Most people saving for their
retirement would seriously consider an investment that offered a 20 percent
annual return, but few pay close attention to the fees they incur. Those fees,
however, can make a big impact on retirement readiness.
Earlier research
by The Pew Charitable Trusts found that nearly a third—31 percent—of those
saving for retirement say they are not at all familiar with the fees charged to
their accounts. About two-thirds acknowledged they had not read any
investment fee disclosures. Another Pew survey found that
81 percent of small-business owners and managers at companies that provide
retirement benefits don’t have a good feel for how much
they or their employees pay in fees to their plans.
To help illustrate the potential
impact of these fees over time, Pew has developed an investment fee calculator.
Users can walk through scenarios that show how fees affect both building
retirement savings and how long a nest egg will last in retirement. Savers can
use the calculator to see how fees could affect their own savings.
Long-term savers rely on compound
interest to drive returns exponentially higher over the course of an
investment. For example, investing $10,000 and realizing a 5 percent return
after one year will net an additional $500 that year; after 40 years, with
compounding, the total investment is worth $70,400, an overall return of 604
percent.
Compounding generates
ever-increasing returns because the earnings are used to purchase more of the
investment. On the other hand, if you took out returns as they were earned—that
$500 each year—after 40 years you would have $20,000, plus your original
$10,000 investment, a return of just 200 percent.
Fees can affect savings directly, by
reducing the amount saved, and indirectly, by lowering the amount available for
compounding—a frequently overlooked but significant detriment to savings
growth. Fees, often structured as a percentage of assets invested, are most
commonly incurred in two ways: as a mutual or index fund fee captured in the
fund’s expense ratio or as a management fee charged by an investment adviser.
Both are generally charged on an annual basis—but the specifics vary widely.
According to the Investment Company Institute, a trade
group, the median equity mutual fund expense ratio in 2017 was 1.18 percent.
Examining where most fees fall, the scale ranged from 0.66 percent (66 basis
points) at the 10th percentile to 2.0 percent (200 basis points) at the 90th
percentile. While the reasonableness of any particular fee is subjective and
individual investors should weigh the value based on personal circumstances,
lower fees generally result in higher returns over the long term.
Take a saver investing $200 a month
for 40 years. If that money was invested in a fund earning 6 percent with an
expense ratio of 0.5 percent and an adviser fee of an additional 1 percent—for
a total annual charge of 1.5 percent (150 basis points), the worker would have
about $268,700 at the end of 40 years.
An annual fee of 1.5 percent may
sound small, but consider that same $200-a-month savings invested in a passive,
target date fund linked to the saver’s expected retirement year—and costing
just 0.5 percent (50 basis points). If this investment saw the same 6 percent
return, it would be worth significantly more after 40 years—about $349,600.
That’s $80,900, or 30 percent, more. Of course, the argument for a managed
account is that investors can hope to see higher returns, but the higher-cost fund
would have to earn around 100 basis points, or about 17 percent more annually,
to be an equivalent deal, a return that research shows is very
difficult to achieve.
Fees are just as relevant when
savers want to preserve accumulated assets in retirement. According to Vanguard,
a fund manager, the average account balance for those 65 and older is about
$200,000. If a retiree expects to withdraw $1,000 a month, a bond fund charging
0.1 percent (10 basis points) with a modest 2 percent return would last 20
years. A fund charging 1 percent (100 basis points) with the same return would
last only about 18 years—and cost the retiree nearly $24,000 in fees and
forgone compounding. The higher-cost investment would have to earn around 90
basis points, or 45 percent more annually, to be an equivalent option.
While it may seem obvious that
paying less in fees results in increased savings, the small percentages make it
hard for many to appreciate the impact over the long term. Pew’s investment
calculator shows the effect that fees have on retirement
savings and demonstrates the benefits to savers of investigating how much they
are being charged.
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