|De­struc­tive Im­pact of Fund Fees

A re­tiree liv­ing off her port­fo­lio may lose hun­dreds of dol­lars a year in in­come for each added ba­sis point of fund ex­pense ra­tio — or ad­viser fee.

Financial Planning - - CONTENT - By Craig L. Is­raelsen

A re­tiree liv­ing off her port­fo­lio may lose hun­dreds of dol­lars a year in in­come for each added ba­sis point of fund ex­pense ra­tio — or ad­viser fee.

FEES DI­RECTLY RE­DUCE PORT­FO­LIO RE­TURNS … AND that comes di­rectly out of the pocket of the in­vestor. There is no way to say that gen­tly.

Un­der­stand­ably, fund com­pa­nies have to charge some­thing. Money man­age­ment isn’t free. Ad­di­tion­ally, many ad­vis­ers charge clients an Aum-based fee.

But what is the im­pact of dif­fer­ent fee lev­els in a re­tire­ment port­fo­lio over a pe­riod of 25 years from age 70 to 95? To put it bluntly, it’s huge.

To eval­u­ate the im­pact of fees (the ex­penses of the funds in the port­fo­lio and the ad­vi­sory fee if ap­pli­ca­ble), we need to have a low-cost re­tire­ment port­fo­lio to act as a base­line for com­par­i­son. The base­line port­fo­lio in this anal­y­sis con­sisted of seven in­dexes.

For this in­dex port­fo­lio, a base­line fee level of 50 ba­sis points was as­sumed, but no ad­vi­sory fee was as­sumed. The 50 bps sim­ply cov­ered the col­lec­tive ex­pense ra­tio of the un­der­ly­ing funds. This port­fo­lio sim­u­lates what an in­di­vid­ual in­vestor would pay as a do-it-your­selfer or if us­ing a robo ad­vi­sory ser­vice. The ex­am­ple fur­ther as­sumes that the in­vestor is in his or her re­tire­ment years.

The re­tire­ment port­fo­lio con­sisted of the fol­low­ing in­dexes: S&P 500, Rus­sell 2000 In­dex, MSCI EAFE In­dex, Dow Jones REIT In­dex, S&P GSCI, Bar­clays Ag­gre­gate Bond In­dex and 90-day U.S. Trea­sury bills.

These in­dexes cover the ma­jor as­set classes that port­fo­lios typ­i­cally con­tain: large-cap U.S. stocks, small-cap U.S. stocks, non-u.s. stocks, real es­tate, com­modi­ties, U.S. bonds and cash. Each as­set class was equally weighted at 14.29%, and the port­fo­lio was re­bal­anced at the end of each year.

The anal­y­sis of the im­pact of fees as­sumed a re­tire­ment port­fo­lio that be­gan with $1 mil­lion and eval­u­ated the end­ing ac­count bal­ance over rolling 25-year pe­ri­ods. The 25-year pe­riod rep­re­sents a re­tire­ment last­ing from age 70 to age 95.

In real life, of course, some re­tire­ment pe­ri­ods are shorter and some are longer, but 25 years seemed a rea­son­able es­ti­mate. The first 25-year pe­riod was from 1970 to 1994. The sec­ond was from 1971 to 1995, and so on.

There were 23 rolling pe­ri­ods of 25 years in this study. The amount of money with­drawn from the port­fo­lio each

year was de­ter­mined by the re­quired min­i­mum dis­tri­bu­tion spec­i­fied by the IRS for tax-de­ferred re­tire­ment ac­counts. The an­nual per­for­mance of the port­fo­lio was cal­cu­lated us­ing the ac­tual his­tor­i­cal re­turns of the stated in­dexes.

From a start­ing port­fo­lio size of $1 mil­lion, the end­ing ac­count bal­ance in the first 25-year pe­riod (1970-1994) was $3,491,175. The to­tal amount with­drawn us­ing the RMD dur­ing this par­tic­u­lar 25-year pe­riod was $4,421,584; this equaled an av­er­age an­nual with­drawal of $176,863, as­sum­ing a to­tal port­fo­lio cost of 50 ba­sis points. All of these fig­ures are in nom­i­nal terms, mean­ing that in­fla­tion has not been ac­counted for.

Of course, that is only one par­tic­u­lar 25-year pe­riod. There were 23 rolling 25-year pe­ri­ods be­tween 1970 and 2016.

A sum­mary of the re­sults for all 23 pe­ri­ods is shown in the ta­ble “The Im­pact of Fees.” The av­er­age end­ing ac­count bal­ance was $2,739,515, as­sum­ing to­tal fees of 50 bps. The av­er­age an­nual with­drawal based on the RMD was $158,407, and the av­er­age to­tal amount with­drawn over each of the rolling 25-year pe­ri­ods was $3,960,176.

Next, we in­tro­duce a to­tal fee level of 100 bps. At this fee level, the av­er­age end­ing bal­ance drops by $310,886, to $2,428,629 — a de­cline of 11.3%. The av­er­age an­nual with­drawal de­clined by $11,554, to $146,853 — a 7.3% drop. Fi­nally, the av­er­age to­tal with­drawal de­clined by $288,841, to $3,671,335 — also a 7.3% drop.

The rel­a­tive de­clines in the end­ing bal­ance and the av­er­age an­nual with­drawal

Re­duc­ing costs in clients’ re­tire­ment ac­counts is vi­tal for an ad­viser who plans to stick around.

tended to hold all the way across the ta­ble. For each ad­di­tional 50 bps of cost, the av­er­age end­ing bal­ance of the re­tire­ment port­fo­lio de­clines by roughly 11.5% and the av­er­age an­nual with­drawal from the port­fo­lio de­clines by roughly 7.2%.

Think of it this way: if a port­fo­lio had a to­tal cost of 100 bps and by us­ing lower cost prod­ucts or re­duc­ing the ad­vi­sory fee the to­tal port­fo­lio cost could be halved to 50 bps, the re­tiree could with­draw $11,554 more from the port­fo­lio each year and her end­ing ac­count bal­ance would be higher by roughly $288,850 af­ter 25 years.

The in­crease in an­nual with­drawal of $11,554 was as­so­ci­ated with a 50 bps re­duc­tion in cost; there­fore each ba­sis point of cost re­duc­tion in­creased the an­nual port­fo­lio with­drawal by $231. As shown in the

chart “Give Me a Raise!” when re­duc­ing the to­tal port­fo­lio cost from 100 bps to a lower fee level, each ba­sis point of cost re­duc­tion added $231 to the re­tiree’s in­come each year (based on Rmd-based an­nual with­drawals).

For a port­fo­lio that starts at 150 bps each ba­sis point of cost re­duc­tion equals $213 more for the re­tiree each year. For a port­fo­lio that starts at 200 bps, each ba­sis point of cost re­duc­tion trans­lates to $196 more for the re­tiree each year.

The pay­off of cost re­duc­tion to the end user is huge and vi­tal for ad­vis­ers who plan to stick around. Cost re­duc­tion is the new sher­iff in town. Said dif­fer­ently, ad­vis­ers need to cre­ate the same cost-ef­fec­tive­ness for their clients that they would want for them­selves. That’s what a fidu­ciary would do.

Clearly, the im­por­tance of keep­ing port­fo­lio costs down has never been greater. But there is good news: build­ing a multi-as­set re­tire­ment port­fo­lio need not be ex­pen­sive. To il­lus­trate this, I have cal­cu­lated the ag­gre­gate ex­pense ra­tio of a 12-as­set class model known as the 7Twelve Port­fo­lio across sev­eral dif­fer­ent fund providers. (Dis­clo­sure: I am the de­signer of the 7Twelve Port­fo­lio.)

As shown in the ta­ble “Low-cost Di­ver­si­fied Re­tire­ment Port­fo­lios,” such a re­tire­ment port­fo­lio can be built in a va­ri­ety of ways for un­der 55 bps — of­ten well un­der that. If us­ing ac­tively man­aged mu­tual funds from var­i­ous fund fam­i­lies, the cost is around 54 bps. If us­ing var­i­ous ETFS, it can be built for 16 bps. If us­ing Van­guard ETFS, the ag­gre­gate port­fo­lio cost is 10 bps.

Cost is clearly not what would stop an ad­viser from build­ing a multi-as­set port­fo­lio. Adopt­ing a low-cost ap­proach is eas­ily ac­com­plished by us­ing any of a num­ber of large mu­tual fund fam­i­lies. More­over, where you pur­chase the port­fo­lio “in­gre­di­ents” mat­ters less than the as­set-al­lo­ca­tion model that is em­ployed.

This is demon­strated by the sim­i­lar­ity in the 15-year per­for­mance across the var­i­ous 7Twelve models built us­ing dif­fer­ent fund fam­i­lies. Again, the as­set-al­lo­ca­tion model has the big­gest im­pact on per­for­mance, not where you pur­chase the in­gre­di­ents.


If you are cur­rently us­ing mu­tual funds in your client’s re­tire­ment port­fo­lios that have an av­er­age ex­pense ra­tio of 100 bps and you are also charg­ing 100 bps ad­vi­sory fee, your clients face a to­tal cost of 200 bps.

If you moved to low-cost ETFS, you could drop the ex­pense ra­tio cost com­po­nent down to 10 bps and if you low­ered the ad­vi­sory fee to 90 bps, your clients are all in at 100 bps.

What does that do for your client? It in­creases their re­tire­ment ac­count bal­ance 25 years later by more than $520,000, and it in­creases their an­nual port­fo­lio with­drawal by over $20,000 each year for 25 years. In short, it changes their fi­nan­cial sit­u­a­tion dra­mat­i­cally.

The era of high-cost funds is over. Lower ad­vi­sory fees and lower-cost in­vest­ment prod­ucts — whether in­dex funds, ac­tively man­aged funds or ETFS — is the right path. In fact, it is the only vi­able path in a com­pet­i­tive and cost-cen­tric world.

An ad­viser who de­cides to adopt a low­cost ap­proach can use any of a num­ber of large mu­tual fund com­pa­nies. More­over, where you buy the ‘in­gre­di­ents’ mat­ters less than the as­se­tal­lo­ca­tion model that is used.

Craig L. Is­raelsen, PH.D., a Fi­nan­cial Plan­ning con­tribut­ing writer in Springville, Utah, is an ex­ec­u­tive in res­i­dence in the per­sonal fi­nan­cial plan­ning pro­gram at the Wood­bury School of Busi­ness at Utah Val­ley Univer­sity. He is also the devel­oper of the 7Twelve port­fo­lio.

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