Are Fees Hindering Your Investment Success?

Today I want to share an unfortunate scenario that we’ve dealt with at Mana many times over the past year. Here it is:

A new client comes in and tells us they’ve been invested for years, but have really never made money in the market. At this point, we request copies of their statements. One overwhelming commonality between these types of clients is that they’re almost always paying fees that they’re unaware of.

What’s up with that?

On its face, the idea of paying fees for a professional service seems totally reasonable. It’s absolutely something we’ve become accustomed to in our everyday life. When you walk into the office of a lawyer, a CPA or tax preparer, a therapist, or a doctor you walk in knowing that you will be billed for the service you came for.

However, when it comes to investing, the fee structure can be MUCH less transparent, and quite frankly, deceiving... These less-than-altruistic billing practices have created an unavoidable stir in the media over the last few years, like this awesome segment by John Oliver.

It’s a frustrating system and people have every right to be angry about it! The hidden costs are dizzying: there are transaction fees (for buying and selling), commissions, and, in some cases, penalties for cashing out too early. Despite my years of experience working as an investment professional, deciphering many of the nuances of these fees was even confusing to me.

The industry’s obfuscation of fees to the retail investor has been one of our biggest motivations for Mana’s fee structure. Stephanie and I purposefully structured Mana as a fee-only, fiduciary advisory firm to provide maximum clarity and transparency for our clients.

A Few Key Lessons on Investment Fees

One of our main objectives at Mana is to keep our clients and readers educated and aware. So, for the rest of this post, I will review important details about a variety of common investment fees. To make things more digestible, I’ve separated each fee lesson according to its associated investment or account. After this review, I will summarize the harsh reality of these costly fees with a quick illustration of how much money you can lose or miss out on if you get stuck paying them.

Mutual Funds

Before we launched Mana, I worked in the mutual fund industry. My first job was selling mutual funds for an investment manager that created one of the first mutual funds in America. Since early in the 20th century, mutual funds have made it much easier for individual investors to participate in the market. Buying just one mutual fund gives owners access to a broad swath of stocks and/or bonds.

Despite their utility, mutual funds may carry several different kinds of fees. If you are thinking of buying mutual funds, the question you need to be asking yourself is, “Is it really worth it?” (I’ll explain how to figure this out later in this post). First, to tally up your costs, you’ll want to find out how much you’re paying for the following fees:

The Expense Ratio. An expense ratio is an annual fee for owning the fund, expressed as a percentage of your investment. A fund’s expense ratio takes into account the cost of managing the portfolio, marketing the portfolio (yes, back in the day it paid for people like me) as well as the catch-all ‘other expenses’.
Sales Loads. Depending on what share class of the mutual fund you are buying, you might be paying your broker a commission to compensate him/her for the effort made to sell you the fund (I hope you are picturing me rolling me eyes right now - how much effort does someone really have to make to sell a fund someone else is managing!?). If you decide to sell the fund, you can be charged a fee for liquidating - and what’s worse - you could also be charged a fee if you sell your investment too early.
Capital Gains Tax. This is one annual fee you’ll pay that you won’t find in its prospectus. Each year mutual funds are required to distribute a portion of the proceeds from the fund's sales of stocks and other assets to their shareholders, regardless of whether the fund made (or lost) you money that year. If you own mutual funds in your taxable brokerage accounts, you’re required to pay capital gains tax on the amount distributed to you (more on this here). Mutual funds are notorious for their high tax cost (aka a hidden fee). According to Morningstar, as a whole, U.S. equity mutual funds gave up 2% of returns to taxes for the three-year period ending June 2019. Even before all the other fees you’re paying, you’ve already lost 2% of your return to taxes - an egregious fee!

In short: if you own a mutual fund, you’re paying for everything that goes inside the fund. Whether these are worth it is dependent upon a confluence of factors: the portfolio management team, the share class, the investment management firm operating the fund, the broker or advisor selling you the fund, and the fund’s tax efficiency. The good news is that the industry has started to come out with technology to empower investors with the knowledge they need to make an informed decision. If you’re interested in finding out how much you’re currently paying for your mutual funds use FINRA’s Fund Analyzer. If you’d like to find out how tax efficient your mutual fund is, Morningstar has created a metric called the Tax Cost Ratio, that will tell you how much of a fund’s return you can expect to pay in taxes on an annual basis.

Exchange-Traded Funds

Until the 1990s, mutual funds were the only game in town, so people were forced to just accept the higher fees that went along with owning them. However, near the turn of the 21st century, things started to change (hello, Vanguard!). Thanks to John Bogle, U.S. retail investors were given a new choice: pay more for a professional management team to actively pick a selection of stock or bonds for you (an actively managed mutual fund) or, pay less to own an entire market of stocks or bonds (an exchange traded fund, aka a passive fund).

There are far fewer fees associated with an exchange traded fund (ETF), because it's built to track an index (such as the S&P 500). Just like mutual funds, ETF fees vary, and you can find the fee details in the prospectus. Here are the fees you can incur when you buy or sell an ETF:

Transaction Fees. ETFs are traded intraday like stocks, which means that you typically have to pay a commission to buy and sell them. Fortunately for us, last fall a price war caused many brokerage firms to eliminate all commissions on stock and ETF trades. Though many of the online brokerage firms took their ETF trades down to zero, it’s still worthwhile to double check whether or not you’ll have to pay transaction fees.
Expense Ratio. An ETF also has an annual expense ratio (see above section for the defintion), yet it will most likely be less costly than a comparable mutual fund. A recent study from Morningstar showed that active mutual fund investors are paying about 4.5 times more than passive-fund investors on each dollar invested. This is a significant difference! To understand the impact this difference can have on your investment assets, keep reading.
Capital Gains. Most ETFs track an index. An index ETF only buys and sells stocks when its benchmark index does. Big investment moves—like when a company is removed from the index completely—happen very rarely. In addition, ETF managers can use capital losses to offset capital gains within the fund, further reducing (or possibly eliminating) the taxable capital gains that get passed on to fund shareholders at the end of each year.

How Financial Advisors Get Paid

If a financial advisor is investing your money for you, there are three ways they can be compensated for their work: commissions, an annual percentage of your entire portfolio, or by charging a flat fee for their service. If you know how your advisor is being compensated, it’s easy to determine whether or not they are acting in your best interest. Sure, you’d think that every financial advisor should act in your best interest, but just about anyone can call themselves a “Financial Advisor” or an “Investment Consultant”. Only a small handful of these are actually fiduciaries. A fiduciary has a legal duty to act only in the client's best interests. This means they aren’t incentivized by commissions, and they won’t be trying to convince you to buy some expensive insurance policy you might not need.

Investor beware! Most advisors who work for big brokerage firms or banks are held to a suitability standard, not a fiduciary standard! In simpler terms, this means that most big-brokerage advisors are only required to recommend products that are suitable for a client. These advisors are not necessarily required to put the best interest of the client first. Advisors who are not required to act in your best interest may push you to invest in a way that puts more money into their own pocket, which frankly, could cost you tens, or even hundreds of thousands of dollars in lost money over your lifetime. The best solution to this problem is to ensure that you are working with a fiduciary.

401ks and other workplace retirement accounts

Americans have $5.9 trillion in employer-sponsored 401(k) plans, yet a vast majority of Americans have no idea how much they’re paying in fees for their 401(k). Even though this stat is specific to workplace 401ks, I’d argue that the lack of knowledge around fees spans all retirement plans. Over the past few months we’ve had clients come to us after paying a decade’s worth (or more) of exorbitant fees when investing in their 403b plans, Thrift Savings Plans and even IRAs.

By now, you can probably guess that calculating how much you’re paying each year won’t be super straightforward when it comes to retirement plans, but it’s important to understand that the sum of your total costs come from two main fees:

Investment Fees
Administrative Fees

You’ll be able to tally up your investment fees by finding the expense ratio of the funds you’re invested in (see, it gets easier because you already know where to find the expense ratio!). The administrative costs are a trickier calculation. The easiest way to do it is outlined by moneycrashers.com:

“To find the fees, first locate your plan’s summary annual report. In this report, you will see a basic financial statement section. Here, you will need to find two numbers: total plan expenses and benefits paid. Subtract the benefits paid from the total plan expenses. Next, you will divide that number by the total value of the plan. The resulting number is your plan’s administrative cost percentage. Multiply the percentage times the total value of your holdings within the plan to get the amount of administrative costs that you paid for during the year.”

You could also have fintech to do the calculations for you. There are an increasing number of reputable websites out there that can help you understand how much you’re paying. At Mana, we like TD Ameritrade’s 401k Fee Analyzer.

Annuities

The investment product that holds the worst reputation for hidden fees is annuities. FYI - this section is not meant to be a primer on annuities; rather, our hope is that after reading this, you’ll know enough about the types of fees you could be charged so that you can make more informed decisions about annuities.

Commissions. All annuities have commissions, which are usually built into the price and not highlighted in the contract. Commissions are a portion of the annuity cost that is given to the agent. The commissions can be anywhere from 1 to 10 percent of the total value of your contract, depending on the annuity type.
Insurance charges. Also known as mortality and expense (M&E) fees and administrative fees, these charges pay for insurance guarantees that are automatically included in the annuity, and the selling and administrative expenses of the contract.
Investment management fees. These are assessed on the investment options within variable annuities - think of these as the expense ratios for your investments inside your annuity.
Surrender charges. Just like a mutual fund may have a surrender charge, most insurance companies will limit the amount of penalty-free withdrawals one can take during the initial years of a contract. You’ll be charged a surrender charge on any withdrawals above that preset limit. Be careful, as surrender charges can be significant and can be imposed for an extended time period. Surrender charges are definitely something you want to understand and be comfortable with before you buy.
Rider fee. Riders are guarantees available in some annuities. For example, a death benefit rider may be available at an additional cost to ensure your heirs receive at least the principal you invested upon your death (minus any withdrawals). Some riders are not optional and may be a standard cost associated with the annuity contract. Know which riders are optional and which are not when it comes to your specific annuity contract.

If you’re thinking about buying an annuity, remember that the more complex the annuity, the higher the fees are likely to be.

The Hidden Cost of Fees and Your Future

So...why does knowing everything I just outlined matter?

The answer is simple: the more you pay in fees, the less you’ll have in the end.

Don’t believe me? A recent Nerdwallet study showed the impact a 1% fee could have on the portfolio of a 25-year old with $25,000 in their retirement fund, adds $10,000 to the account every year, earns a 7% average annual return and plans to retire in 40 years. They then compared the performance of this portfolio against a portfolio with a fee of 0.09% - all else stayed equal. The end result: the 0.09% portfolio ended up with $533,000 more after 40 years - $2.30 million versus $1.77 million.

Vanguard did a similar study comparing an investment without a fee to one with a 2% annual expense, and found a similarly dismal outcome:

What drives these huge losses?

First, as your assets grow, the total amount you pay in fees increases. Think about it: 1% of $100,000 is $1,000; 1% of $800,000 is $8,000. If you’re paying a percentage of assets fee, the more your assets grow, the more you’ll pay in fees. Second, you don’t just lose the amount of fees you pay - you also lose all the growth the fees you’re paying would have had for all the years you would have stayed invested. Just like how compound interest can exponentially increase the growth of your savings, the same thing happens in the inverse when investment fees compound.

Closing Thoughts

Now that I’ve outlined the most popular investment fees and their associated long term costs, I hope that you as a reader feel more aware about some of the complexities in financial decision making. I hope the time you’ve spent reading this article has proved useful. Mana exists for the sole purpose of empowering people around their money. For too long the investment industry has shrouded its fees in mystery. This article is meant to present the basic knowledge that’s necessary to peel back the layers of each of your investment vehicles, and to determine how much you’re actually spending on your investments. I want to emphasize that not all costs are bad! But you should be confident and clear about your choices. After all, if your money is going somewhere other than your portfolio, make sure it’s serving your life in the best way possible.

Cristina Livadary is a fee-only financial planner based in Los Angeles, California and is the CEO of Mana Financial Life Design. Mana Financial Life Design provides comprehensive financial planning and investment management services to help clients organize, grow and protect their wealth throughout life’s journey. Mana specializes in advising professionals in the tech industry, as well as women who work in institutional investing, through financial planning and investment management. As a fee-only fiduciary and independent financial advisor, Cristina never receives commission of any kind. She is legally bound by her certification to provide unbiased and trustworthy financial advice.