A new bill calls for the elimination of 12b-1 fees.

There's no such thing as a free lunch in life or in the mutual fund business.

That, in essence, is the fund industry's Milton Friedmanesque argument in favor of the persistent 12b-1 fee, which is now more popular than ever and generating about $10 billion annually, estimates Lipper Inc. The revenue brought in by this fee is critical to the continuing sale of many funds that depend on third-party channels, including financial planning broker-dealers, the industry says.

"Some 80% of funds are using third parties to distribute these funds. How are these reps going to be compensated if we don't have these fees?" says a spokesman for the Investment Company Institute (ICI). The ICI has consistently argued that the 12b-1 rule is fair and important to its members, many of whom have built their business around it. That's because, in a no- or low-load environment, funds are incurring large expenses that the 12b-1 offsets, industry officials claim.

Still, as Financial Advisor was going to press, three members of Congress were proposing an extensive review of mutual fund charges. The Mutual Fund Reform Act, sponsored by Senators Peter Fitzgerald (R-Ill.), Susan Collins (R-Maine) and Carl Levin (D-Mich.), calls for the abolition of the 12b-1 and soft dollar arrangements.

At the top of the list of issues before Congress and the regulators is the 12b-1 fee. It has become more and more controversial as it has become the charge of choice in much of the industry. The fee is seemingly ubiquitous because of the less frequent use of front-end loads, or the so-called A shares. The latter were once a staple of the fund industry. Now sales loads have been replaced by the fund fee du jour. For example, today about two-thirds of the some-16,000 funds tracked by Morning-star have a 12b-1 charge. The ICI notes that this is part of a long-term trend.

"Since the adoption of the rule," states an SEC pamphlet on the fee, "more than half of all mutual funds have enacted the rule 12b-1 plans, using the charges alone or with sales loads, as the primary means of financing distribution. Other funds, typically funds with front end loads, have added a relatively modest rule 12b-1 to pay for some sale commissions, printing prospectuses and sales literature, advertising and similar expenses."

The 12b-1 charge generally ranges from the pesky (0.01% annually) to the large (1% annually), according to Morningstar. But some suggest this charge, which was adopted by the Securities and Exchange Commission in 1980, has become "abused." The problem, say 12b-1 critics, is that the fee's original purpose-to allow more fees for investment companies so they can help investors-has been distorted. As fund expense ratios continue to rise, the investor is getting stuck with the entire lunch bill, not to mention golf outings galore.

In the 1980s, regulators envisioned this: Investment companies, so the fund industry says, should be allowed to levy these charges so they would be able to market effectively. This would bring in larger amounts of assets. Big asset bases would mean that funds could adopt economies of scale, and would then be able to reward investors in lower expense ratios as the bucks came rolling in. That, in theory, was how it was supposed to work out.

In giving its blessing almost a quarter century ago, just as the Age of Reagan was about to dawn, the SEC said a a registered open end management company could implement or continue a 12b-1 plan if fund directors voted to approve it based on the idea that it would benefit the fund company and its shareholders.

But are these charges benefiting the shareholder or are they a disguised sales charge, designed to help the investment company at the expense of the clients?

Morningstar analyst Chris Traulsen, who is not calling for the abolition of the 12b-1 rule, nevertheless says that the use of the charge has had unintended consequences. "Despite the original intent of the 12b-1, it doesn't seem to be protecting investors. Expense ratios are not coming down," Traulsen says.

His evidence goes beyond expense ratios-it is an examination of how these fees have been used. Almost two-thirds of the $10 billion in 12b-1 fees is now going to compensate brokers, some 32% is devoted to fund administrative costs and the remainder for advertising and promotion. That's according to a 2003 Perspective column at the ICI Web site.

"It appears that the use of 12b-1 fees by mutual funds has far exceeded the scope of the rule authorizing them," Traulsen adds. Nevertheless, despite pointing out the problems of the fee, Traulsen doesn't favor any dramatic solutions. He says there is an effective case that can be made for the 12b-1 fee.

"Some investors need advice from a sales rep. Good advice will help them from jumping in and out of funds and avoid mistakes," he notes. He points to studies that show the average investor only holds a fund for about 18 months, not nearly long enough to gain the benefits of a full cycle. Paul Schott Stevens, an ICI outside counsel, recently made this same point and also argued that the fee is just another way of paying for a fund.

Stevens, in testimony to Congress, said that, "In many cases, investors are receiving professional advice or other services from financial intermediaries when investing in mutual funds; Rule 12b-1 has made it possible for funds to provide investors with a choice of how and when to pay for these services."

Louis Stanasolovich, a fee-only planner at Legend Financial Advisors in Pittsburgh, says that he sometimes uses funds with 12b-1 fees. That's because "we use funds from many different platforms, and the fee is hard to avoid."

He thinks the 12b-1 fee rule should be amended, not abolished. "The average person needs help with funds. This is one way to provide such help," Stanasolovich says. Still, he concedes there are some abuses. He says regulators should end the use of 12b-1 fees in funds that are closed and will likely not see dramatic asset growth.

Without rising asset bases, he notes, the investors in these funds will be stuck with 12b-1 fees that will never decline and might increase. He also believes that the SEC should not allow funds to use directed brokerage, or placing trades through firms that sell their funds as a means of rewarding them.

Morningstar's Traulsen suggests that 12b-1 abuse is coming from the lack of effective disclosure of practices that, at times, hurts investors. And that generates controversy for the fund business.

T. Rowe Price, for one, which applies 12b-1 fees to some of its funds with advisor class shares, is re-evaluating the use of this fee. "We are reviewing this area," says a T. Rowe Price official. Many other fund families, no doubt, are waiting to see how far regulators want to go in reforming these controversial charges or maybe, given the times, jettisoning them.

Traulsen believes that the regulators should require that investors be given more explicit information on how this fee is used and how much each investor pays. He also favors breaking out charges that are deferred. An example of this would be B shares, which are paid when an investor cashes out.

"How about a monthly or a yearly statement on how much the investor paid in 12b-1 fees?" Traulsen suggests. He would also argue that investors, in a quarterly or yearly statement provided by the fund, have B-share charges detailed and compared against competing cost structures.

More and clearer disclosure is where all parties to this debate seem as though they can reach agreement. However, after that, there is plenty of argument over how the 12b-1 rule should be reformed or whether it should even continue.