Small Fees Can Have a Big Impact on Retirement Accounts
Calculator illustrates major effect of compounding, even when the difference in fees is slight.
Although people would like more money for their retirement, few pay much attention to the fees charged to their retirement accounts. But these fees, even when they appear small, can affect—in a big and negative way—a person’s ability to retire.
To help illustrate the potential impact of fees over time, The Pew Charitable Trusts has developed a new investment fee calculator—allowing users to see how much they risk losing because of fees. The calculator guides people through scenarios that show how fees affect building retirement savings as well as how long a nest egg will last in retirement.
Fees limit savings directly by reducing the amount saved, and indirectly by lowering the amount available for compounding. Often structured as a percentage of assets invested, fees are most commonly incurred in two ways: either 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 types of fees are generally charged on an annual basis, but actual practices vary widely.
According to the Investment Company Institute, a trade group, the median equity mutual fund expense ratio in 2017 was 1.18 percent of assets. Most fees fall between 0.66 percent (66 basis points) at the 10th percentile to 2 percent (200 basis points) at the 90th percentile. While the reasonableness of a fee is subjective, lower fees generally result in higher returns over the long term.
Take, for example, a saver investing $200 a month for 40 years. If that money was invested in a fund earning 6 percent with a fund 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. But consider that same $200 invested monthly in a fund and costing just 0.5 percent (50 basis points) in fees. If this investment saw the same 6 percent return, it would be worth $349,600 after 40 years— $80,900, or 30 percent, more. The higher-cost fund would have to earn 17 percent more annually than the lower-cost fund to be equally profitable, 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 people 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 while costing the retiree nearly $24,000 in fees. And because the retiree would also forgo the benefit of compounding the investment returns, the investment with the higher fee would have to earn around 45 percent more annually to make up the gap.
While it may seem obvious that paying less in fees results in greater savings, the small percentage difference between fees can make it hard for many investors to fully understand the impact over the long term. To make matters worse, many people saving for retirement are not aware of plan fees.
Earlier research by Pew found that nearly a third—31 percent—of people saving for retirement say they are not at all familiar with the fees charged to their accounts. About two-thirds acknowledged that they had not read any investment fee disclosures. And most small-business owners and managers at companies that provide retirement benefits don’t have a good understanding of how much they or their employees pay in fees to their plans.
People need to be aware of fees and their effects, and we at Pew are hopeful that our new calculator will help raise that awareness. After all, we all could use more money in our retirement accounts.
This article was originally published on Forbes on November 16, 2018.