Predicting costs key to portfolio shake-up

Couple didn't fully realize hidden price of investing

Abdul Taufiq is an avid reader of personal finance, subscribing to business magazines and exploring financial websites. But when he wanted to apply some of this advice to his portfolio, he ran into problems.

First he tried to consolidate his retirement accounts from past employers, but found that he was triggering significant fees. Then he logged on to a portfolio calculator through his 401(k) provider, but it wouldn't include all his assets. So, Taufiq and his wife, Lisa, who are saving for both retirement and college for their two daughters, decided to get professional help and applied for a Globe Money Makeover.

"I got stuck," said Abdul Taufiq, 48, a systems administrator for commercial real estate firm CB Richard Ellis, when the couple sat down with fee-only financial adviser Rick Miller of Sensible Financial Planning in Cambridge. "It's easy to say diversify, but how?"

Too much information can leave people confused when they have to make investment decisions, Miller told them. Yet good portfolio management isn't complicated. It can be reduced, he said, to four basic principles: Pick an asset allocation with a comfortable amount of risk, diversify your investments, use low-cost index funds, and rebalance periodically.

The devil, of course, is in the details. So Miller walked the Taufiqs through their investments, offering some new strategies and providing specific advice on how to give their portfolio both muscle and direction.

Choosing an asset allocation wasn't an issue. The Taufiqs already had about 80 percent of their $107,000 portfolio in equities. They were comfortable with the downside market risk, which Miller explained could result in a drop in asset value of 26 percent or more in any given year.

But when it came to diversification, Miller said, the couple's mutual fund portfolio was too heavily invested in big US companies, which accounted for more than half of their investments. "You could be better diversified," Miller told them, recommending they double their international investments and move about 10 percent of their portfolio into US real estate.

When Miller began talking about the need to control investment costs, however, Abdul Taufiq realized he had been dealing with only part of a very significant issue. "I've looked at load fees, not management fees," he said.

Miller explained that even though the Taufiqs weren't paying a load or sales fees on mutual fund investments, they were still spending far more than they had to. Abdul Taufiq's 401(k) investments, he noted, charge annual management fees of about 100 basis points, or 1 percent of assets invested. That's much higher than the 10 to 30 basis points charged annually by the index funds that Miller recommends.

"We can't predict returns, but we can predict costs," Miller explained, noting such a seemingly small difference can add up to big dollars over time. Invest $100,000 for 30 years, he said, and the fund that charges just 20 basis points will be worth nearly 40 percent more than the average managed fund that charges 136 basis points. That would mean an extra $178,000 after taxes for the investor, he said.

To keep costs down, Miller said Abdul Taufiq shouldn't fully fund his 401(k). Instead, he should only contribute enough to qualify for his company's matching contribution. Then the Taufiqs can use the remaining money to fund Roth individual retirement accounts, which offer better low-cost investment alternatives. After contributing the current maximum of $4,000 a year to each of their Roths, the couple should then put the remaining $5,000 of their annual savings into a family emergency fund or into a 529 college savings plan to help cover future tuition costs, he said.

Given Abdul Taufiq's limited 401(k) investment choices, Miller began rebuilding the Taufiqs' portfolio by looking for the lowest cost 401(k) investment option. That turned out to be the Dreyfus S&P 500 Index fund, which charges an annual management fee of 50 basis points.

"Put all of it in that fund," Miller recommended, explaining that IRAs and other accounts can be used to provide needed diversification.

So how does the Taufiq portfolio look after Miller's makeover? The couple will still have five accounts, but Lisa Taufiq will have a new Roth IRA. With the exception of Abdul Taufiq's 401(k), however, all their accounts will be at a single firm like Vanguard, Fidelity, or T. Rowe Price. That will cut down on the paperwork. The investments themselves will be more broadly diversified and have significantly lower management fees.

And the couple's emergency fund will become a joint account, with Lisa Taufiq joining her husband as an account holder. "Otherwise, if you have an emergency, she may not be able to get to the money," Miller said.