Costs and Fees Associated with Investments

Risks and returns on one side; costs and fees on the other. The Series 6 outline breaks fund and variable-contract compensation into transaction charges, share-class loads, account-structure fees, variable-contract surrender charges, ongoing 12b-1 fees, Mortality and Expense (M&E) charges, and soft dollar arrangements. Every one of these must be disclosed; several have numerical caps the exam loves to test.

What transaction-based charges apply to Series 6 products?

• Markups, commissions, and net transactions must be disclosed on the trade confirmation (Function 3.4 topic; Securities Exchange Act (SEA) Rule 10b-10)
• Reasonable-basis markup and commission standards apply (FINRA's 5% policy and the Regulation Best Interest (Reg BI) Care Obligation)

Exam Tip: Gotchas

• A net-transaction price hides the dealer's compensation inside a single quoted number. FINRA Rule 2232 forces the confirmation to label the trade as net, so the customer knows the price is not gross.
• The 5% policy is a guideline, not a hard cap. The standard is reasonable-basis compensation given the facts, and Reg BI's Care Obligation reaches the same conclusion by a different path.

What are the mutual fund share classes and their loads?

Open-end mutual funds typically offer three retail share classes plus a no-load alternative.

Rep obligations:

• Must explain the differences among classes and recommend the class suitable for the customer's expected holding period and dollar amount
• Must factor in breakpoints, Rights of Accumulation (ROA), and Letter of Intent (LOI) in the Class A analysis
• FINRA Rule 2341(b) caps aggregate sales charges at 8.5% of POP (front-end + CDSC + asset-based) when breakpoints, ROA, and LOI are all available
• Funds that do not offer breakpoints, ROA, and LOI face a lower cap (6.25% or 7.25%)

Exam Tip: Gotchas

• The 8.5% maximum is conditional. It applies only when the fund offers breakpoints, ROA, and LOI. Funds without these features get a lower cap. The 8.5% cap is the headline; the conditions are where the exam traps candidates.
• A 1.00% 12b-1 fee is not a no-load fund. The "no-load" label requires 12b-1 fees of 0.25% or less. A fund with no sales charges but a 0.75% 12b-1 fee is a level-load fund, and the rep must disclose the ongoing fee accurately.
• Class B converts to Class A; Class C does not convert. The Class C holder pays the 1.00% 12b-1 fee forever. The exam likes to test the distinction between converting and non-converting classes.

What is a non-discretionary fee-based account?

A fee-based account charges the customer a flat or tiered asset-based fee (typically 1.0 to 1.5% of assets under management (AUM) annually) in lieu of per-transaction commissions.

• Non-discretionary means the customer retains final authority over each trade; the rep may recommend but does not have written authority to execute without the customer's approval
• A non-discretionary fee-based account is unsuitable for a customer with low trading activity: the customer pays the fee whether or not the account is actively managed
• FINRA has brought enforcement actions for "reverse churning": moving buy-and-hold customers into fee-based accounts to generate higher ongoing compensation than the commissions the customer would have paid
• A rep recommending a fee-based account must have a reasonable basis to believe the arrangement is more cost-effective for the customer's expected activity level

Think of it this way: A fee-based account is a volume discount for active customers. A buy-and-hold customer who generates two trades per year is paying a subscription for a service they do not use. The rep who moves that customer into fee-based has made the wrong recommendation, and FINRA has the enforcement record to prove it.

Exam Tip: Gotchas

• A non-discretionary fee-based account is a poor fit for a buy-and-hold customer. Two or three trades per year at commission rates would cost the customer far less than a 1.0% annual asset-based fee. The rep must be able to justify the activity level.
• Non-discretionary means the rep cannot trade without approval. Do not confuse a fee-based account with a discretionary account: in a fee-based non-discretionary account, every trade still needs the customer's go-ahead.

How do variable annuity surrender charges work?

A surrender charge is a back-end fee deducted from withdrawals made during the surrender period of a variable annuity. It is the insurer's mechanism for recovering the up-front commission paid to the selling representative.

• Typical schedule: 6 to 8 years, declining each year (for example, 7% in year 1, 6% year 2, down to 0% after year 7)
• Disclosure requirement under FINRA Rule 2330: the rep must confirm the customer understands:
  • The surrender period length and the annual declining schedule
  • That surrender charges apply on partial withdrawals in excess of the free-withdrawal amount (typically 10% per year)
  • That a 1035 exchange into a new contract resets the surrender period
• Surrender charges are not tax-deductible: they reduce the amount the customer receives but do not offset ordinary income on the earnings portion

Exam Tip: Gotchas

• A 1035 exchange resets the surrender period. The customer gives up the gains of the old contract's fading schedule and restarts the clock. Reg BI and Rule 2330 require the rep to justify the swap in writing.
• The 10% free-withdrawal amount is industry-standard, not rule-mandated. Each contract sets its own free-withdrawal feature; the rep must know the specific contract the customer owns, not a generic assumption.

What are 12b-1 fees?

An asset-based distribution fee authorized under Investment Company Act (ICA) Rule 12b-1 to pay for fund marketing, advertising, and compensation to selling broker-dealers.

• Cap: up to 1.00% per year total
  • Distribution component ≤ 0.75%
  • Service component ≤ 0.25%
• A fund with a 12b-1 fee > 0.25% may not be called no-load under FINRA's standard
• Requires a written 12b-1 plan approved by the board (including a majority of independent directors under ICA Section 10) and renewed annually
• Disclosed in the prospectus fee table and the shareholder's annual report

Exam Tip: Gotchas

• The 12b-1 service component is capped at 0.25%. Above that, the "no-load" label is no longer available, even with no front-end or back-end charge.
• The 12b-1 plan must be renewed annually by the board. A lapsed plan means the fund cannot charge the fee. Independent-director majority is a separate structural requirement under ICA Section 10.

Mortality and Expense (M&E) Charges on Variable Products

An M&E charge is an ongoing asset-based fee in a variable annuity or variable life contract covering:

• Mortality risk: the insurer's risk that annuitants live longer than expected (annuitization guarantees) or that insureds die before premiums offset the death benefit (variable life)
• Administrative expense: ongoing contract administration

Typical ranges and stacking:

• 1.15 to 1.40% per year for variable annuities
• Variable life M&E is generally lower but augmented by cost-of-insurance (COI) charges that rise with the insured's age
• Separate charge from sub-account expense ratios (the sub-accounts carry their own expense ratios layered on top of M&E)
• Disclosed in the variable-contract prospectus and the FINRA Rule 2330 disclosure for deferred variable annuity recommendations

Real-world example: A variable annuity with a 1.25% M&E charge plus a 0.90% sub-account expense ratio plus a 1.00% guaranteed-lifetime-withdrawal-benefit (GLWB) rider costs the customer 3.15% per year before any underlying fund transaction costs. A long holding period is required to overcome that drag.

Exam Tip: Gotchas

• M&E is not the same as the sub-account expense ratio. The M&E is the insurer's charge; the sub-account expense is the fund's charge. Both apply, stacked on top of each other.
• Rider fees layer on top of M&E and the sub-account expense. Total annual cost on a variable annuity with a living benefit rider can easily reach 2.5 to 3.5% per year. The customer must understand the full stack before recommendation.

What are soft dollar arrangements?

Soft dollars are a compensation arrangement where an adviser pays for research and brokerage services by directing client securities trades to a particular BD at a higher commission rate, rather than paying in cash.

Safe harbor under SEA Section 28(e):

• An adviser using client commissions to obtain eligible research or brokerage services is not in breach of fiduciary duty, provided:
  • The service falls within the statutory definition of research or brokerage
  • The service provides lawful and appropriate assistance to investment decision-making
  • The commissions are reasonable in light of the value of services received

Conflict of interest and disclosure:

• Soft dollars create tension: the adviser's client pays (through a higher commission) for services the adviser receives
• Disclosure in the fund's Statement of Additional Information (SAI) and the adviser's Form ADV is required regardless of safe-harbor compliance
• Series 6 candidates must recognize soft dollars as a conflict of interest that must be disclosed when they affect a fund's brokerage practices

Exam Tip: Gotchas

• Soft dollars are disclosed in the SAI, not the summary prospectus. A customer who asks "how does the fund choose brokers?" is entitled to the SAI on request, free of charge.
• Section 28(e) is a safe harbor, not a license. The adviser must show the commissions are reasonable in light of the services received. Excess compensation is a conflict even inside the safe harbor, and the disclosure obligation is not waived.