In 1961, two-thirds of the salesmen employed by such dealers earned less than $1,000. Another 22 percent earned between $1,000 and $5,000. And only 11 percent earned over $5,000 selling securities.

Now, these figures are the obverse of what I have said. They explain the prevalence of part-timers and the high turnover rate among salesmen selling mutual funds.

We have already adverted to the view that the accelerating rate of growth of the mutual funds in recent years has contributed to strains. on the market mechanisms. Fortunately, such cases thus far have not occurred too often, but they have arisen, and with increasing frequency.

The displacement of direct investment by indirect collective investment has already done much to change the character of the securities markets.

At the root of this development is the unprecedented concentration of investment decisionmaking power to which the growth of the funds has already led and the probable further increases in mutual fund assets at a rate far higher than growth rates in the economy as a whole or in other areas of the securities business.

It has been suggested that if present trends-which may in part result from the undue bias of retailers in favor of fund shares because of existing sales load levels continue at the rapid pace of recent years, they may seriously disrupt the mechanisms of the securities markets. Our mail and our face-to-face contacts with investors, with people in the securities industry, with executives of listed corporations and with students of the markets-and with Members of Congress-show us that there is a mounting public disquiet about some of the market implications of the greatly accelerated mutual fund growth, particularly the trading tactics of the more speculatively oriented mutual fund managers.

It is clear that institutionalization, not only through mutual funds, but through pension funds, equity investment by insurance companies, growth in the volume of assets managed by banks and other professional trustees, and types of investment companies other than mutual funds, is here to stay.

Indeed, it is almost a certainty that this trend toward institutionalization will proceed at an impressive rate.

I am confident that our securities markets will ultimately adjust themselves to this so-called "institutionalization" which will continue in any event. But the problems it presents are difficult, and we cannot dismiss the suggestion that the present artificial compensation system that makes the sale of mutual fund securities so much more remunerative than sale of other securities may result in an undesirable forcing of the pace of institutionalization.

The mutual fund business may once have been an infant industry in need of protection from the forces of competition. But that need is questionable today when one considers the industry's present size and its rate of growth.

In 1940, the Commission raised some serious questions about sales loads. Even then a Commission spokesman told this committee that "4 or 5 percent" was the appropriate load for investment company securities. The Commission shied away from fixing a flat amount "because immediately the maximum would become the minimum in every case."

82-865-67-pt. 1

The Commission therefore recommended that "for the present, at least, we ought to leave ***(the sales load problem) to competition among the different distributors."

For 27 years the Commission has waited for the hoped-for competition among principal underwriters to materialize. It hasn't, and I'm sorry to say it shows no sign of materializing.

F. THE COMMISSION'S PROPOSAL

This brings us to the question of an appropriate remedy.

One answer that comes to mind, and in many respects the simplest, is: remove the legal barrier to retail price competition in the sale of mutual fund shares and other redeemable investment company securities. This position has much in its favor.

Indeed, it has in its favor the support of certain editorial writers who otherwise feel that our recommendations are appropriate, but in this particular area they feel that we have fallen on our faces.

They argue for retail price competition in its usual vigorous form. My colleagues and I discussed this proposal, its virtues and defects, for untold hours. And I undertook to expose this proposal to the industry almost a year ago.

In our discussions, among other things, we considered the views of spokesmen for principal underwriters and retail dealers who told us that the mutual fund business could not stand competition, that dealers would no longer bother to sell fund shares, and that the funds would be depleted by redemptions.

We at the Commission then thought, and still think, these arguments are overstated. Indeed, if you refer back to chart C, you will note that the dollars reinvested through the automatic reinvestment privilege begin to approach the level of redemption without the necessity of sales efforts.

Nevertheless, section 22(d) of the Investment Company Act has done much to shape the mutual fund industry into its present form. This is undeniable. And it may be a valid argument that to introduce a competitive regime in this industry would be to break too sharply with its established ways of doing business.

Moreover, as we at the Commission considered the alternative of competition, we were also impressed by what we considered to be a serious drawback to it which stems from the fact that not all load funds are distributed by independent brokers and dealers. A substantial number of load funds, including some of the very largest ones, are sold exclusively or almost exclusively, through their principal underwriters' own sales organizations-referred to in the vernacular as "captive sales organizations."

The introduction of free competition among the independent retailers, who perhaps could not readily obtain shares of these funds in sufficient quantities and on a regular basis, might not have too much immediate effect on these so-called captive sales organizations.

Six large organizations of this type alone employ almost 20,000 salesmen, and the funds they sell account for about one-fourth of all mutual fund sales in this country.

I am just reminded of another calculation that our people have made that at the present time, because of this very high sales charge,

there are approximately-well, there is approximately one salesman for every 70 holders of mutual fund shares, and I think that number has dropped some. And, obviously, with this continued distortion in sales remuneration, it is like a vacuum that will fill up with salesmen no matter how large the sales charge gets to be or, more accurately, because of it.

I think, in fact, Mr. Wallich in his prepared statement which he submitted to the committee adverted to this particular matter, Mr. Chairman, in greater detail, and with much more expertise than I have now used.

Where there is, and can be for all practical purposes, only one retail seller, retail price competition cannot work in quite the same way as it does where there are many retail sellers. Hence, competition might give captive sales organizations an undue advantage over their independent broker-dealer competitors.

Although there are ways to mitigate this possibility, they would require that the basic competitive scheme be supplemented by regulation. In any event, it is far from certain that free retail price competition would produce much in the way of savings for the ordinary mutual fund purchaser.

As the industry urges, direct personal contact between a salesman and a prospect plays such a large part in mutual fund retailing, and this creates a sales environment in which price tends to become less of a consideration than it is in most economic relationships.

Since we cannot assume that many of the small, unsophisticated investors who constitute so large a segment of the mutual fund market will be aware of the fact that some comparison shopping among competing dealers would or could save them money, there are some real questions about the efficacy of retail price competition as a control on sales charges in this industry, even if the industry were prepared to accept it. And, as I have indicated, they are not.

For these reasons and although we were not impressed with all the arguments made the Commission when it issued its report was, and still is, of the opinion that although the issue is narrowly balanced, a regulatory approach is preferable to one that would rely entirely on price competition among retailers.

Accordingly, we have recommended that the Investment Company Act be amended to place a limit of 5 percent of the amount invested on sales loads for mutual fund shares, but with power in the Commission to provide exemptions from this limit where appropriate, particularly for small transactions.

When compared with prevailing sales load levels, this would produce substantial savings for investors while still providing those who sell mutual fund shares with a level of compensation substantially higher than that found in any other segment of the securities industry. We believe that the adoption of this proposal will result in fairer treatment for mutual fund investors and will furnish a firm foundation for the future development and growth of mutual funds as an investment medium for those who wish to participate in the securities markets by buying an interest in a professionally managed, diversified port folio.

IV. CONTRACTUAL PLANS

A. INTRODUCTION

I would now like to speak to the third of the three principal areas that I mentioned earlier, the so-called contractual plans, sometimes referred to otherwise as penalty plans.

All that I have thus far said about the sales load problem is true in a most exaggerated form when we examine a situation that now exists in the sale of mutual fund shares on the installment plan. There are two main ways in which investors can accumulate mutual fund shares by paying relatively small amounts every month.

Under the so-called voluntary plan, the investor makes his monthly payments and the same amount-typically 8 percent or 8.5 percentis deducted from each payment to cover sales load, whether or not there is any sales activity involved or required. In many cases there is no sales activity required, although if a particular customer has not sent his check in by the first of the month he might get a telephone call to remind him of it or a notice.

The second method, the so-called contractual plan with which we are here concerned, is far more costly for many investors. Contractual plans are held by one of every four mutual fund investors and account for about 10 percent of total mutual fund assets.

The distinguishing feature of the contractual plan is the so-called front-end load. It works essentially as follows: As permitted under the act, up to 50 percent of the first years' payments is deducted for sales load. Thus, under a 10-year plan calling for the investment of $3,000 through monthly payments of $25, at a sales load of 8 percent, the total load on the $3,000 to be paid in would be $240. The first year's payments, 12 installments of $25 each, would amount to $300. Of this, one-half, or $150, would be deducted for sales load.

There are some deductions for other matters, and we will deal with those later.

But that figure alone amounts to over 60 percent of the total load on the contemplated investment, if all payments are made to the end. The front-end load usually amounts to from 50 to 80 percent of the total load that is contemplated. The variations depend chiefly on the scheduled duration of the monthly payments. Contractual plans are offered for periods ranging from 5 years to 25 years, the 10-year plan being the most common.

Another factor is whether the front-end load is deducted from the first 12 or first 13 installments. Most plans require the first-month payment be a double installment.

Chart D shows comparative sales charges of the contractual plan and the voluntary plan. Again to save time, I merely refer the committee to that chart.

The CHAIRMAN. Mr. Cohen, in your statement you referred to certain charts. Are they included in this document?

Mr. COHEN. Yes, but they are included in the longer of the two statements.

The CHAIRMAN. Thank you.

Mr. COHEN. I would like to add that we will supply for the record certain additional tables and other matters to which I have referred in my testimony.

The CHAIRMAN. Very well.

Mr. COHEN. As I say, this amounts to over 60 percent of the total load on the contemplated investment even if he makes all the payments to the very end, which in very many cases, as I shall explain, is not done.

Now, this is done notwithstanding the fact that, despite the somewhat misleading term "contractual plan"-and I am not accusing anybody of this; the Commission has accepted this expression so if there is any "invidium" to be allocated we should accept a portion of it— the investor has no obligation to continue his payments.

He may, and as I will describe later he often does, stop considerably short of his goal. When he goes, he has in effect paid a sales load on shares he never bought so that the sales load on the amount he has actually invested is so high that in any other context it would be, in the words of section 22 of the act, "unconsionable or grossly excessive." Certainly I think anyone would agree that a sales charge of 100 percent-$150 on a net investment of $150-is indefensible.

Sellers of contractual plans receive five or six times as much from the first year's payments as they get from selling the same dollar amount of mutual fund shares at the sales load applicable to a lumpsum purchase and to installment purchases under a voluntary plan on which no front-end load is charged.

Thus, they have an incentive to seek out customers without much regard to the likelihood that they will be able or willing to continue the plan beyond the first year.

On the other hand, salesmen have very little incentive to endeavor to see to it that the investor continues beyond the first year, since the so-called trail commissions—that is, the remaining 40 percent of the load spread over the remaining 9 years' payments are quite small.

It is a question of devoting time which might result in a small trail commission as against devoting the same time to selling a new plan with a very high front-end load.

It would be almost unnatural to expect salesmen to do other than what they do.

The financial incentives to the salesman created by the front-end load are thus inconsistent with the best interests of the small investors to whom these plans are sold. Few of us can predict what our financial position and needs will be over the next 10 years, and this is particularly true of persons of modest means with growing families.

Yet, unless a person can do this with considerable accuracy, he is subjecting himself to the risk of extraordinary cost.

But the front-end load subsidizes and encourages salesmen to engage in indiscriminate door-to-door selling and to sign up everybody who they can persuade to put his name on the dotted line and to make a few initial payments.

While responsible contractual plan sponsors deplore overselling and I believe have made attempts and are making attempts to deal with that problem, it seems almost inevitable, given the financial incentives involved, that this will occur more often than it should and more often than the sponsors would like to see it.

There is another interesting aspect of this front-end load that I might mention at this point.

A person is sold a plan and, if the particular underlying fund does poorly, he is faced with a terrible problem of discontinuing payments