One common complaint when it comes to mutual fund fees, is a general hatred for DSC (Deferred Sales Charge) load mutual funds. While I understand that nobody likes paying fees, I also think that this fund load is misunderstood and can be beneficial for smaller investors who invest through an advisor.
What are DSC fees and how do they work?
When you buy a DSC mutual fund from an advisor, you don’t pay any kind of direct sales fee. Instead the mutual fund company will pay the advisor an upfront sales fee – usually around 5%. This way all of your money gets invested and your advisor gets some payment.
The catch is that these funds have a DSC fee schedule which usually start at around 6% and last for approximately 6 years. The fee will decline each year until it gets to zero. The DSC fee is only applied to investors that sell their mutual fund units before the DSC schedule has finished.
Here is a sample DSC schedule:
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If you were to sell your mutual fund in year one, the DSC fee would be 6.0% of the investment amount. If you wait until year 4 to sell, the DSC fee would be 3.0% of the sale amount. Note, that some companies will calculate the fee on the original purchase amount.
The problem is that most people who buy DSC funds are not aware of how DSC fees work and consequently get upset if they sell their funds and get nailed with unexpected fees.
Why DSC fees are not as bad as you think (and ways to reduce the fees)
1) Advisors need to get paid
If you want to use a financial advisor then you have to pay them. It takes time for an advisor to meet with you, get an account set up and handle the paperwork and transactions. DSC load funds allow smaller investors to avoid paying direct fees and enable them to get all their money invested.
Trailer fees are not enough. Trailer fees are fees – usually 0.5% to 1.0% per year which are paid to the advisor from the mutual fund. These can be very lucrative for larger accounts, but for a small investor – they don’t add up to squat.
The alternative to DSC funds for a small investors is direct fees. For example, an advisor might charge $100 to set up an account.
2) DSC fees are not applied to switches between funds at the same fund company
If you own XYZ Growth Fund and you want to switch over to XYZ bond fund, then you should be able to make that switch without paying any DSC fees. The original DSC schedule should carry over to the new fund.
Of course this means you can’t leave that particular fund company without paying DSC fees, but you are not locked into any single fund.
3) DSC fees go down over time
If you wish to withdraw your money from a DSC fund, phone the fund company to find out how much the DSC charge will be. If you’ve had the account for a while, then you won’t be paying the maximum charge.
4) 10% free option
Most fund companies have an annual 10% free withdrawal for DSC funds. What this means is that you can take 10% of the fund value (as of the beginning of the year) and switch it to a non-DSC version of the fund. Or you can just redeem the 10% amount if you wish.
This is something that you have to request every year, but the more DSC load units you can switch to non-DSC load, the lower the DSC fee will be if you sell the fund.
5) Negotiate the DSC charge
While the basic DSC fee can’t be changed, you can sometimes negotiate with your advisor to reduce the amount of fee that the advisor keeps. Any difference will be deposited in your account as a new purchase.
For example if the DSC fee is 5% and your advisor agrees to reduce her commission to 3%, then the 2% difference will be placed in your account.
This leads to the interesting situation of a “cash-back” purchase where you end up with more money in the account than you deposited. In the example above, you would end up with 102% of your original purchase.
This is typically used when an investor is moving money from one fund company to another and is hit with DSC charges on the sell side, however it will work for any purchase.
The amount you have to invest will help determine your success with this strategy. The more money you have, the more leverage you have.
6) Timing of the sell
Check with your advisor or fund company to see if the DSC fee will drop significantly if you wait a bit. If you made a large purchase to open the account and you are close to a lower level in the fee scale, it might be worthwhile to wait.
Please note, that these rules are general. Phone your advisor or fund company to verify the exact fund company rules before doing anything.
Should I wait to convert my expensive funds to cheaper index funds?
If you own an expensive mutual fund with a 2.50% annual MER and wish to switch to a cheaper fund which has a 0.5% annual MER, then you will save 2.0% per year. As long as you stay invested in the cheaper fund for at least a few years, then the annual savings will quickly outpace any DSC fee.
Should mutual fund DSC fees be banned?
The main problem with DSC fees is the lack of disclosure. Most financial advisors “sell” mutual funds and DSC fees are not a good sales pitch. A friend once told me that an advisor tried to get him to invest his house down payment savings in DSC equity mutual funds. That kind of advice is as bad as it gets.
If DSC load funds were banned, then it is likely that no money will be saved by investors. Here are some things which might happen – especially for smaller investors:
- Front load fees more likely to be charged. These are fees which will apply to the sale price and will come out of the investment amount.
- Direct fees more likely to be charged. Fees like account setup fees, transaction fees might be charged.
- Refusal of service. An advisor is not going to work for peanuts – if you are not a profitable client then they will likely refuse to work with you.
DSC fees are an indirect method for mutual fund clients to pay their advisors. Lack of DSC fee disclosure is bad, but DSC load funds are not.
Larry MacDonald makes a good argument against DSC fees.