This is a post from staff writer Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the adviser for The Motley Fool’s Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks.
In my post from a few weeks ago, I explained how Wall Street wants your balls – that is, if you compare retirement savings to balls, as I did in the second video in that post.
Investment advisors and mutual funds take money (or balls) out of your account, somewhere around an average of 1.5% a year. But that’s not the only cost to you, because you now have a smaller account, and you’ve missed out on the growth of the money that could have been in your account if it didn’t go to a financial-services entity.
To illustrate this, let’s assume you have $100,000 and you invest that money in the stock market via a mutual fund that charges 1.5% a year. Let’s also assume that the stock market returns 8% a year for the next 20 years, but paying 1.5% knocks your return down to approximately 6.5%. (Yes, paying some mutual funds and investment advisors leads to market-beating returns, which I’ll get to later.) Here’s what the next two decades could look like:
|Year||Value at the End of the Year||Annual Fees||Cumulative Fees|
Your initial investment more than tripled in value. To quote the Schoolhouse Rock song about interjections, “Hooray!” But along the way, you paid a total of $58,240 in fees. (“Eeks!”) That 1.5% you paid each year ended up being worth 17% of your ultimate investment. (“Drat!”)
But that’s not all! You missed out on what that $58,240 could have grown to, if it didn’t get taken out of your account. Had you instead invested in a super-cheap index fund or exchange-traded fund that charges 0.10%, your account would be worth $457,440. In other words, the fees you paid cost you $105,175 – and reduced your account by a third. (“Rats!”) That’s the real price of paying “just” 1.5% a year.
Build your own retirement savings, not someone else’s
Let’s look at it a different way, courtesy of the folks at Flat Fee Portfolios, an advisory firm that believes investors are better served by paying a fixed dollar amount instead a percentage of the account value (known in the industry as “assets under management,” or AUM). In the words of founder Mark Cortazzo, “The AUM fee increases in absolute terms as your account grows [as demonstrated in the table above]. With a flat fee, the benefits of market appreciation actually reduce the fee as a percentage of the portfolio.”
For their scenario, the people at Flat Fee Portfolios assumed:
- Two investors start with $250,000 and want to have $1,000,000 before retiring.
- One pays a fee of $199 a month, the other pays 1.5% a year (billed quarterly).
- The investors earn a compound annual return of 7.74% (the historical return for a mix a portfolio that was 60% stocks and 40% bonds, according to Morningstar).
The results? The first investor reaches $1,000,000 in 20 years, the other in 23 years and three months. In other words, the latter investor has to work more than three years more, while presumably enabling some financial-services people to retire sooner.
Admittedly, paying $199 a month ($2,388 a year) only makes sense if you have a big enough portfolio. But the illustration shows the potential consequences of paying an annual expense of 1.5% versus a fee that starts out at less than 1% and declines as a percentage of the account value.
What if those fees paid off?
The illustration above assumes that the chosen mutual fund provided no value for its 1.5% fee. This is consistent with the overwhelming evidence that the majority of actively managed funds (those that pay a management team to pick the investments within the fund) do not outperform a relevant index fund (which just buys all the investments within the index, and saves a lot of money in the process). But approximately a third to a quarter of actively managed funds do outperform index funds. In these cases, the funds earned the fees they charged you.
Or perhaps you’re paying an investment advisor, who is helping with your decisions about asset allocation – i.e., how much to invest in U.S. stocks, international stocks, bonds, cash, etc. Plus, the advisor might be providing financial-planning services, such as calculating whether you’re saving enough for retirement or offering tax-saving tips. Assuming the advisor is providing good advice, this may also be a case where the fees are more than justified.
But if you’ve chosen either or both routes – investing in actively managed funds and/or hiring an investment advisor – make sure you’re keeping tabs on the costs and benefits. Empirical evidence as well as my own experience tells me that many investors are paying too much for too little. Or, again in the words of Schoolhouse Rock, “Hey! That’s not fair, givin’ a guy a shot down there.”
(“Darn, that’s the end.”)
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