How Wall Street eats a third of your savings and makes you work longer

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:

YearValue at the End of the YearAnnual FeesCumulative Fees
1$106,500$1,500$1,500
2$113,423$1,598$3,098
3$120,795$1,701$4,799
4$128,647$1,812$6,611
5$137,009$1,930$8,541
6$145,914$2,055$10,596
7$155,399$2,189$12,785
8$165,500$2,331$15,116
9$176,257$2,482$17,598
10$187,714$2,644$20,242
11$199,915$2,816$23,058
12$212,910$2,999$26,057
13$226,749$3,194$29,251
14$241,487$3,401$32,652
15$257,184$3,622$36,274
16$273,901$3,858$40,132
17$291,705$4,109$44,241
18$310,665$4,376$48,617
19$330,859$4,660$53,277
20$352,365$4,963$58,240

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.”)

More about...Investing, Planning, Retirement

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William @ Drop Dead Money
William @ Drop Dead Money
7 years ago

Good point, and it’s the reason I always stayed away from managed funds. But… you should never use finding fault with the system as an excuse to not save. Just accept that even though it’s not perfect, it’s still the best long term saving option available, so just save like crazy and make the most of it. In the long run, the tax break and your consistent saving are enough to cancel out the inefficiencies and leave you with enough to “retire” (meaning do what you want to do). The only thing you need to look out for is the… Read more »

Lincoln
Lincoln
7 years ago

This is another great article by Robert, and also some interesting ideas raised by William. One observation I would like to make is that the further you get into your retirement planning, the more it matters to pay attention to fees. Specifically, 1.5% on 1 million dollars is a lot more than 1.5% on 10 thousand dollars. When you look at Robert’s chart, you are paying way more for the same service as before. If you are OK having your fees compound, you better be very careful when picking the rate your fees are compounding at. I think once a… Read more »

Mrs EconoWiser
Mrs EconoWiser
7 years ago

Haha! That is exactly why I am a passive investor. My Dutch index fund charges 0.3% to 0.5% and tracks the MSCI indexes. I sleep well 😉

Rohit @ The Money Mail
Rohit @ The Money Mail
7 years ago

By the nature of the market, on average half of the funds will out perform and half of the them will under perform. It is very difficult to predict which side a fund will end up. If you are seeing stock market exposure, it is always better to go with an index fund with low fees.

Creating a systematic investment plan or dollar cost averaging method you can build a position in an index and manage your average cost.

justin@thefrugalpath
7 years ago

This post makes a great point. Most people see the 1.5% fee as a fee on their entire assets. However, they don’t realize that if you’re only earning 10% per year that 1.5% is 15% of your actual earnings. And this is why I use index funds for my retirement accounts.

Elizabeth
Elizabeth
7 years ago

I think this post does a good job of drawing attention to something many of us take for granted: those fees! I think I need to account for them somehow in a spreadsheet… or something. Oy.

Nicoleandmaggie
Nicoleandmaggie
7 years ago

Vanguard for the win!

TB at BlueCollarWorkman
TB at BlueCollarWorkman
7 years ago

I didn’t know that! SUCKS! It’s not really fair! Man, those Wall St people really screwed the pooch in 2008 and just keep jerking us around now, don’t they? Makes me want to just put all my money under the mattress and be done with it.

chacha1
chacha1
7 years ago

Robert’s point is that you can avoid getting screwed by Wall Street if you educate yourself and pay attention.

In the past, a lot of fees were hidden. With recent reforms, which certain rich people are trying to reverse, the fees are exposed.

An investment that earns 6.5% is still better than an investment that earns 0% … so the mattress is never the best option. 🙂

Tracey H
Tracey H
7 years ago

But for those of us who really don’t want to manage our own money, finding a good advisor (who can buy a variety of products) and getting lots of extra advice from them (independent advice on insurances of all kinds, estate planning, etc.) can be worth it. We pay 1.25% for all of that (with our cash portion separate and managed ourselves–why pay a fee on that?).

Where did the $199/month number come from? Is that an average of real rates or is it just a number pulled out of the air?

Robert Brokamp
Robert Brokamp
7 years ago
Reply to  Tracey H

The $199/month is the fee charged by Flat Fee Portfolios: http://www.flatfeeportfolios.com/investment-portfolio-solutions/flatfees. Sorry, I should have made that clear.

Ethan
Ethan
7 years ago

Great info! Will have to go back over my retirement account. Article seems to be lacking in any interesting cat pictures…:)

William
William
7 years ago

I’ve always been leery of the lack of diversification in having all my eggs with one provider. Whether that’s vanguard or some other group — if it turns out to be run by a Madoff, I seem to be in trouble. Which is why I’ve got my eggs in a few baskets. The pre-tax stuff is with an employer-provided plan (TSP) which itself is pretty well diversified. The post-tax stuff is with Vanguard. And the non-tax incentivized accounts are with ING, and are a really small amount of the total. This gives diversification along three different axis: investment, company, and… Read more »

Gen
Gen
7 years ago
Reply to  William

I’m not positive, but I think the TSP funds have even lower fees than Vanguard, which is why we max out our TSPs as well as maxing out a Roth IRA through Vanguard.

William
William
7 years ago
Reply to  Gen

@Gen: Exactly right. TSP’s is about 0.025%. Compare this to vanguard, where funds are 0.19%. That means TSP is about one-tenth the expense of vanguard.

But, TSP varies from year to year. Here’s a chart:
https://www.tsp.gov/investmentfunds/fundsoverview/expenseRatio.shtml

Mrs PoP @ plantingourpennies
Mrs PoP @ plantingourpennies
7 years ago

Vanguard 2045 has fees of 0.19% and better historical returns than the Fidelity 2045, which has expenses of 0.76%. Quality doesn’t have to cost more.

Jennifer
Jennifer
7 years ago

This is especially important if you are a young investor with decades to pay fees (I opened my Roth at 23). The most important thing I look at is expense ratios. Most of my money is in an index fund with Vanguard at .06%. I get extremely annoyed at the options I have with my employer and even the index funds are over priced. The money is in lieu of social security so I just make the best of what I have available and know that I’ll be set whenever I decide to retire.

FC
FC
7 years ago

You get what you pay for. If you want active professional management of a fund that can, among other things, take defensive positions when the market turns for the worse or take more aggressive positions when the market is increasing, you, of course, pay more. If you want index funds that simply tracks an index for better or worse and nothing more, you will pay less. This info is all clearly disclosed in the prospectus. Nonetheless, I agree with the premises of this article, that people should have this information before making an investmetn descision.

William
William
7 years ago
Reply to  FC

@FC: If Vanguard’s cheap & passively managed funds outperform Fidelity’s actively managed funds, then I am not sure you do get what you pay for.

Which, also, seems to be the thrust of the article….

Kevin
Kevin
7 years ago
Reply to  FC

FC, If you do indeed “get what you pay for,” then every higher-fee fund should outperform all funds with lower fees than itself, right?

Why, then, is exactly the opposite actually the case? That is, why do lower-fee funds, on average, outperform higher-fee funds?

FC
FC
7 years ago
Reply to  Kevin

I know that index fund investing in very popular right now, especially for those who solely focus on cost, however, just stating that average performance is higher for an index fund compared against an actively managed funds is not very helpful. What are the indexes of each tracking? What are the objectives of each Fund? Some people do not solely focus on return, but rather preservation of capital. Are money market funds, which are actively managed, bringing the performance average down for all actively managed funds? What about volatility? In my view, and ultimately I guess this is my point,… Read more »

CDB
CDB
7 years ago
Reply to  FC

I think that the vast majority of active money managers *believe* that they are able to take aggressive or defensive positions that deliver better performance and thus justify their larger fees.

Although I find this faith touching, it is not borne out by any of the studies that I have read about. A lot of classic Wall Street literature further confirms this…”A Random Walk Down Wall Street”…”The Big Short” by Michael Lewis…”Where Are All the Customer’s Yachts”…and many more.

Monja
Monja
7 years ago

I didn’t know that, of course. But looks like what happens everywhere: the big bosses get the money of the small ones and let them work for you. the question is just how you can get a big boss… hopefully there will remain people who are honest and you can trust

Sam
Sam
7 years ago

Drives me crazy, glad they can’t keep hiding the ball (the fees) as they are required to disclose. Sadly the default funds that a lot of people are being funneled into have the highest fees, the target date funds.

Matt at Healthy N' Wealthy
Matt at Healthy N' Wealthy
7 years ago

They say it’s easier to get robbed by a guy with a pen than a guy with a gun.

Thanks, Robert.

Question: if you’re charged a percentage fee, do they lower the fee if your account goes lower? Perhaps this is a ridiculous question, as you should obviously pay less in that event, but you never know.

chacha1
chacha1
7 years ago

For those of us in company 401(k) and equivalent plans, please don’t assume that you have no power over what investments are offered. Corporate benefits departments can be astoundingly ignorant. Do some research on low-fee funds and present the information to your employers. Educate your bosses about what options would be better for you and your co-workers. Most employers, believe it or not, want their staff to do better. Mutual funds, like any other commercial product, are responsive to demand. If high-fee funds start seeing companies pull their 401(k) accounts out in favor of low-fee funds, the average fees *will*… Read more »

mike
mike
7 years ago

Nothing new here, move along. For pete sakes the fee issue has been beat to death, even on this website. How about something new, different and I know there may be a few people who haven’t heard this before but any quick tip guide makes this a top 5 issue now when investing along with indexing. I need fresh stuff to keep me coming back to this site.

Luke
Luke
7 years ago

I’d have to disagree. As John Bogle says, when it comes to expenses/fees, “You get what you DON’T pay for”.

Dylan
Dylan
7 years ago

Robert, “you gotta be cool when you’re walkin’ on Wall Street, like goin’ to school.” 🙂

Tara
Tara
7 years ago

I’ve been reading that fees are one of the best indicators of long term investing success (along with a high savings rate of course!) – lowest fees over the long term wins the game. I am sticking with Vanguard – 0.06 on the Total Stock Market fund, 0.18 on the Total Intl Stock Market fund, and 0.10 on the Total Bond Market fund.

rr2
rr2
7 years ago

The effect of the fees really become noticeable when you consider the withdrawal phase. The typical recommended safe withdrawal rate is 3-4% of your portfolio. If the advisor takes 1.5% of the portfolio value, then it is almost like a 37.5-50% tax at the beginning of the withdrawal phase!!!

Cat
Cat
7 years ago

What bothers me the most is not which fund to choose (since I won’t know the figures from both accounts) is the TAX ISSUE. You pay taxes on what you make. It’s only fair that the government give refunds based on what you lost!

Jebut
Jebut
7 years ago

What has always been unclear to me is where I can see these fees being ‘withdrawn’. I don’t get a bill saying ‘we withdrawn 1.5%’ from your investment so it possible to see this somewhere. Should it be visible and/or is it visible somewhere I am not aware of?

Kelly@Financial-Lessons
7 years ago

I like the tone of this article. Sometimes its difficult for me to understand investments and stuff along these lines, but I think this is broken down pretty well and actually entertaining. Thanks!

Sriraksha Financial Planning Services
Sriraksha Financial Planning Services
7 years ago

Like your post. When it comes to investing in stocks and equities, most people focus on the risk and returns part , but seldom think of the charges and fees which eat into the profits.

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