Costs of Retirement Investing

Costs can cramp your retirement lifestyle

Graph showing growth of retirement savings with fees and without feesThe Impact of costs on Your Retirement Investing

The recent White House initiative to introduce higher fiduciary standards for retirement investment advisers has focused attention on adviser fees and potential conflict of interest.  Conflict of interest arises when some advisers receive commissions and other remuneration when placing clients’ money in certain mutual funds that have high expenses. A recent study released by the White House estimates that “Savers receiving conflicted advice earn returns roughly 1 percentage point lower each year…”

Fortunately, I have managed my own investing and utilized index funds as a general rule. I have spent more time seeking an ‘optimal’ investment policy than examining the full impact of fees. But adviser fees are only part of the equation. Investing costs also include mutual fund fees, transaction costs, and tax impacts that you are paying on top of the adviser fees. To assess the overall impact I created a very simple example for myself that assumed total fees of 1.5% per year. For a portfolio return I used 5% as a long term approximation. For each year over a 25 year period I computed the return and then subtracted the fee to calculate the after fee balance. The returns are plotted on a log scale. While 1.5% doesn’t seem like that much, it becomes very significant over time. You can characterize this two ways. The ‘no fee’ result is almost 46% more than the ‘with fee’ total or the ‘with fee’ result is about 31% less than the ‘without fee’ total at the end of 25 years. The fees are a double whammy really. Not only does the investor pay almost $61,000 in fees over the time period, but has less money working to earn returns throughout the entire period. This is just a baseline example. More rigorous studies conducted by very credible researchers are described below.

Studies on the impact of fees go back at least to William Sharpe’s 1966 paper, “Mutual Fund Performance” that appeared in the Journal of Business. I have not been able to find a copy of this article on the web, but his more recent one, “The Arithmetic of Investment Expenses” is available at the CFA Institute. (I think you will have to register to read it.) William Sharpe is the recipient of the 1990 Nobel Memorial Prize in in Economic Science and Professor Emeritus at Stanford University. (You can read more about Professor Sharpe at Wikipedia.) The paper analyzes several scenarios and includes a Monte Carlo analysis. Sharpe’s conclusion: Under plausible conditions, a person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in high-cost investments. Sharpe’s analysis includes only the difference in mutual fund fees, comparing the lowest cost index fund with the average fee for actively managed funds. He does not include adviser fees or other costs.

John Bogle, the founder of Vanguard and creator of the first index fund, has been a steadfast advocate for the individual investor and consistently emphasized the importance of keeping retirement investing costs as low as possible. Cost is one of his four factors for retirement investing. In his recent research paper, “The Arithmetic of All-in Expenses”, Bogle tallies the total costs of investing and the long term impact on the ‘terminal wealth’ of the investor. The paper estimates all investing costs, adviser fees, fund fees, trading costs, taxes and drag from cash holdings. The Bogle analysis first estimates all-in costs from the standpoint of the individual cost elements and then estimates total fees extracted from the market at an aggregate level. The numbers square pretty well. His estimate shows a much more dramatic impact. The conclusion: Compared with costly actively managed funds, over time, low-cost index funds create extra wealth of 65% for retirement plan investors. I really recommend that you take time to read this paper.

As I have stated, the twin elements of my investment policy have been asset allocation and its implementation through index funds wherever possible. It turns out that keeping costs low is more important than a specific asset allocation. A little book, Global Asset Allocation, by Mebane Faber is very instructive. (Mebane Faber is managing director and portfolio manager at Cambria Investment Management, where he manages portfolios based on quantitative strategies.) The link above will take you to Amazon. The Kindle download cost $2.99. You can get a free Kindle reader directly from Amazon. This definitely passes my latte test. Faber provides a very thorough analysis based on real data from 1973 to 2013 that compares several portfolio allocations. He finds that the various allocations yield quite similar rates of return. Faber then looks at investing costs and concludes very simply “Fees are far more important than your asset allocation decision!”

The primary purpose of the above papers and analyses is to evaluate the impact of costs over the working career while the individual is investing for his or her retirement. For those of us that have retired, our current retirement portfolio is our starting point. The key is that a person retiring at 65 may easily have another 30 years to live. That might mean a retirement period of spending from accumulated funds that is longer than the working period it took to accumulate the funds. So costs still matter– maybe more than ever.

Faber reports that:

  • The average financial advisor charges 0.99 % per year. (Although the most expensive quarter of advisors charge over 2% per year.)
  • The average ETF charges 0.57% per year.
  • The average mutual fund charges 1.26% per year.

Financial advisers can be very helpful. But you should take time to read the citations and to analyze your own situation. You may be surprised about how much it is costing you. The fees you are paying could be the difference between a comfortable retirement and a financial struggle.