“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.
- $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