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A Devastating Impact of High Fees on Your Account

April 21, 2015 By Vitaly 1 Comment

FEES!

How do you usually approach your investing? Do you solely focus on returns without giving due consideration to risk? Or do you put some efforts to figure out your investment objectives, preferences/constraints, and risk tolerance first?  Well, if you are concerned with returns only then you are at a much higher risk than you think. Why? Because you may end up with a portfolio that is “stuffed” with high-risk investments and that is not compatible with your personality and goals. A sound investment approach should start with identifying your investment goals, understanding your risk attitude, and drafting a plan. Once done, the next step is asset allocation. Actually, this is the point when things start to get a little bit complicated. With some research and efforts I am more than sure you can do it on your own, but the help of a fiduciary investment adviser may be very convenient and can save you a lot of time and hassle.

However, this time I am not going to dip into the investment process or asset allocation. Today, I would like to discuss another extremely important element of the successful investment process that can save you a lot of money and time. The element I am talking about is called FEES!

For a few reasons, people usually ignore or overlook fees they pay. High fees, as I will show later, can cost you a lot of money and even extend time needed to reach your goals.

Some reasons why people remain ignorant about fees:

  1. Fees seem to be too small to have a big negative impact on the account. For example, an average equity mutual fund charges 1.3-1.5% per year. Most people end up thinking that’s way too low to pay attention to, which is not correct.
  2. Automatic deduction of fees. People do not pay fees directly. They do not write checks. When you pay your electricity or mobile bill each month, for example, you have to write an actual check or pay a bill online, seeing how your money disappear from your account. If the bill is too high, next time you will probably adjust your habits and cut on electronics in order to save. However, in the investment industry you pay fees directly from your account, meaning you don’t always have a clue how much you are actually paying.
  3. There are too many fees out there. Sales loads, redemption fee, account fee, 12b-1 fees… Mind boggles when you try to understand what they are. The most important thing you have to know when deciding which fund to invest in is Expense ratio. The Expense ratio includes all fees incurred by the fund during the year and charged to shareholders.

Performance Erosion

A few months ago, a client of mine (in his early thirties and with a high level of risk tolerance) asked me to review his 401K account and offer my suggestions on how he can optimize it. He wasn’t satisfied with the growth rate of his account over the last few years compared to the market (as measured by the S&P 500 index) and wanted to understand what was dragging his account.

I will skip on the specifics of the review and his previous asset allocation, and jump directly to the fees. The first thing that draw my attention was a 0.97% expense ratio of the fund that his plan administrator invested his money by default. No wonder it was the most expensive fund in the lineup. While I’ve seen people being invested in even more expensive funds, 0.97% is way too much and you should probably avoid investing in such expensive funds unless you know what you are doing.

After the review, not only we were able to decrease my client’s annual expenses, but allocate his funds more efficiently, in alignment with his financial goals and risk tolerance.

In the example below, I have assumed a $20,000 initial investment, 5% annual rate, 34 years before the retirement and 3 expense ratios: 0.97% – the expense ratio before we made changes, 0.2% – the expense ratio of a Lestna 80 portfolio that he chose for his Roth IRA account, and 0.12% expense ratio for a diversified portfolio that we created within his 401k by changing the portfolio structure and asset allocation. No taxes assumed because of the tax-free nature of his accounts.

Fees_neg

As you can see, by reducing the annual fees from 0.97% to 0.20%, my client will be able to save an additional $22,724 (or 30%). By reducing the fees from 0.97% to 0.12% he will be able to save $25,435 or 34% more than if he maintained the previous asset allocation.

If we take into account consistent annual contributions to the account, then his total savings will be even more.

A Few Guidelines on Fees

  • Try not to pay more than 0.5% in annual fund expenses.
  • If your fund charges more, identify if there is an additional value for paying more. Check fund’s risk/return metrics and compare to the benchmark index.
  • Consider rolling over your 401K into a traditional or Roth IRA to get access to all available funds on the market, not just those offered by your plan administrator.
  • Consider opening a self-directed brokerage account within your 401k. As with your IRA account, you will be able get access to all available funds and to create a much cheaper and effective portfolio. However, brokerage transactions costs may be an issue.
  • If you plan administrator does not allow you to make an in-service withdrawal and/or open a self-directed brokerage account, you may be better off by simply spreading your funds between Total Stock Market and Total Bond funds. These funds are usually cheap.

 

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I am a fiduciary financial advisor at Lestna Retirement. I help people build financial confidence and retire with dignity. More...

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