculations), various filing fees (e.g., NASDAQ, CUSIP), Blue Sky registration fees by state, print and typesetting costs for production of regulatory documents, and seed money.”

While the cost to launch a share class “can vary widely depending on several factors, the data reported to the Institute show that on average the direct cost to launch a fund share class is $31,000,” Blass wrote.

ICI, the fund industry’s trade group, estimates that to comply with Labor’s fiduciary rule, “funds may need to launch more than 3,500 T share classes. The cost of creating approximately 3,500 new share classes will total at least $111 million.” Of this, Blass continued, ICI estimates that funds “may have already spent upwards of $17 million in costs that they will be unlikely to recover if the rule is revised or rescinded.”

Cost Benefits of T Shares

Traditional A shares purchased through a broker include an immediate fee called a front-end load (expressed as a percentage of the purchase) as well as management fees and ongoing fees for distribution expenses, called 12b-1 fees, Morningstar explained in its research.

Some investors stand to save money with T shares because they offer a lower front-end sales loads than A shares. In general, from early filings, Morningstar said, “we believe most T shares will have a 2.5% maximum front-end load — that is, the most an investor could pay in up-front fees would be 2.5% of their investment. In contrast, A shares average a maximum front-end load of 4.85% among the more than 3,000 A shares with loads we track in the Morningstar database.”

Investors with less money to invest in IRAs could also benefit from the shift to T shares from A shares because these are investors who would be more likely to pay the maximum load, Morningstar said. “In fact, just 5.7% of A shares have lower maximum loads than the 2.5% maximum front-end loads we expect to see with T shares.”

As Blass told Labor in his comment letter, “intermediaries plan to use T shares for transitional purposes, until they can develop a better solution (such as ‘clean’ shares, on which brokers charge an ‘external’ commission). Because other solutions will require significant implementation time due to regulatory requirements, however, many fund companies have determined that they have little choice but to go through the expensive and time-consuming process of preparing the T shares.”

Ellenbogen agreed that T shares are “transitional because most of the broker-dealers, big and small, are not really set up to divorce the commission payments from the payments to asset managers,” whereas with the clean shares “everybody gets paid directly.”

Going forward, regardless of the fiduciary rule’s fate, Morningstar anticipates the continued trend of “unbundling of asset management” fees, Ellenbogen said, suggesting “services will be billed separately, and then financial advice will have its own fees and not be wrapped in a 12b-1 fee.”

— Read Morningstar Pushes Change in DOL Fiduciary Rule Enforcement on ThinkAdvisor.