Costs and Fees Associated with Investments

With a clear understanding of risks, returns, and disclosure obligations, you can now examine what investors actually pay. Costs and fees directly reduce returns, making them a critical factor in suitability and a frequently tested area on the Series 7.

Markups and Markdowns

• A markup is the difference between the price a broker-dealer pays (interdealer price) and the price it charges the customer in a principal transaction (dealer sells from inventory)
• A markdown is the difference between the price the broker-dealer credits the customer and the current interdealer price when buying from the customer in a principal transaction

The 5% Markup Policy

• FINRA Rule 2121 requires markups/markdowns to be fair and reasonable
• The 5% policy is a guideline, not an absolute rule - it states that markups, markdowns, and commissions should not exceed approximately 5%
• The actual fairness depends on several factors:
  • Type of security (stock vs. bond)
  • Availability and price of the security
  • Dollar amount of the transaction
  • Disclosure to the customer
  • Pattern of markups at the firm
• Applies to both listed and OTC securities

Exempt from the 5% policy:

• Mutual funds (sales charges disclosed in prospectus)
• Variable annuities
• New issues sold at a fixed offering price
• Municipal securities (governed by MSRB Rule G-30)

Exam Tip: Gotchas

The 5% policy is a GUIDELINE, not an absolute cap. A markup over 5% is not automatically unfair, and a markup under 5% is not automatically fair. The exam tests this distinction. Also, the 5% policy does NOT apply to mutual funds or municipal securities.

Commissions

• A commission is the fee charged by a broker-dealer acting as agent (executing a trade on behalf of the customer)
• In an agency transaction, the broker-dealer does NOT own the security; the commission is separate from the security's price
• Commissions must be disclosed on the trade confirmation
• Subject to the 5% markup policy guideline

Net Transactions

• In a net transaction, the broker-dealer acts as principal and charges no separate commission or markup
• The price the customer pays (or receives) already includes the firm's compensation
• The customer sees a single "net price" on the confirmation
• Common in the bond market (especially fixed-income principal trades)
• The firm must still ensure the net price is fair and reasonable

Mutual Fund Share Classes

Breakpoints (Class A)

• Breakpoints are volume discounts that reduce the front-end sales charge as the investment amount increases
• Letter of Intent (LOI): Investor commits to reaching a breakpoint within 13 months; receives reduced sales charge retroactively; shares held in escrow until commitment is met
• Rights of Accumulation (ROA): Current account value plus new purchases counts toward breakpoints; existing holdings valued at current NAV (not original purchase price)
• Breakpoint selling is a violation: selling a fund amount just below a breakpoint to charge a higher sales charge when a slightly larger purchase would qualify for a discount

Exam Tip: Gotchas

Breakpoint selling is a suitability violation. If a customer invests $49,000 and the breakpoint is at $50,000, the representative MUST inform the customer of the breakpoint. Failing to do so, or splitting the purchase into smaller amounts to avoid breakpoints, violates FINRA rules.

Additional Notes

• Class B shares are increasingly rare; many fund families have discontinued them
• No-load funds: No front-end or back-end sales charges; may still charge 12b-1 fees up to 0.25% and still be called "no-load"

12b-1 Fees

• Annual fees charged by mutual funds to cover distribution and marketing expenses (named after SEC Rule 12b-1)
• Deducted from the fund's assets (reduce the fund's NAV), not charged directly to the investor
• Maximum: 1.00% of net assets per year under FINRA rules
  • Up to 0.75% for distribution/marketing
  • Up to 0.25% for shareholder service fees
• A fund charging more than 0.25% in 12b-1 fees cannot call itself a no-load fund
• 12b-1 fees are ongoing annual charges; they accumulate over time and can significantly erode long-term returns

Surrender Charges (Variable Annuities and Variable Life Insurance)

• Surrender charges (also called CDSC) apply when a variable annuity or variable life insurance contract is surrendered or partially withdrawn during the surrender period
• Surrender periods typically last 6-8 years, with declining charges each year (e.g., 7%, 6%, 5%, 4%, 3%, 2%, 1%, 0%)
• Most contracts allow penalty-free withdrawals of up to 10% of the account value per year during the surrender period
• Surrender charges are a key suitability factor; variable annuities are generally unsuitable for investors who may need short-term access to funds

Mortality and Expense (M&E) Risk Charges

• An annual charge assessed on the separate account assets of variable annuities and variable life insurance
• Compensates the insurance company for:
  • Mortality risk: The risk that annuitants live longer than expected (the insurer must continue payments)
  • Expense risk: The risk that actual administration costs exceed expectations
• Typical M&E charges range from 1.00% to 1.50% per year of separate account assets
• Deducted daily from the separate account (reduces investment returns)
• Combined with investment management fees and 12b-1 fees, total annual cost of a variable annuity often exceeds 2.00%

Exam Tip: Gotchas

Variable annuities carry multiple layers of fees: M&E charges + investment management fees + 12b-1 fees + administrative fees + possible surrender charges. The total annual cost is significantly higher than a comparable mutual fund. This is why variable annuities are generally unsuitable for tax-deferred accounts (IRA, 401(k)) - the tax-deferral benefit is redundant, but the extra fees remain.

Non-Discretionary Fee-Based Accounts

• Accounts that charge a flat annual fee (often a percentage of AUM) rather than per-transaction commissions
• The firm does not exercise discretion (the customer makes all investment decisions)
• Must be suitable for the customer's trading activity
• The fee is typically charged quarterly (e.g., 1% annual fee = 0.25% per quarter of account value)

Exam Tip: Gotchas

Non-discretionary fee-based accounts can be UNSUITABLE for inactive accounts. If a client makes only a few trades per year, commissions would cost less than the annual advisory fee. Recommending a fee-based account to generate higher revenue is a violation.

Soft Dollar Arrangements

• Soft dollars occur when a broker-dealer provides research and brokerage services to an investment adviser in exchange for directing client trades (commissions) to that broker-dealer
• Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor: an adviser does not breach fiduciary duty by paying higher commissions for eligible research services, provided the adviser determines in good faith that the commissions are reasonable relative to the value received

What Qualifies Under the Safe Harbor

• The adviser must make a good faith determination that the soft dollar commission is reasonable relative to the research value received
• Soft dollar arrangements must be disclosed to clients (typically in Form ADV Part 2A)

Exam Tip: Gotchas

Soft dollars can only pay for research and brokerage services. Using soft dollars for office equipment, rent, or personal items is a violation. The exam often presents a list of expenses and asks which can be paid with soft dollars. Only research-related services qualify under Section 28(e).