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The Securities Exchange Commission recently voted, unanimously, to "…improve the regulation of mutual fund distribution fees and provide better disclosure for investors." This proposal, which still requires a 90-day public comment post publication in the Federal Register, has the potential to do more good for investors, particularly 401(k) investors, than any of the other fee and disclosure regulations that have recently come to pass.

Why, you may ask, is this such a big deal? The answer is that this proposal is targeted directly at the worst-kept secret in the mutual fund world: 12b-1 fees.

If you ask the investment industry for a definition of a 12b-1 fee, you will get a vaguely-worded response. This, for example, comes from the Investment Company Institute:

What Is a 12b-1 Fee?

12b-1 fees, also known as distribution fees, are one component of a mutual fund’s annual fund operating expenses and can be thought of as an alternate way of paying sales-related expenses, such as compensating investment professionals. A fund can have 12b-1 fees only if its board of directors has approved a 12b-1 plan authorizing their payment.

Clear? No? An easier, more realistic definition can be provided in one word: commissions. 12b-1 fees provide an ongoing source of commissions for the broker who sold the fund. In many cases, a portion of these fees is also retained by the company that manages the fund and, most importantly to 401(k) investors, the firm that provides the recordkeeping and administration for the plan.

The mutual fund industry has also at times attempted to muddy these waters by stating that the fees are actually needed for marketing. They don’t have an answer when pressed as to why funds that are closed to new investors need to have marketing.

Perhaps the quickest way to grasp 12b-1 fees is to think of them in the context of a car purchase. The dealer knows that few individuals are going to come in and write a check for $30,000. The buyer knows that he can’t write a check for $30,000. Yet, the majority of the haggling that takes place over a car purchase is concerned with the sticker price. What the dealer knows is that they can afford to take less, much less, than $30,000 up front as long as they make it up on the back side through the financing.

Can’t afford $30,000? How about $577 a month --- which is another way to get to a $28,000 purchase price at 14% interest over 72 months with $13,541 in interest payments? Similar to interest rates, 12b-1 fees can be dialed up or down for a particular fund purchase. In the investment world, this is done by offering different share classes of the same fund.

12b-1 fees allow fund companies and the brokers that represent them the opportunity to waive some or all of the initial fee (commission) while building it back in over time. Don’t want to pay a 5.5% fee up-front? What if we waive the fee and just charge you an extra .75% on your investment each year instead? Sure, if you hold the fund for 20 years you’ll end up paying commissions that are several times greater than if you had simply paid the up-front fee. The table (bottom of page four at this link) shows one of the largest mutual funds in existence. Note the difference in 12b-1 fees and total operating expenses for A and C share classes. Please also note that the up-front commission for A shares is a one-time charge while the 12b-1 fee is ongoing.

FINRA, the regulator that oversees brokers, investor protection and market integrity, has this to say on the topic of C shares:

"Additionally, in most cases, your total cost would be higher than with Class A shares, and even Class B shares, if you hold for a long time."

While it therefore probably not in the best interest of an investor to purchase a C shares it is apparently not enough of an issue to compel action from FINRA.

We’ve previously dissected the alphabet soup of share classes that exist in an attempt to explain revenue sharing within the 401(k) industry. The 401(k) industry grew up with the mutual fund industry, and these same practices apply with one variable – in addition to brokers, the recordkeeper for the Plan may also receive some or all of the 12b-1 fees as a way to defray their costs. The more the recordkeeper receives in these "soft dollar" fees, the less they have bill to the employer, or the participants.

All of this is well-known to mutual fund companies, brokers and recordkeepers. The SEC estimates that $9.5 billion in 12b-1 fees was paid in 2009 alone, so it’s safe to assume that this practice is understood by the industry. The SEC’s goal with these potential regulations is to eliminate the practice of charging reoccurring fees (12b-1 fees) that exceed the potential front end cost – no more $30,000 cars that cost $43,500 by the time the payments are complete.

The brokers, fund companies and recordkeepers are adamantly opposed to this idea as it will reduce their revenue and commissions. There does not appear to be a middle ground in this argument: the status quo continues and the industry and its players continue to reap the gains, or the SEC forces this change and many in the industry find a way to live on less – while investors potentially take home more.

Specific to the 401(k) industry, this change would eliminate the ability to offer the most expensive funds with the highest 12b-1 fees. Recordkeepers would be forced to find another way to cover their costs and generate profits. Any profits beyond what the market will bear will eventually be sacrificed, while the need to disclose and bill someone (employers or participants) for the fees that can no longer be paid by the investments could potentially bring the industry into a new era.

This should be fun to watch.

Marshall J. Cobb, CRSP, is president and founder of Cobb Retirement Solutions, LLC., an independent, fee-only firm offering qualified plan analysis and oversight exclusively to corporations and organizations. Cobb’s first-hand knowledge as a veteran representative of retirement plan vendors beginning in 1990 gives him a unique perspective as he advises his clients. Cobb runs his office -- based in Houston, Texas -- with employees and clients across the country