Fees matter. Even for savvy investors who pride themselves on proactively putting money away every month, hidden investment fees can eat away at your 401(k) to the tune of millions of dollars over time.
Rebalance prides ourselves on our Better K 401(k) solution, which can reduce our clients 401(k) fees by over 50%. Which is why a recent Forbes article titled “How a 1% Investment Fee Can Wreck Your Retirement” caught my attention.
I recommend you read this article, which succinctly outlines exactly how much of your nest egg is eaten up by retirement fees. In an example presented by the author, a savvy investor loses 25% of their overall wealth to advisor fees alone!
The bottom line: fees matter.
How A 1% Investment Fee Can Wreck Your Retirement
Investment fees are easy to ignore. You don’t get billed for your advisor’s fee or the expense ratio of a mutual fund. They quietly take it out of your investment portfolio every quarter. Yet fees can have a huge impact on your wealth.
In this article, we are going to examine four aspects of investment fees. First, we’ll look at the numbers to see just how big an effect seemingly small fees can have on your wealth. Then we’ll consider whether high investment fees translate into better returns. Third, we’ll look at how to determine the investment fees you currently pay. And finally, we’ll look at a free tool that I use every day that includes an investment fee analyzer.
Investment Fees Matter
Even a 1% fee, over a lifetime of investing, can significantly reduce the value of a portfolio. Using Vanguard data, we know that from 1926 through 2019 an 80% stock and 20% bond portfolio returned 9.7% a year. Let’s imagine we invest $1,000 a month over a 40-year career. Using a savings calculator, we know that the portfolio would grow to about $5.8 million.
Yes, compounding is a beautiful thing.
Let’s now assume we pay an advisor 1% of our investments for their services. That’s a standard fee in the industry, although you can find less expensive and more expensive advisors. The result is that on an after fee basis, our returns drop from 9.7% to 8.7%. The result is a portfolio of just $4.3 million. The one percent fee cost us about $1.5 million, or 25% of our wealth.
In the above example, we didn’t consider mutual fund fees. If our advisor invested our money in mutual funds that also charge a 1% expense ratio, our wealth would fall further, down to about $3.2 million.
High Fees Do Not Generate Better Returns
In defense of fees, some argue that higher fees generate better returns. Studies do not support this conclusion. A study by S&P Global published in 2020 found that actively managed funds underperformed their respective index over a 10-year period:
Large-cap funds made it a clean sweep for the decade—for the 10th consecutive one-year period, the majority (71%) underperformed the S&P 500. Their consistency in failing to outperform when the Fed was on hold (2010-2015) or raising (2015-2018) or cutting (2019) rates deserves special note. Of the large-cap funds, 89% underperformed the S&P 500 over the past decade.
The results for mid-cap and small-cap funds weren’t much better: “84% of mid-cap funds and 89% of small-cap funds underperformed over the longer 10-year period.”
Studies by Morningstar have similar results.
How to Find a Mutual Fund’s Expense Ratio
Determining a mutual fund’s expense ratio is easy. As a starting point, a prospectus will include this information. Most 401k and other workplace retirement accounts should also provide this information. If you know the ticker symbol of the fund, you can also find the expense ratio on Morningstar. I have a video series that walks you through how to use Morningstar’s free tools.
Keep in mind that the expense ratio is not the only fee a mutual fund will charge. They also charge transaction fees that aren’t reflected in the expense ratio. That’s another reason to favor low-cost index funds. They tend to trade less frequently than actively managed funds, keeping transaction fees lower.
As for advisors, make sure you understand the fees they are charging you. If you don’t know what they are, ask.
It’s easy to forget about investment fees. Yet they are one of the most important aspects of investing. They are also a great indicator of returns. The lower the fees, the higher your returns, in most cases. That’s why index funds are such an important part of long-term investing.
This article was originally published in Forbes on February 5, 2021.