An easy way to see how fees are eating your 401(k)
One of the more outrageous things I've ever heard is my long-ago investment adviser informing me that he would charge 5% of assets under management to suggest mutual funds for my retirement portfolio.
In a world where 8% annually is a healthy return on a mutual fund, that was (and is) a very steep fee.
No one is such a great fund picker that you, I, or anyone else should pay, not just 5% of whatever the portfolio earns, but 5% of our total nest eggs to have Mr. Magic Funds take the helm.
His proposed fee was in addition to the amount I was paying my mutual fund managers.
The average annual fee (also called an expense ratio, and usually identified in a fund’s prospectus as the total annual fund operating expenses) for an actively managed mutual fund is 1.26%, according to Morningstar, which provides independent investment research. The average index fund charges 0.76%.
The fee that an investor pays makes a huge difference in the ultimate value of an investment, a point the Securities and Exchange Commission (the SEC, which regulates U.S. financial markets) recently made in a bulletin for investors called "How Fees and Expenses Affect Your Investment Portfolio."
In it, the SEC points out just how many fees and expenses lurk in the fine print of most mutual funds.
To illustrate fees' effect, the SEC used simple, conservative assumptions: a 1% fee on an initial investment of $100,000 that grows for 20 years at 4% annually.
Over that 20 years, the 1% management fee costs the investor nearly $40,000. That figure includes a direct cost of $27,832 and an opportunity cost — the return the investor could have earned by reinvesting the fees — of $12,067.
To put it another way, a similar fee-free portfolio would have contained $220,000 at the end of those 20 years, a gain of $120,000. With the fees, the portfolio gains $80,000. Fees eat about a third of the investment's return — and that's before the IRS takes a second bite from portfolios that aren't tax sheltered.
Fees also come in sneaky, not necessarily obvious forms.
The SEC divides expenses into two groups: transaction fees, which a brokerage firm might receive when it buys or sells a stock, and continuing fees and expenses, which exchange-traded and mutual funds charge for managing investments.
Investors might also pay markups, due when a brokerage sells securities from its inventory at a price higher than the market rate; sales loads, sometimes assessed when you make or sell an investment; surrender charges, imposed when someone pulls out of an investment early; investment advisory fees, which are what Mr. Five Percent wanted to charge me; and 401(k) fees, additional expenses for operating and administering retirement plans that employees pay on top of fund management fees.
If this sounds sneaky and confusing, that's because it is.
The SEC makes it a little easier by also pointing readers toward a Financial Industry Regulatory Authority calculator that allows investors to compare funds.
I tried out the analyzer, picking three funds essentially at random and because they all had "growth" in their names.
I invested an imaginary $100,000 and made the same return assumptions for each fund.
After 10 years, one fund's return is about $5,000 behind the other two.
The yield difference is because the lower-performing fund's expenses are 0.2% and 0.13%, respectively, higher than those of the better-performing funds.
Those are tiny numbers, but they matter. Bigger differences would matter even more.
The site also tells me that all three funds charge fees that are higher than the average for similar growth-oriented mutual funds, which might cue me to keep looking at other fund candidates before I invest.
In choosing investments, you don't have much bargaining ability. Your power lies in your ability to educate yourself and choose funds with your eyes open to the fees their managers charge.
Of course, you might be willing to pay higher management fees for better returns. Remember, though, that there is no fund or fund manager that consistently beats all the other, similar options.
Most often, higher fees just mean more money for managers, but less money for you.