Mutual funds with sales charges (loads) are typically grouped into share classes. The key difference is how and when the sales charge is collected. Here are the three share classes covered below:
Class A shares assess a front-end load, meaning the sales charge is collected when you buy shares. Class A shares are also subject to breakpoint schedules, which reduce the sales charge as the investment amount increases. Here’s an example:
ABC Fund Class A Breakpoint Charge
| Volume | Sales Charge |
|---|---|
| $0 - $24,999 | 8.5% |
| $25,000 - $49,999 | 7.0% |
| $50,000 - $99,999 | 5.5% |
| $100,000+ | 4.0% |
Breakpoint schedules reward larger purchases with lower sales charges. Funds must offer breakpoint schedules if they assess the maximum sales charge of 8.5%.
If a customer doesn’t currently have enough money to reach the next breakpoint, they can sign a letter of intent (LOI). An LOI is a pledge to invest the additional amount (the shortfall) within the next 13 months. Signing an LOI lets the customer receive the lower sales charge immediately.
Using the breakpoint schedule above, assume a customer has $20,000 to invest. They could sign a $5,000 LOI (pledging to invest the additional $5,000 within 13 months) and receive the 7.0% sales charge today instead of 8.5%.
LOIs can also be backdated up to three months to include recent prior purchases. Using the same example, if the investor had purchased $1,000 a few weeks earlier, they could reduce the LOI amount to $4,000.
Backdating does not extend the LOI period. If an LOI is backdated three months, the customer still has a total of 13 months from the original LOI date - so they would have only 10 months remaining to make the shortfall deposit. If the customer fails to make the required deposit, the higher sales charge is assessed retroactively.
LOIs can’t be satisfied by asset appreciation. If the investment grows in value, that growth doesn’t replace the required shortfall deposit.
However, funds may offer rights of accumulation, which can reduce sales charges on future purchases. With rights of accumulation, your existing holdings in the fund count toward breakpoint levels. For example, if a customer already has $40,000 invested in a fund and wants to invest an additional $10,000, the new purchase qualifies for the $50,000 breakpoint.
Financial professionals must inform customers when they are close to a breakpoint. For example, if a customer wants to invest $24,000 in the ABC fund above, the registered representative must explain how the customer could reach the $25,000 breakpoint (they’re only $1,000 short). The customer’s options include:
Either option qualifies the customer for the lower 7.0% sales charge. The customer can also choose to do nothing and accept the higher sales charge.
There can be a financial incentive for a representative not to help a customer reach a breakpoint, because the higher sales charge generates more revenue. Using the same schedule:
That’s a $290 difference. If the customer isn’t notified of breakpoint options, the financial professional commits a violation called a breakpoint sale. Breakpoint sales are subject to regulator-imposed fines and/or suspensions. The representative must act as a fiduciary by putting the customer’s interests ahead of their own, which includes explaining available ways to qualify for lower sales charges.
Breakpoints are available to individuals and some groups. Many funds offer householding, which allows family members living at the same address to combine purchases to qualify for lower breakpoints.
Breakpoints also apply regardless of where the fund is purchased. If you invest $10,000 in the same fund through five different firms, it’s treated as a $50,000 purchase for breakpoint purposes.
Investors may also use the combination privilege, which allows purchases across multiple funds within the same fund family to be combined for breakpoint purposes. For example, an investor buying $10,000 of the ABC Stock Fund, $10,000 of the ABC Corporate Bond Fund, and $5,000 of the ABC US Government Bond Fund would qualify for a $25,000 breakpoint.
Class A shares are generally most suitable for long-term investors investing larger amounts. Because the sales charge is paid up front, selling too soon can make the investment inefficient - the investor may not have enough time for returns to offset the initial load.
Class B shares assess a back-end load, meaning the sales charge is collected when you sell shares. This is also called a contingent deferred sales charge (CDSC). The CDSC typically declines the longer the investor holds the shares. A typical schedule looks like this:
ABC Fund Class B CDSC Schedule
| Years of ownership | Charge |
|---|---|
| 1 year | 8% |
| 2 years | 6% |
| 3 years | 4% |
| 4 years | 2% |
| 5+ years | 0% |
A CDSC schedule reduces the sales charge for longer holding periods. If a CDSC applies when shares are redeemed, the fund deducts the charge from the redemption proceeds before paying the investor.
Most CDSC schedules eventually reach a point where no sales charge is due. In the example above, shares held for 5 years or longer can be sold with no CDSC. Many fund companies convert Class B shares to Class A shares once the CDSC period ends.
Class B shares are generally suitable for intermediate- to long-term investors investing smaller amounts. Investors with larger amounts to invest often benefit more from Class A breakpoint schedules.
Class C shares are best known for ongoing marketing fees, which create a level load (a continuing cost rather than a one-time sales charge). Class C shares typically don’t impose a front-end or back-end sales charge, although some impose a one-year CDSC. In that structure, the investor avoids the back-end charge by holding the shares for at least one year.
The most significant expense for Class C shares is usually 12b-1 fees. This is a marketing fee intended to reduce a fund’s expense ratio by attracting more investors.
Most mutual funds have operating expenses that don’t change much as assets under management grow. For example, assume a fund has $100 million in assets and $1 million in annual operating expenses. At that level, the expense ratio is 1%. If the fund could grow to $200 million in assets while keeping operating expenses at $1 million, the expense ratio would fall to 0.50%.
12b-1 fees are used to grow a fund’s assets in hopes of lowering expenses on a per-investor basis. There are two components:
Together, the maximum annual 12b-1 fee is 1%.
Each share class typically has a different 12b-1 fee level:
Regulators recognize that ongoing 12b-1 fees reduce investor returns over time. Because of this, a fund charging more than 0.25% in 12b-1 fees can’t market itself as a “no load” fund. Otherwise, an investor might buy a fund expecting low costs while still paying an ongoing marketing fee.
Class C shares are generally suitable for short-term investors. Because 12b-1 fees continue year after year, long-term investors typically avoid this share class. Even though 1% may sound small, it’s charged repeatedly. If an investor holds Class C shares for ten years, they pay the 1% annual fee ten times!*
*Technically, 12b-1 fees are assessed quarterly, although the fee is expressed as an annual percentage. For example, assume an investor owes an annual 12b-1 fee of $100. The fund would charge $25 per quarter instead of a one-time $100 fee.
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