## Tuesday, January 5, 2010

### Deferred Sales Charges Penalize Regular Savers

Larry MacDonald sparked a spirited debate over how Deferred Sales Charges (DSCs) on mutual funds are calculated. The debate centered on how an investor who makes regular monthly contributions to a mutual fund is affected by DSCs. However, even if DSCs are calculated in a way more favourable to the client, they can be surprisingly high even for loyal investors.

Consider the case of a hypothetical investor Tara who made regular monthly contributions to the Investor Group Canadian Equity Fund C for 10 years. She then had a sudden need for the money and withdrew the full amount. How much will she pay in DSCs?

The debate is whether Tara will pay DSCs on the full amount based on the date of her most recent contribution, or whether the DSC will be calculated for each contribution separately. The language in the fund’s simplified prospectus seems to imply that the date of purchase of each fund unit is tracked separately for calculating the DSC. Based on the following schedule, the first 3 years of contributions would have no DSCs, and the more recent contributions would be charged a sliding scale of DSCs.

During first 2 years: 5.5%
During 3rd year: 5.0%
During 4th year: 4.5%
During 5th year: 4.0%
During 6th year: 3.0%
During 7th year: 1.5%
More than 7 years: 0%

At first glance, it seems that Tara will be charged much less than the 5.5% DSC that would apply if the fees were calculated based on the date of her last contribution. However, the DSC is not as much smaller as I thought it would be.

To simplify the analysis, we’ll assume that Tara bought a fixed number of units each month rather than investing a fixed dollar amount. This won’t affect the conclusion much.

Tara’s DSCs will be calculated as two years at 5.5%, one year at each of the other percentages in the table, and three years of no DSCs. This averages out to 2.9%, which is more than half of what she would have been charged if she were a manic investor who invested a lump sum yesterday and withdrew it today.

This fund’s MER is 2.85% and the total MER fees Tara paid over the 10 years works out to about 13%. Tara has been a loyal client who has paid substantial MER fees, and she is now being hit with DSCs of 2.9%. This seems more like an opportunistic fee grab rather than a fair charge for fickle investors who jump from fund to fund.

1. This subject reminds me of a dark, bitter joke I heard awhile back.

First the revised version:

Why does it cost so much to get out of a DSC fund?
-Because it's worth it.

And the original joke:
Why is divorce so expensive?
-Because it's worth it.

2. Gene: I like the revised version. No doubt many of those who have been through a divorce would like the original version as well.

3. I asked my wife what she wanted for our Anniversary this year, she said a Divorce.

I said I didn't want to spend quite that much this year...

4. I've actually heard a financial advisor claim that DSCs help investors by committing them to a fund long-term. With so many no-load funds out there, investors should refuse to pay loads of any kind -- deferred or not.

5. CC: Everything has positive and negative aspects. It's true that DSCs have the positive attribute that they encourage commitment to investing. Let's call that 1 unit of positiveness. The money investors lose through DSCs and the ultra-high MERs that most funds with DSCs charge would then count as about 100 units of negativeness. So far, DSCs are down 99 units.

6. Thank you for posting this. I'm certainly a non-specialist when it comes to money markets and feel very misled with the information I was provided with respect to my investment, but at least with your help I now understand how and why I was charged so much in redemption fees long after the initial 7 years had passed. Thank you, too, for providing the links which were also especially helpful while doing "my homework".