High Investment Fees Can Damage Your Retirement
Investment fees can take a big bite out of your retirement fund. These fees can knock 1 to 5 percent – or even more – off your annual returns. If you are investing for retirement, these fees can be the difference between a great retirement or just surviving. In an example below, the difference between investing in a high fee mutual fund and a low fee fund is $800,000 removed from your nest egg.
In this blog post we will go over the different fees associated with ETFs, mutual funds, and annuities. We will also show how investments are impacted by those fees. In another post, we will discuss why annuities are not often a good investment for most investors.
Some of these expenses show up on your statements. Other fees are embedded in the fund structure and can only be found by reading the fund prospectus. They are referred to as expense ratios, transaction fees, custodian fees, and load fees, among others.
Investment fees are unclear and can be unnecessarily confusing. There are a lot of possible fees investment firms can add to a fund’s cost structure. We will review those fees so you can make informed investment decisions and save money. At the end of this post, we will graphically illustrate the effect of different fee structures on your investment. It is eye-opening.
A quick caveat, investment firms should be compensated for their work, but not over-compensated.
Expense Ratios
Our first stop is expense ratios. ETFs and mutual funds often charge investors a fee to cover their operating, management, and administrative expenses. These fees are either expressed as a gross expense ratio or net expense ratio.
A gross expense ratio represents a fund’s operating costs divided by the average dollar value of their assets under management. It is the percentage of assets paid from participating shareholders to continue running the fund’s operations.
Operating expenses also account for fund marketing and promotion expenses. These fees are called 12b-1 fees, from section 12b-1 of the 1940 Investment Company Act. These fees are listed in a fund’s prospectus. Check the prospectus to find out how much you are charged.
Net expense ratios are calculated the same way as gross expense ratios, but after any fee waivers or reimbursements.
Fee waivers and reimbursements are ways for a fund to attract more investors. A fund may also reduce different expenses, such as management fees and 12b-1 fees, to attract additional investors.
If the gross and net expense ratios are the same, the fund does not offer any discounts to new investors.
Some funds charge little to no fees for staying invested. Beware, there are funds with expense ratios as high as around 50%. The amount paid to a fund to continue operations depends on the fund’s strategy, style, and focus. Funds that have high expense ratios are likely to be actively managed funds or are invested in highly volatile markets. Some examples would be small cap stocks, derivatives, or international funds. If the fund has an annual return of 100%, a 50% percent fee is probably cheap. However, if the fund returns 55%, which a very high return, the 50% fee is very expensive.
You can generally expect the opposite with index or large cap stock funds, whose expense ratios are much lower.
Either way, expense ratios make a big difference over the time of the investment. These fees are deducted annually from the fund’s assets – not from an investor’s brokerage account.
If you were to invest $20,000 in a fund with a 1% net expense ratio, you would be charged $200 per year for fund expenses. If the expense ratio is 5%, the charges would be $1000. In this case, the fund must earn 5% for you to break even. (These examples ignore return to illustrate our point).
It is hard for a high expense ratio fund (usually an actively managed fund) to beat a low expense ratio fund (usually an index fund) over the long term, even though the high fee funds usually market themselves as a high return funds.
Load Fees
In addition to fund operating expenses, there may also be broker commission fees for buying and selling fund shares. These fees, called loads, are used by some, but not all mutual funds. They are built-in commissions for the brokers who sell the mutual funds to their clients. Loads are not a great deal for investors. They are a great deal for brokers.
There are two types of load fees: front-end and back-end.
Front-end load fees are charged to investors when they buy into a load mutual fund and reduce an investor’s initial investment. These load fees range from 0.30% to 5.75%, according to MutualFunds.com.
A back-end load, or deferred load, is charged to investors when they sell or redeem their existing shares – usually before a specified period. The fee charged may depend on how long the investor holds their shares. For instance, after a year, the back-end load might be 3%, but after two years, the fee may decline by a percentage point to 2%.
Back-end load fees range between 0.95% to 5.00%. Keep in mind that the back-end fee is based on the value of the shares when they are sold. The mutual fund takes a fee on the price appreciation of the fund (if there is a positive return).
Mutual funds that do not charge commission loads are called no-load funds. Many of the large mutual fund companies have moved to no-load funds.
An annuity is a contract between an investor and insurance company where the investor makes a lump-sum payment or series of payments and receives regular disbursements.
Annuities have a whole new level of charges for low returns. We will discuss this in a later blog post. For now, you should know back-end loads are referred to as surrender charges for annuities.
If an investor withdraws money ahead of the disbursement schedule, a surrender charge applies to the money withdrawn. Annuities can also have front-end fees, annual fees, and commission charges. If we have not made it clear, be wary of annuities.
Redemption Fees
Redemption fees are intended to mitigate transaction costs that mutual funds incur when an investor sells fund shares shortly after buying them. They are often a small dollar amount per transaction.
These fees sound similar to back-end load fees – both are charged when an investor redeems mutual fund shares – but each has a different purpose.
Redemption fees are meant to discourage short-term trading and reduce any affect these types of trades may have on long-term shareholders. Redemption fees are returned to the fund and not the fund management company. Back-end load fees are commission-based, whereas redemption fees are sent directly to the fund to reimburse them for short-term transactions.
If you are a long-term investor, redemption fees should not affect your return on investment.
Transaction Fees
Transaction fees are usually a lump-sum payment every time you make an order to buy or sell stock or fund shares. These fees cover costs the brokerage incurs when buying and selling shares on your behalf.
Brokerages may charge a transaction fee when you purchase certain ETFs or mutual funds. Sometimes this is the case when the brokerage is not affiliated with the fund in question. This provides a reduced, or no, fee incentive to invest in the brokerage’s funds versus other funds through the same brokerage.
Fidelity, for example, does not charge transaction fees for any of its funds, but it may charge a transaction fee for investing in funds from other investment firms. A $75 transaction fee would apply if an investor wanted to participate in some funds. Fidelity does not charge a transaction fee for all funds from other companies, so check the details for your brokerage firm.
Account Fees
Custodian or account service fees refer to annual brokerage account fees, mutual fund account fees, and closing account fees. Depending on the account, the fees range from around $20 to triple-digits.
For retirement accounts, these fees cover mandatory IRS reporting, but at a lower cost. In other words, some retirement account fees are unavoidable.
When opening and closing an account, research the brokerage’s account policies. There might be fees required to maintain an account with certain brokerages.
Vanguard, for example, charges a $20 annual brokerage fee for nonretirement accounts if the total amount of the investor’s assets in Vanguard ETFs and mutual funds is less than $10,000.
Why Fees Matter
Let’s go over an example. We have obtained expense ratio data for thousands of exchange-traded funds and mutual funds. We will show you how expense ratio fees can affect your investment in the long-term.
Suppose you have invested $50,000 as a lump sum earning 10% per year. After 40 years you could retire with a little over $2 million. Of course, that excludes around $114,000 in expense fees at 0.5% per year.
But these fees can be much higher. For a high fee fund, you would retire with little over $1.4 million. That’s about a $800,000 difference! Depending on your expectations, this might not entirely cover your expenses during retirement.
The graph above illustrates our point – fees, high and low, affect investment performance over a long period. Every year (or month), these expenses are deducted from a fund’s assets. When that happens the potential returns that can be compounded is reduced in subsequent years. As an investor, you can reduce the affect those fees have on your portfolio and retirement savings.
You may have noticed the no-fee fund generates the best results in this example. In the past few years, some brokerages have begun to offer these funds with little or no cost. However, they are index mutual funds.
Conclusions
By not researching the fees, commissions, and loads you may wind up losing a lot of money. We know reading fund prospectuses is boring. However, you must find out the fees you are paying if you want to maximize your return on investment. Fortunately, the SEC has required these charges to be reported in a standard format for each fund. After you do it the first time, it is easier to do the second time.
Focusing on the charges can mean a difference of several hundred thousand dollars over your investment life. The money saved from investing diligently creates higher returns and allows you to live a better retirement.