Paying high fees for financial services is slowly becoming a thing of the past. Information and transparency have driven down the fees and made investors much savvier about the fees and expenses they used to pay to Wall Street brokers. Low cost commissions, low management and administration fees, and ultra-efficient investment funds are now expected by investors.
Just as internet shopping has revolutionized shopping and made retailers much more competitive, the online financial services have made investing much more user-friendly and efficient for the individual investor. Fees and expenses that could have reached over 2% of asset values annually are now often less than 1% (and sometimes zero) on many products.
The numbers may appear small, but they make a big difference to you.
Why are low fees so important?
First of all, because it is your money!
As Charlie Ellis writes, the current representation of fees charged is as a percentage of assets under management. The disclosure is stated as an annual fee of a percentage of your assets being anything from zero to over 2%. The manager is earning a return on your money (your assets) and his fee should be viewed as a percentage of the return. If the manager earns an 8% return and charges you 2%, then they are pocketing a quarter of what you earned. If they only earn 6% on your money they are taking 30% of your return. Those are obviously substantial amounts.
Secondly, the loss of a large portion of your returns adds up to a lot of money over time. Here’s an example. Suppose I’m a hard working college graduate who is just starting my career at age 30. I take a good job and earn $40,000 per year. Over the course of my career I get 4% raises every year. Being thoughtful about my retirement, I invest 10% of my wages every year in a 401(k) retirement savings plan. If I average an 8% return over my 35 year career, I will have accumulated just over $1.1 million dollars when I retire at age 65. If I pay just 1% in fees on my 401(k) I will accumulate just $931,073 or $158,980 less. That’s twenty-one percent less in final value of my retirement funds.
But wait! It could be worse. Some retirement plans can have expenses as high as 2% of assets. If you paid 2% over your career you would end up with only $772,093 in your account. That’s a whopping $358,250 or 46% less to spend in your retirement.
The fees you pay are hugely important. First the fees expropriate a large portion of your returns. It’s your money that is invested and going to work each day , but the return it earns is being paid out to a manager -- not to you. Secondly the erosive effects of annual fees eat away at your saving and can leave you with much less to enjoy at the end of your career.
I’m paying a big fee because it’s worth it!
One of the common arguments in pricing financial services is clients pay high fees to get expert advice that over time will earn a higher return on their investments. The hypothesis is that active investment managers employ a special skill set which enable them to earn higher returns and they must be compensated for their talents. The alternative hypotheses is that markets are efficient and that no manager can consistently outperform the market so paying a premium for their service is a waste of money.
The financial literature is full of tests of this hypothesis but I thought I would run a quick and unscientific test for myself. The Wall Street Journal publishes a monthly review of returns on over nine thousand public funds available to investors. I sorted the recent returns by fees which ranged from 4.65% of assets to zero. I found that 600 funds charge two percent or more in annual fees.
Looking at a long time period to smooth the results, I wanted to know what these high priced funds would earn for a long-term investor. The 600 funds averaged just 6% over the past decade. The hypothesis is that fees told you something about return, so I compared this to the funds with the lowest fees. There were 90 funds that charged nothing for management fees over the past ten years. These were ultra-low cost, target date funds which were designed to be the most efficient and largely passive funds. Over the same time period they averaged a 6.1% annual return. Yes, the low cost funds earned more than the high cost funds! The fees were not an indicator of performance.
Feed the pig -- not the wolves
There is a federal government commercial out there that is encouraging saving with the catch line of “Feed the pig!” The idea is to encourage savers to put more savings into their personal piggy banks. Perhaps the better moniker would be “Stop feeding the wolves!” The fees that you pay on your retirement accounts can significantly reduce your retirement wealth. By paying close attention to your investment cost, you can increase your wealth by 20-46%. The lower fees do not reduce your investment performance and paying up for a more expensive manager doesn’t necessarily mean higher returns.