Today is April Fools’ Day and also kicks off National Financial Literacy Month. We thought it might be a good time to look at commonly misunderstood and underestimated fees that impact countless retirement investors.
Mutual funds as we know them have been around since the 1920s and have helped individuals invest with professional managers running a portfolio of stocks oand other securities. They allow investors to spread risk by buying a basket of stocks, without the need to research every company. Mutual funds are also the most common investment vehicles in 401(k) retirement plans.
However, many investors may not realize how much they’re paying in fees over the long term for the privilege of investing in mutual funds in 401(k) plans. The average stock fund charges an average expense ratio of about 1.4%.
A 2012 study by Demos estimated that the median-income two-earner American family will pay, on average, about $155,000 over the course of their lifetime in 401(k) total fees. Put another way, those fees will gobble up nearly one-third of the investment performance.
In Canada, it is estimated that a 25-year-old who invests over 40 years and uses an investment adviser selling conventional mutual funds will end up paying more than $170,000 in lifetime fees.
A separate study by AARP estimated that more than 70% of 401(k) plan participants in America didn’t even realize they were paying fees.
Perhaps investors don’t understand how much they’re paying in fees because they don’t get a bill. Rather, the amount is simply deducted from their account. Also, fees are sometimes disclosed as a percentage of assets, so investors may not realize how much they’re paying as a dollar amount.
This doesn’t mean there is something inherently wrong with mutual funds. Investors should just clearly understand all the fees they might be paying, including expense ratios, 12b-1 fees, management fees, administrative fees, operating costs, front and back-end loads, and other account fees.
The soaring popularity of low-cost index funds and passively managed ETFs is a signal that investors are getting tired of paying the higher fees of active mutual funds, most of which trail their benchmarks.
It’s certainly a good thing that investors are paying less in fees with these passively managed vehicles.
However, index funds are no panacea for bad investor behavior. For example, investment researcher Morningstar calculates “investor returns.” These are dollar-weighted performance figures that measure how the typical investor in that fund fared over time, incorporating the impact of cash inflows and outflows from purchases and sales.Over the past 15 years, investors in the Vanguard 500 Index Fund earned less than half of the fund’s total return. This is known as the behavior gap.
Of course, investing in an S&P 500 index fund is easier when the benchmark gains more than 30% like it did last year. The S&P 500 hasn’t suffered a 10% correction since summer 2011. However, index funds that mirror the market will take a hit if stocks pull back.
“After five years of a bull market, passive investing is in a renaissance. Investors are quick to adopt the method du jour and we will see who is swimming naked when the tide goes out,” writes one blogger. “When the 20% correction comes, I predict there will be a mass exodus from the Johnny come passives.”
The bottom line is that mutual-fund investors should have a good handle on the total fees they’re paying, and realize that index funds will ebb and flow along with the market.
Photo Credit: Sam Howzit via Flickr Creative Commons
DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. Past performance is no guarantee of future results.
