What it means
The charge exists to pay a sales commission without taking money from the investor at the outset. The fund company pays the adviser up front and then recovers that cost from the investor's redemption if they leave before the schedule has run its course.
From the investor's side the arrangement looks appealing, because the full amount appears to be invested on day one. The cost is simply postponed and made conditional, and it usually comes with a higher ongoing annual fee than a version of the same fund sold without a commission.
The declining schedule is the defining feature. A typical arrangement might charge 5% in the first year, falling by a percentage point each year until it disappears, which creates a strong incentive to stay put and a real penalty for needing the money early.
Two details decide how much the charge actually costs. First, whether it is applied to the amount originally invested or to the market value at the time of sale, and second, whether the fund allows a free redemption of part of the holding each year, which many do.
Regulators in several markets have restricted or banned these charges on the grounds that they trap investors in underperforming funds and obscure the true cost of advice. Rules differ by jurisdiction and have tightened over time, so anyone holding a legacy position should check the schedule attached to their own units rather than assuming the practice still applies.
In practice
Real-world examples.
Example
An investor needs cash for a house deposit eighteen months after buying a fund. The 4% charge on a $40,000 investment costs $1,600, so she sells a different holding instead and keeps the fund until the schedule expires.
Example
A couple review an old portfolio and find two funds still inside their redemption schedules with one year to run. Their adviser recommends switching the rest of the portfolio now and leaving those two until the charge reaches zero.
Example
A retiree holding a fund with a 10% free annual redemption allowance withdraws that portion each year. Over three years he moves a meaningful part of the holding out at no cost at all while the schedule continues to decline on the remainder.
Formula
Calculation
Charge payable = Applicable redemption rate for the year of sale x The base amount, which is either the original cost or the current market value depending on the fund's rules
An investor puts $50,000 into a fund with a schedule of 5% in year one, 4% in year two, 3% in year three, 2% in year four, 1% in year five and nothing afterwards. They sell in year three when the holding is worth $62,000. If the charge applies to the original cost, it is $50,000 x 0.03 = $1,500, leaving proceeds of $62,000 - $1,500 = $60,500. If instead it applies to market value, it is $62,000 x 0.03 = $1,860, leaving $62,000 - $1,860 = $60,140. The difference of $1,860 - $1,500 = $360 comes purely from which base the fund uses, and waiting into year four would have cut the charge on cost to $50,000 x 0.02 = $1,000.Case study
Seen in the real world.
Dunmere Wealth is an illustrative, fictional advice firm whose client files were full of funds carrying deferred sales charges sold years earlier. A new compliance lead reviewed the book and found several clients had been advised to switch funds while charges still applied, with the cost absorbed quietly out of the proceeds.
The firm built a simple schedule for every affected holding showing the current rate, the date it reached zero and the free redemption allowance available each year. Advisers were then required to show that schedule to the client and to document the reason for any sale that triggered a charge.
In the illustrative year that followed, the firm's clients paid roughly 70% less in redemption charges than the year before, mostly because sales were sequenced around the schedules instead of ignoring them. Nothing about the funds changed; the firm simply stopped paying a fee that patience would have removed.
Watch out
Common mistakes.
- Assuming a fund has no sales charge because nothing was deducted at purchase, when the commission is waiting in the redemption schedule instead.
- Selling just before an anniversary date and paying a whole percentage point more than waiting a few weeks would have cost.
- Overlooking the free redemption allowance, which often lets an investor take out part of the holding each year without any charge at all.
Questions
People also ask.
Is the charge the same as an early redemption fee?
They work similarly, but a deferred sales charge is specifically there to recover a commission already paid to the seller, while a short-term trading fee is usually charged to discourage rapid in-and-out trading and is paid back into the fund.
Does the ongoing fee differ on these units?
Usually yes, this version of a fund typically carries a higher annual management expense than a version sold without a commission, so the cost continues long after the redemption schedule has expired.
Should an investor always wait for the schedule to expire?
Not always; if the fund is unsuitable or badly run, the cost of staying can exceed the charge, which is a calculation worth doing rather than a rule to follow.
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