What it means
The charge exists to fund the commission paid to whoever sold the product. Because no upfront fee was taken from the investor, the fund company pays the adviser at the outset and then recovers that cost through higher ongoing fees and, if the investor leaves early, through the exit charge.
The schedule is the part worth reading closely. A typical arrangement charges 5% for a sale in the first year and then 4%, 3%, 2% and 1% in each following year, reaching zero after five or six years, at which point the holding can be sold at no cost.
How the charge is calculated varies more than people expect. Some products apply the percentage to the current value and others to the original amount invested, and the difference matters a great deal on an investment that has grown well.
Most schedules include a free withdrawal allowance. Commonly an investor can take out 10% of the balance each year, or reinvested dividends and gains, without triggering any charge, which is enough for someone drawing modest income but not for someone who needs the capital back.
The order in which units are treated also matters. Many funds apply the charge on a first in, first out basis, so the oldest and cheapest tranches are sold first, and an investor contributing regularly will find each new payment starts its own clock.
The wider point is that no fee structure is genuinely free. A share class with no upfront charge and a CDSC almost always carries higher annual costs, so the real choice is between paying more each year and paying a lump sum if you leave early.
In practice
Real-world examples.
Example
An investor holding a fund worth $120,000 needs $10,000 for a house repair. Because the schedule allows a 10% free withdrawal each year, the $120,000 x 10% = $12,000 allowance covers the amount and no charge applies.
Example
A retiree bought a $200,000 annuity with a seven year surrender schedule and wants to move to a cheaper contract in year two, when the charge is 6%. The $200,000 x 6% = $12,000 exit cost outweighs the annual saving from switching, so the adviser recommends waiting.
Example
A saver contributes $500 a month into a fund carrying a five year CDSC. Five years after starting, only the earliest contributions have cleared the schedule, so a full withdrawal still triggers a charge on the most recent two years of payments.
Formula
Calculation
CDSC = redemption amount x the charge percentage applicable to the year of sale
Net proceeds = redemption amount - CDSC
An investor puts $50,000 into a fund whose CDSC schedule runs 5%, 4%, 3%, 2%, 1% and then zero from year six. The holding is worth $58,000 when she sells the lot during year three, when the applicable rate is 3%.
If the charge applies to the current value, the CDSC is $58,000 x 3% = $1,740 and net proceeds are $58,000 - $1,740 = $56,260. If it applies to the original amount invested instead, the CDSC is $50,000 x 3% = $1,500 and net proceeds are $58,000 - $1,500 = $56,500, a difference of $1,740 - $1,500 = $240 on the same sale.
Waiting matters more than the calculation basis. Selling in year four at the same $58,000 value would cost 2%, or $58,000 x 2% = $1,160, and waiting until year six would cost nothing at all, so leaving three years early costs $1,740 of value for no investment reason.Case study
Seen in the real world.
This illustrative and fictional case involves an invented investor advised by Corbin and Vale, a fictional advice firm. She placed $180,000 into a fund share class with no upfront charge, an annual expense ratio of 1.85%, and a CDSC schedule of 5%, 4%, 3%, 2% and 1% across five years.
The alternative share class carried a 3% upfront charge and an annual expense ratio of 0.95%. On $180,000 the upfront route would have cost $180,000 x 3% = $5,400 immediately, while the deferred route cost nothing on day one but $180,000 x 0.90% = $1,620 more in fees every year, so the two broke even after $5,400 / $1,620 = 3.3 years.
She held for seven years, so the illustrative outcome was straightforward. She avoided the exit charge entirely but paid roughly 7 x $1,620 = $11,340 of extra annual fees against a $5,400 upfront charge she would have paid once, leaving her about $11,340 - $5,400 = $5,940 worse off before any compounding. The fictional lesson is that the CDSC is only half the question, because the annual cost attached to the same share class usually matters more for anyone holding for the long term.
Watch out
Common mistakes.
- Believing a fund with no upfront charge is cheaper, when the sales cost is normally recovered through higher annual fees and an exit charge instead.
- Assuming the schedule runs from the date the account was opened, when each separate contribution usually starts its own holding period.
- Overlooking the free withdrawal allowance and selling more than needed, when a partial withdrawal within the allowance would have carried no charge at all.
Questions
People also ask.
Is a CDSC the same as a surrender charge?
Very nearly, since surrender charge is the term used for annuities and life policies while CDSC is the equivalent on fund share classes.
Does the charge apply to growth as well as to the original investment?
It depends on the contract, because some apply the percentage to the current value and others only to the amount originally paid in.
How can an investor avoid paying one?
By holding until the schedule reaches zero, staying within the annual free withdrawal allowance, or choosing a share class with no deferred charge from the outset.
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