Management fees can knock a big chunk out of your retirement savings portfolio
In the late 1960s, The New York Times said we had entered the age of "people's capitalism," citing the broad increase in mutual fund and stock ownership.
There were fewer than 300 mutual funds then. Money market funds did not yet exist. Fixed-income funds were rare. Most funds were sold with a stiff 8.5 percent front-end commission. There were no index funds, no exchange-traded funds, and only a handful of low-load and no-load funds. Most funds were sold, like stocks, by brokers.
That distribution system - what I call the legacy system - still exists. Front-end commissions have come down, "B" shares and adviser shares have been added, and insurance companies have gotten into the market by wrapping an insurance contract around a mutual fund and creating variable annuities. Brokerage firms have also added "wrap accounts," substituting an annual-percentage-of-assets fee for transaction commissions.
And the legacy distribution system continues to manage, and charge fees on, trillions in financial assets, usually with a goal of charging about 2 percent (or more) of assets in any account.
But, just as we are now a nation of cellphone users and many have abandoned land lines, the last 40 years have also produced two major distribution systems to build and tend our retirement nest eggs.
Low-cost institutional distribution. If you work for a large employer, you probably have a 401(k) plan from a firm like Fidelity, T. Rowe Price, Vanguard, or American Century. In these plans your employer selects a menu of funds. Over time, the typical expenses of these funds have declined. It may cost only 70 to 80 basis points (0.7 to 0.8 percent) to hold and manage your entire nest egg at a Fidelity or T. Rowe Price, or as little as 20 basis points at Vanguard. Basically, this new distribution system costs two-thirds less than the legacy system. At the far extreme of low costs there is the federal Thrift Savings Plan. It runs at a barely measurable cost - 3 basis points. That's 0.03 percent.
Low-cost retail distribution. A parallel low-cost system for individual accounts has been developed for taxable accounts and all the independent qualified-plan accounts such as IRAs, Roth IRAs, SEPs, etc. Using broad "platforms," such as Fidelity brokerage, Schwab, and ETrade, you can now buy no-load funds or low-commission exchange-traded funds over the Internet. This makes it possible to build retirement savings at a total cost that can range down to 20 basis points. Like the low-cost institutional distribution system, this system can cost one-third to one-tenth as much as the traditional (and expensive) legacy system.
Let's suppose you are 30, earn $50,000 a year, and will earn annual raises that exceed a 3 percent inflation rate by 1 percentage point a year. Let's also assume you save 10 percent of your income each year, whether directly out of income or a combination of your contribution and matching funds from your employer. Your savings are invested in a portfolio with an expected return of 9 percent, before fees and expenses.
The result, when you retire at 66?
Well, you'll need a lot more money than you might think because your final salary will have quadrupled to $205,000 by age 66. It won't buy a lot more than $50,000 did at age 30, but you'll be making more dollars. If there were no investment expenses, you would accumulate $2,088,800 over the period. That's 10.18 years of final income.
If you have investment expenses of only 20 basis points, your net return will be 8.8 percent. You'll accumulate $2,000,000. That's 9.75 years of final income, or 96 percent of what you'd accumulate in an ideal world with no expenses.
If you invest through a 401(k) plan that cuts 70 basis points a year off your 9 percent return, you'll accumulate $1,797,000, or 8.76 years of final income. Basically, the cost of investing is cutting your return 14 percent.
But, if you are subject to the legacy distribution system and lose 2 percentage points of return to its bloated expenses, you'll accumulate only $1,263,000. That's 6.15 years of final income. The legacy distribution system will have reduced your accumulation by 40 percent.
That's a burden higher than the highest federal income tax rate.
Scott Burns is a syndicated columnist. He can be reached at scott@scottburns.com.
