Are Soft Dollars Bleeding Your Retirement?

The subject of soft dollars has become a sore point for many on Wall Street. Many mutual funds have used soft dollars for many years, and they do not appear to be slowing down in the near future. Here are the basics of soft dollars and how they could affect your retirement funds.

What Are Soft Dollars?

The term "soft dollars" refers to a method of payment that mutual fund companies often use instead of hard money. Many mutual fund companies use soft dollars, or commission revenue, to pay their individual vendors. Instead of writing a check for the payment, the mutual fund will pay them in kind with soft dollars. This could represent a form of increased business for the vendor in a dollar-for-dollar exchange, or it could be some other type of arrangement.

Soft Dollar Example

In order to understand the soft dollar concept, looking at an example can help. Let's say that a particular vendor provides accounting services for a mutual fund. Instead of the mutual fund actually paying the account with a check, another agreement is put in place. With the agreement, the mutual fund places its trades through a particular broker. This broker adds a certain amount of money onto each transaction. This money that is added to the fee is then paid to the account from the third-party broker. Typically, since a mutual fund deals with such a large volume, the fee will be minuscule. However, when you charge this fee for millions of different transactions, it can really add up quickly. Therefore, the mutual fund can pay its bills without actually showing the expense on the books. It is just looked at as a transaction cost of purchasing securities. 

Why Mutual Funds Do This

Mutual funds use this method so that they do not have to show these expenses on their books. When you have fewer official expenses to show, it will look as if the expenses associated with running the fund are lower. Therefore, they can show investors a lower expense ratio overall. Many investors look at expense ratios when comparing mutual funds, and a lower expense ratio is attractive to them. Therefore, this can actually provide them with more business in the long run.

How This Affects You

The practice of using soft dollars is not in an investor's best interest. Every time the transaction fee for a purchase of a security is raised, you, the investor, will be paying for it in one way or another. Regardless of whether it is added onto the expense ratio or taken out of the transaction costs, you will still be paying for it in the long run. Therefore, if you are using mutual funds for your retirement dollars, this could take a big chunk out of your returns over the years. The more soft dollars that are used, the less money you have for retirement.

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