The cost of doing business on Wall Street can be more than exposure to risk. The market crash of 2008 and the first quarter of 2009 gave many investors good reason to think their approach to a comfortable retirement. For most Americans living today, this was the biggest financial crisis in their lifetimes. Now that the market has made recovery, many investors are looking more closely at the fees and loads that can erode their nest eggs substantially over time.
An article in the Wall Street Journal, “The Hidden costs of Mutual Funds”, pointed out doing business on Wall Street can cost investors significantly more than they anticipate. The average expense ratio for mutual funds, according to the article, is 1.31%, but is that the total cost for owning a mutual fund? The hidden costs can be as much, or in some cases, greater than the advertised cost. The buying and selling of securities in the portfolio can add an additional 1% to 3% of undisclosed commission expenses to the owner. Currently the Securities and Exchange Commission does not require these commissions to be factored into the expense ratio, so the average fund owner who thinks they are paying 1-2%, may be paying 3% or more to own a particular fund.
California Congressman, George Miller, Chairman of The Committee of Education and Labor, proposed legislation in 2008 that would require full disclosure of hidden fees and loads in 401(k) plans. Wall Street according to Congressman Miller, opposed the proposed legislation with ferocity.
According to the Investment Company Institute, 83% of American's retirement savings are at risk to market fluctuation and the high fees charged by Wall Street's middlemen. In March 2009, when the DJIA dropped under 7,000- the lowest close in 11 years - all eyes were focused on Wall Street's instability. After two years, and after close to a trillion dollars of taxpayers bailout money was unleashed, on February 1, 2011, the DJIA closed over 12,000 points and IRAs and 401(k) plans saw much awaited growth. Today, retirement savings in America is estimated to be in the $29 trillion range, of which approximately 80% is in mutual funds and other securities. Assuming an average of only 2% combined fees and loads, Wall Street will pocket a whopping $464 billion annually of money intended for Americans' retirement years.
A Missed Opportunity
Wall Street's appetite for the fees and loads tied to mutual funds is a lost opportunity for IRA owners. Why a lost opportunity?
“Because fees and loads are gone from your account forever."
The following example illustrates the long-term financial impact of mutual fund fees:
Bob is age 50 and will not need money from his retirement account until he retires at age 65. This means Bob has 15 years of potential growth for his retirement nest egg before he will need income to supplement his Social Security and company pension plan. Let's assume that the account will earn 5% compounded interest. Doing the math, $300,000 earning 5% for 15 years will grow to $623,678.
Now let's see what would happen if Bob earned 5% in a mutual fund that charged 2% in fees and loads. The same $300,000 would have grown to only $467,390 in Bob's retirement account by age 65 because the net rate of return would be 3%. That represents a difference of $156,288 less savings at retirement time. The 2% that Bob gave up in fees and loads represented the lost opportunity to earn compound interest. If the total cost of owning the fund averaged 3% to 4%, the negative impact at retirement time would have grown exponentially.
It Doesn't End There!
Fast-forward 15 years, when Bob has reached age 65. He has suffered the loss of $156,288 of savings, due to the loss of compounding of the fees and loads that were systematically extracted from his retirement accounts. Now it's time to begin the distribution phase. The game plan is to transform what is left into a reliable stream of retirement income.
This is where the lack of compounding only further compounds the retiree's frustration. As long as Bob's savings remains in his 401(k) or mutual funds, the fees and loads will continue to eat away the potential gains. If there are no gains, the fees and loads will begin to erode the principal.
If Bob needs only 5% annually from his remaining account balance of $467,390, he will still be paying Wall Street its 2%. That will generate a drain of 7% when Bob only needed 5% to maintain his lifestyle in his retirement years. The extra drain due to the cost of doing business with Wall Street is 40% more than Bob needed to reduce his nest egg.
Let's do the math. Bob is now 65 years old, with $467,390 left in his IRA or 401(k). If the account continued to 5% and he took only 5% for income, his savings remain the same ($467,390). But if the account under The Street's management, the 2% load would be to eat away at the principal and the account would reduced by 2% annually. Wall Street, in this case, is Bob's 40% partner during the distribution phase.
The more the mutual fund owner makes, the more they pay
If you own a fund with a current value of $500,000 and the total cost of owning that fund is 2%, your annual cost is $10,000. This money is unceremoniously removed from the IRA owner's account each year. In the above scenario assume that Bob's account has grown from $500,000 to $600,000 after several years of market gains. The same 2% load will have gone from $10,000 to $12,000.
Try to visualize someone reaching into your retirement savings and removing $10,000 or more each year. Next imagine that same person using that money to take a lavish vacation or buy an expensive watch. At this point you might say, “They can't do that!” Unfortunately they can do that, and that is exactly what they are doing.
The Solution:
Get help to uncover the hidden costs of owning your mutual funds. Look beyond the expense ratio and dig into the turnover ratio and other hidden trading and advertising expenses.
Understand how these fees, loads and other expenses are taken out of your accounts each year. Consequently less than 100% of your money is working for you.
Also, understand the long-term effect due to the lack of compounding interest on the money that has been moved from your accounts. Calculate how the fees and loads will impact your retirement income or could reduce the inheritance to your heirs.
The End Result:
You may be comfortable with the cost of owning a particular fund, or you may have just gone into shock after learning about the hidden fees and loads. The key issue is that if you are aware of the real cost of owning a particular fund, you can make informed decisions about positioning your retirement assets.
The current turbulence on Wall Street and the high cost of investing in mutual funds are reason enough for anyone to reassess their investment choices, reduce expenses, and take the appropriate steps to guarantee a comfortable and risk-free retirement.