How much are you paying in fees just to invest for your retirement?
Source: 401kcalculator.org via flickr.
Surprisingly, the majority of investors don't have a good answer to this question. In fact, most Americans even think that the investment funds in their employer's retirement plan are completely free. However, this is absolutely false.
According to FeeX -- whose mission is to help investors become aware of the actual cost of their investment fees -- there was about $600 billion in financial service fees paid in the U.S.in the last year alone.
What fees should you be on the lookout for? And more importantly, what can you do about them?
How do funds charge fees?
The main fee associated with most mutual funds and ETFs is called the "expense ratio," which is obtained by dividing the fund's operating expenses by its total assets under management. Generally, the largest component of this is the fee paid to the fund's manager(s), and can also include other expenses, including, but not limited to, legal costs, record keeping, accounting and auditing fees. Expense ratios are generally in the low single-digit percentile range, and are often less than 1%.
There are often additional fees charged by employer-sponsored retirement plans to make up for the employers' costs to run the plan. Usually, smaller employers' plans come with higher fees, but this can vary widely. According to one report, a plan with 100 participants with $50,000 average account balances can have total costs ranging from 0.36% to 1.71%.
But a small percentage won't really make a difference, right?
This is a very common misconception. After all, an expense ratio of less than 1% can't possibly take too much out of your investment returns, right?
Nothing could be further from the truth. Let's take a look at an example of an investor who has $50,000 invested in mutual funds with an average expense ratio of 0.8%. And let's say that these funds produce total returns averaging 7% per year.
The first year the impact is relatively small, as 0.8% of $50,000 is just $400. However, as your investments grow, the hit becomes larger and larger each year. Plus, you miss out on the gains those fees would have generated year after year.
After a 30-year time period, the original investment would be worth about $304,000, even if you never contribute another dime to your account. Sounds pretty good, right?
Well, if it weren't for the fees involved, your returns would be a staggering $76,700 higher. And, by the time you're ready to retire in 30 years, the fees alone will take about $2,400 per year out of your returns. That's why getting control of your fees is so important.
According to Yoav Zurel, FeeX's CEO, the average American household will pay about $150,000 in investment fees over its lifetime. And most of this is without their knowledge, as 70% of Americans think their retirement funds are completely free.
"Investments will go up and investments will go down, but fees are the only part of your investment performance that is under your control", said Zurel. "Taking control of your fees is the number one way investors can increase their long-term returns."
What can you do about it?
The first step is to become aware of what you're actually paying. By either requesting a prospectus, or simply by logging on to your brokerage account, you should be able to discover your fund's expense ratio.
Then, take a look at a few other funds with similar compositions. In today's market, there should be a decent number of funds that are similar to whatever you're currently invested in. Compare the expense ratios, and see if you might be able to do better. And don't ignore relatively small differences. The difference between, say, 0.40% and 0.60% can make a significant difference over the long term.
Performance is obviously important too, so make sure you take this into consideration before deciding to switch. Funds with similar compositions should have similar performance histories; but make sure the lower-fee fund has performance at least on par with what your current investment has produced.
Also, it's worth mentioning that it's possible for similar funds to have very different performance histories due to turnover, or the cost of trading within the fund. Under SEC law, funds are not required to disclose their trading expenses, but they do disclose their turnover ratio, which is the percentage of the portfolio that is replaced during a certain time period.
Again, similar funds should have similar numbers, but if you are seeing two very different performance histories from two funds that look the same on the surface, this may be the reason.
What if your funds are in your employer's plan?
Finally, if your investments are in your employer's plan, it can be a bit tougher to track down the fees you're paying. However, under the Department of Labor's current laws, you are entitled to request a fee disclosure from your employer... so request one. Check if there are funds available to you with lower fees that still meet your long-term goals.
You may be surprised at the difference between fees in the same retirement plan. A quick look at one very large public retirement plan's offerings reveals expense ratios ranging from 0.02% for an S&P index fund to 0.50% for an international growth fund. If the index fund averages roughly the same or better performance than the higher-cost option, it may be worth considering.
