How Lower Fees and Expenses with Index Funds Could Mean 33% More to Spend in Retirement
Published on - February 6th, 2008 (by J.D. Roth) This is a guest-post from Dylan Ross. Dylan is a Certified Financial Planner and owner of Swan Financial Planning, LLC a registered investment adviser in New Jersey. He is an active commenter at Get Rich Slowly, both on the blog and in the forums.
“Fees are the investor’s enemy,” J.D. recently told me. He’s right. There are many ways to illustrate the drag that fees place on portfolio returns. 
This is often shown by calculating the difference in portfolio value after investing a lump sum over a number of years.
While these sorts of examples make a compelling case for lower fees, it’s still unclear just how this affects an investor’s lifestyle. A better way to demonstrate the negative impact of high fees is to show how they result in lower future withdrawals. After all, that’s why we invest our savings — so we can spend them in the future.
Let’s compare investing in low-expense, no-load index funds to higher expense, actively managed class-A mutual funds. We’ll make the following assumptions:
- $20,000 is invested every year for 25 years.
- The underlying investments return 7% each year.
- Annual expenses are 0.2% for the index funds and 0.75% for the actively managed funds.
- Additionally, each $20,000 contribution to the actively managed funds has a 5.75% front-end load sales charge.
To keep the comparison simple, we’ll assume the investments are held in non-taxable accounts, and that all numbers are in today’s dollars (before inflation). Based on these assumptions, after 25 years:
- The low-cost index portfolio will grow to $1,312,830.
- The higher cost actively managed portfolio will grow to $1,138,310.
The active portfolio will have $174,520 less than the index portfolio. This is a typical way to demonstrate the impact of higher fees. Though compelling, this only tells half the story.
Let’s now assume that after 25 years of saving, we begin to withdraw money to live on. If withdrawals are based on 4% (before expenses) of the starting portfolio value — which is generally accepted as a safe and sustainable withdrawal rate that still allows for inflation adjustments — we get a better sense of the toll that higher fees will take.
- The low-cost index funds can support a withdrawal of $49,887 per year.
- The higher-cost actively managed funds can only support a withdrawal of $36,995 at that same withdrawal rate.
That is less than 75% of what the index portfolio supports!
The large difference in withdrawal amounts is due to the small difference in annual expense being applied to the larger portfolio balances after 25 years of savings and growth, resulting in a substantial annual expense. When you account for this annual expense, it eats away a greater portion of your withdrawal, leaving you with a lot less money to spend.
For more on this subject:
- All Financial Matters: Fees matter
- Business Week: Mutual fund fees: The awful truth (via Vintek)
- Previously at Get Rich Slowly: The three enemies of growth
Dylan previously shared “What is a financial plan and why have one?” with GRS readers. He often offers uncredited behind-the-scenes advice when I am drafting technical articles.
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Great point. Fees can be a great equalizer. A lot of people will tout their return and forget about,fees, taxes, dividends and risk reward.
You have to compare apples to apples to understand what is really going on.
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The up front sales charges are what really get me fired up. I think paying 5% upfront to the broker is ridiculous.
Excellent point on the withdrawal rate, too. We often forget the other side of retirement — spending.
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I guess that when calculating a fund, you’d have to spend some time figuring out what this find would have to make to even equal an index fund and then how much it would have to make to beat it. And whether that’s even worth it…
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This doesn’t even take into account that over time 80% of managed funds DO NOT beat the average of the s&p index. This comparison is looking at both the index and the managed fund having the same rate of return.
Also 0.75% is a fairly low rate for a managed fund. Most of the ones in my 401k are over 1% in addition to having the front load. And Vanguard’s index fund fees are usually lower than the 0.2% given as an example here. Fidelity is also very low.
What about the tax burden that actively managed fees incur and low turnover index funds do not?
Great article – thanks!
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That’s pretty amazing. I’d forgotten about the ongoing fees in retirement, so it took me a good 5 minutes to work out why it was so much lower for the actively managed fund.
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As a fellow CFP, I applaud your effort here. This is a nice, simple illustration of the effect of fees on long-term investments.
To be completely fair, though, I think you need to account for sales charge break points on the loaded fund. The fact that they can be reduced as an account balance grows has a big impact on the bottom line.
The no-load, low-cost fund should still come out on top assuming equal investment returns, but the “real life” margin of victory is a bit smaller.
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Dylan,
This story is compelling, but not quite as accurate as portrayed. 2 assumptions skew the results directly toward index funds:
1) The underlying investments return 7% each year.
2) Additionally, each $20,000 contribution to the actively managed funds has a 5.75% front-end load sales charge.
Now, I am in the A-share, front-end load (but with low expenses!) support crowd (for full disclosure). A look at the most recent Barron’s will show a number of mutual funds that have outperformed various indicies over x amount of time. Sure, that’s not the case with all funds, and a good number of them stink, but choosing the right one makes #1 a tough assumption to make.
The second assumption, in most cases, is just flat out wrong. All the front-load companies I work with offer Rights of Accumulation and Breakpoints – lowering the fee based on total assets accumulated. Once an investor hits, for instance, $50,000 the front-end load goes down to 5%. Corresponding breakpoints happen at certain intervals, usually 25,50,100,250,500k and 1 million. This siginificantly lowers the front-end load (to sometimes 1% or less).
Sure, you’re still paying a load vs. a no-load, but the gap in the difference now becomes much smaller, wouldn’t you agree? I’d be interested in an analysis using breakpoints. Factor in the possibility of beating the index (which most don’t, but some do), and it sounds again like we’re comparing apples to kiwis. Can’t both be tasty?
This is a pretty long-standing argument, and there are definitely ups and downs to both sides. Each type of fund caters to a different type of investor. Read your prospectus. All that jazz. Just playing devil’s advocate! I love this blog and what you’ve done and am happy to contribute thoughtful conversation to it as best I can.
Thanks!
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KC,
In a tax-advantaged account (401k, IRA, etc), there would not be an additional tax advantage to the index funds. The tax advantages of low-turnover funds and ETFs really come into play in non-qualified accounts.
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What I get out of this… I have to save 20K a year for 25 years and then can only expect 50K a year to live on if I don’t want to run out? Ouch, if you can manage to save/invest 20K a year, 50K is gonna be a hell of a big reduction in your standard of living.
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Nick, It sounds like your issues are with what was portrayed and not whether it is accurate as portrayed. I’ll address your two arguments in order.
First, yes, there are mutual funds that out perform a comparable index for specific periods of time; however, the longer the time frame, the fewer the number of actively managed funds doing so. And the real problem is in the chances choosing these funds before they outperform (anyone can pick the winning horse after the race is over). This example is based on 25 years of accumulation and an unknown length of time for withdrawals.
I took neutral positions as to whether actively managed funds will outperform or under perform. This is because all of the active management in the market is *The Market*, so if active management as a whole is doing X%, well, then the market (and index funds) must be doing just as well.
The bottom line is that it would not be prudent to use a higher withdrawal rate, banking on the possibility that you can chose funds that will consistently beat the market. If you’re wrong, you run out of money.
Second, and also in response to Brian B., if we assume zero load, the withdrawal amount increases by $2,257 to become $39,252 per year, which is still over $10,000 less than the index funds. So, depending on breakpoints, withdrawals would be something between $36,995 and $39,252.
I did not use breakpoints to keep it simple. If this were a real portfolio of funds, breakpoints would depend on how many different fund families were used and how much money went to each. Also, the annual expense plays a much larger roll in the outcome than the load. For example, a zero load and 0.88% expense (0.13% higher) will result in a similar withdrawal amount. So, with some breakpoints, an expense between 0.75% and 0.88% would have a similar result.
There are a number of details I could have included; however, my goal was to create an example that most people could relate to without drowning them in numbers.
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Great to read that,
Thanks,
tracy Ho
wisdomgettingloaded
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What perfect timing! Dylan and JD, I’ve entered a link to this excellent post at Funny’s three-minute-old rumination on investing (“Yikes and Double Yikes”), which mentioned low fees for index funds. I’m also forwarding your post to a bunch of my friends–very interesting!
–vh
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Why not re-run the comparison, but nix the front-end load? I would be interested to see the effect that has on the results.
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Good work and timely. I just read over at Yahoo Finance that most folks are unaware of 401(k) fees. “A 2007 survey found that 65 percent of Americans responded that they don’t pay 401(k) fund fees at all. Of those who knew they paid something, 83 percent had no idea how much.”
As you have shown, fees are too large of a factor for people to naively dismiss.
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You want real world? Here’s an excellent calculator that shows you the effect fees will have on your mutual funds over any period of time. It digs down to a level you won’t find on the FINRA site or any other, it takes into consideration many of the hidden fees that are rarely quantified by these calculators. i.e. the cost of fund trading turnover, found only in the SAI
It’s free to use and a great way to see the dramatic effects of expenses and internal fees on your investments over any significant period of time.
Personalfund.com
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If you are looking for non-managed Index Funds, then presumably you would be better off with a lower yearly fee and no front or back loads as they try to match their base index and fees just subtract from what would normally be similar returns off of similar funds… (Vanguard and Fidelity both have low fee quality products that would fit this)… However, I’m not sure I agree with the blanket **Buy an Index Fund** mentality…. There are very good managed funds … In particular, Heebner runs several that have beaten the market handily: So for example, CGMFX (CGM Focus Fund) is a intensely managed fund with a $2500 buy in, no front of back loads (per Morningstar) and a 1.02 yearly fee .. (It also produces a paltry .09 yield)
However, if you review the returns over the last few years and compare them to say VFINX (Vanguard 500 Index) with an 0.18 expense ratio and a 1.19 yield, your returns over a 5 year period are as follows:
2004 2005 2006 2007 ytd
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CGMFX 12.4 25.3 14.9 80.0 -8.1
VFINX 10.7 4.8 15.6 5.4 -6.0
The Growth of $10K over this period between CGMFX and VINFX would be approximately $26K -vs- $13K. The fees would make a negligable difference. Clearly if you were dropping $20K per yer into each fund, then CGMFX would **far** outstrip the Vanguard fund.
In fact, beginning with $20K and depositing $20K per year in CGMFX would yield approximately (I just spit out the numbers using Microcalc without checking for typos) $210,505.58 over this period, whereas with VINFX, the return for the same would be $99,258.33. (Less expenses of course…). I’m no genius, but one number sure looks bigger than the other!!!
I’m not saying that you should disregard the author’s article, but I do think you should take any point of view (including this one) with a dash of Yankee cynicism. And I do need to clarify that Heebner sure has been on a roll over the last several years.
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Thanks for the interesting article.
It seems people need to make good decisions for their retirement to get a bit better result.
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@John Egan,
I own (and am very happy with) CGMFX. However, although your numbers are compelling, it needs to be said that all of the time periods you address were during a bull market (the recovery from the dot-com bust having started in late 2002-early 2003, depending on what you’re looking at). Basically your numbers don’t reflect how well the fund does in a bear market, which we may be entering.
Ken Heebner makes big bets on a very limited number of funds and as such, can be extremely volatile. When he wins, he can win big. But it cuts both ways. He can also lose big. Looking at the numbers today, CGMFX is down 12.40% YTD, while the Vanguard Total Stock Market Index (VTSMX) is down 9.36% If this is indicative of a pattern, the next few years might not bode so well for CGMFX.
Also note that with an annual turnover of 250-500%, you get whacked very hard in the tax department. Considering how much of those gains are short-term gains (which are taxed at income rate), you can lose close to half of your gains to the tax man if you live in a state with a high income tax.
Don’t get me wrong. I’m not knocking CGMFX. As stated, I own it myself, and am pleased. But you’re fooling yourself if you think that you aren’t courting a large amount of risk for the gains you’ve achieved so far.
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RE: John Egan’s point on active management vs. indexing… There is plenty of research out there that supports the idea of indexing as a perfectly viable (even possibly superior) strategy in efficient parts of the market (eg, domestic large cap stocks). But active management can provide superior results in less efficient market sectors (small cap stocks, emerging markets, etc.).
Don’t get me wrong, expenses matter… a lot. But at the end of the day, roughly 94% of performance is delivered by your asset allocation, not the specific investments you use.
So whatever else you do, be sure to start with the appropriate stock/bond/real estate/commodity, domestic/international mix. THEN, worry about what specific vehicles you use to build your portfolio (with cost being an important factor, of course).
Again, nice job here, Dylan. A few hundred words is scant space to develop an idea like this.
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Quick question. What is a good site that can allow you to easily display all the fees for a index fund and/or a mutual fund you are interested in so you can do a comparison? Plus this article has got me thinking about my current investments. I would love to do a comparison amongst them all to see all the fees I’m paying. I’m not completely naive ( I do know none of them are load bearing) but I couldnt’ quote you the expense perecentage paid on any of them at this time.
Thanks.
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If you have the means to invest a 20k lump sum every year (lets say $15k into a 401(k) and $5k into a Roth IRA) on January 1, the best option to minimize fees would be to use exchange traded funds! They have even lower ongoing fees than their equivalent index funds and the broker fees would be virtually nothing ($15 per $20k invested is less than 1/10 of a percent).
If you are investing in taxable accounts the ETF route is the best way to invest as well. You will almost never get a taxable distribution and will pay long term capital gains taxes. You can get almost complete tax deferral for your whole investing career.
For a hypothetical portfolio of:
40% International (VEU)
45% Domestic (VTI)
5% Emerging Markets (VWO)
10% Total Bond Market (BND)
The composite (weighted average) expense ratio would be 0.155% which is about half the expense ratio of even the index funds!
Index funds are the next best option IMHO. Actively managed funds are over priced, if you want active management buy BRK.B shares!
This is the ETF strategy I’d love to use once I’ve got enough money to make lump sum deposits (for now I’m limited to $100 deposits per paycheck).
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I followed how you calculated the amount of growth for both funds and got the same results. However, I’m not following the withdrawal amount calculations:
For the index you have $1,312,830 if withdrawals are based on 4% (before expenses)
Wouldn’t that be?
1,312,830 * 0.04 = 52513?
I could see taking 4% after the 0.2% annual fee, but that is:
1,312,830 * 0.998 * 0.04 = 52408
So how did you get $49,887? Is there a 5% transaction cost?
-Rick Francis
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Rick, $52,513 (4%) is the gross amount available, before expenses. Out of that, $2,626 is needed to pay the fees on the $1,312,830 (0.2% expense) leavening $49,887 available for withdrawal.
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Hey mp,
Check out my comments in comment #15. FINRA also has a mutual fund comparison calculator called the FINRA Mutual fund expense analyzer, it’s not bad but IMO personalfund.com is far more comprehensive.
The Kiplinger Fund Finder is also a pretty cool online tool that allows you to pre-screen mutual funds. Enter the criteria that’s most important to you and it returns the funds that match your tastes.
This ‘fund finder’is effective when looking for cost efficient actively managed mutual funds.
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[...] guest point on the great Get Rich Slowly entitled How Lower Fees and Expenses with Index Funds Could Mean 33% More to Spend in Retirement spells it out with solid numbers right there. One third more is a heckuva reward. Additionally, [...]
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Thanks again for this post. Recalling it while scribbling this afternoon, I’ve linked to it at http://www.funny-about-money.com/Funny_about_Money/Blog/Entries/2008/2/21_Life_in_the_punch-a-button_lane.html.
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The return % is calculated after the fees are subtracted. Right?
This model assumes that the index and fund held the same positions….therefore the managed fund would cost more and therefore generate a smaller return %.
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dem1an, the 7% return is *before* fees.
Managed investments as a whole, before fees = index funds, before fees. That’s what an index is, a measure of all the actively traded investments. You cannot use different returns to compare the same markets. Active management and indexing are not different markets, just different strategies. In the end, the performance of managed funds, before fees equals the performance of index funds, before fees.
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[...] If the other funds in your plan are expensive, try to find an index fund with low fees. (I’m a fan of index funds in the first place, and think they should be one of the first places you look [...]
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