Friday, November 7, 2014

What Appear to Be 'Small' Annual Management Fees Will Dramaticaly Lower an Individual Participant's Long Term 401(k) Investment Returns

Little things mean a lot, and small recurring annual investment fees generally result in much lower than otherwise easily achievable results for an individual 401(k) participant over a working career. It's a totally unnecessary and huge waste of saved and invested money that, if not for the payment for non-value added services, would have accrued to the benefit of the individual and his family during retirement.

Knowing the facts will result in our making better decisions, but unfortunately 401(k) investing is one area where ignorance prevails to the detriment of the individual saver and plan participant. So please read on and see if the 'shoe of ignorance' fits anybody you know. If so, let's help them wise up.

After all, since it's our 'non-expert' invested MOM (my own money) at risk, for the vast majority of individuals, investing in an S&P 500 index fund is likely to be the lowest cost and highest performing 401(k) investment offering available.

You get what the stock market returns without paying anybody to receive those returns. And over time the market will exceed inflation by a wide margin and similarly outperform other available investment choices, including cash and cash equivalents, bonds, gold, silver and real estate.

Understanding Your Real, Real Returns tells a compelling story about the potentially destructive impact of "low fees" charged to individual investors by 401(k) fund managers:

"A recent post of mine discussed the importance of understanding your real, real returns (see here).  That is your return after fees and inflation.  We don’t usually hear about this return which is really strange because it’s the money that actually goes into your pocket. . . . In fact, the real, real return in stocks over the last 30 years has been just 5.97%. . . .

We all know the story on inflation over the long-term and certainly in recent years.  Historically, it runs about 3.5% although it’s been much lower in recent years.  But it’s still the biggest chunk reducing your returns.  Leaving your assets in cash form is generally a dreadful idea over any sustained period of time, but it’s shocking how many people do this.

But what doesn’t get as much attention is the adverse fee effect.  If you’re looking at a real return (after inflation) of 6-7% in stocks then we have every reason to be mindful of any other frictions like taxes and fees that might reduce that return even further.  But what is the average fee effect?  To put things in perspective consider that the average mutual fund charges 0.9% relative to the average low fee index which charges 0.1%.  That’s a 0.8% difference.  It doesn’t sound like much, but take a 7% compound annual growth rate on $100,000 and extend that over 30 years.  Just how much of an impact does it make? The mutual fund ends up with a balance that is 23% lower than the index.  In other words, the mutual fund could just mimic the return of the index and reduce your return by $150,000. {NOTE: ~$750,000 vs. ~$600,000 ending balance.}

What’s really frightening about this is that most of the 401K space is captured by high fee funds.  As Ben Carlson notes, less than 20% of existing funds in 401K plans have an expense ratio lower than 0.5%:
“Less than 20% of these funds offer expense ratios of less than 0.5%, but more than half charge 1% or more in expenses. More than a quarter of these funds still charge more than 1.5% and almost one in ten charges more than 2%. There’s no way that this many funds deserve to be charging this much for their services, especially when you look at the dreadful performance against simple index funds over time.”
This is madness. . . . It needs to change. . . . fees in this business are ripe to come down.  Way down. And that’s a good thing."

Summing Up

Small things can add up to really great big things over time. Such is the case with annual recurring investment fees charged by investment managers.

And those "small fees" cumulatively amount to a whole lot over a working career, resulting in needlessly low returns and needlessly low account balances.

And as a rule, these actively managed funds do not outperform passive index funds even before their 'small' and often unnoticed recurring fees are subtracted.

So my fellow individual investors, please be careful and know what you are paying to these
'experts.' But even more important, don't continue to pay for what you're not getting. Check it out and be willing to believe your 'lying eyes.'

After all, it's your money. Why give it away to strangers? Or even your friendly brokers?

To repeat, please take a few minutes and check out the low cost, high performing over time S&P 500 Index funds offered by both Fidelity and Vanguard. You'll be much better off and much wiser for having done so.

That's my take.

Thanks. Bob.

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