Imagine top scientists engaged in a serious discussion about whether the Earth is round or the moon is made of cheese. Silly, right? Now imagine investing professionals engaged in a serious discussion about whether investment advisory fees of 1.5 percent plus $750 a year on a $450,000 portfolio are too high. That's what I encountered in the Q&A section of BrightScope.com, a 401(k) ratings firm.
Some quick math tells us that this investor is shelling out $7,500 a year. These costs don't account for the underlying cost of the investments. Over 10 years, and assuming an 8 percent return that would have been earned had these fees stayed in the account, this investor will lose nearly $110,000 -- or almost 25 percent of the starting balance in the portfolio.
It's time to get real. High investment costs will wreck a portfolio. Here are five costs that are the most pernicious:
- Advisory fees. Paying an investment advisor 1 percent or more annually almost guarantees below-market performance. Even the most talented advisers, over the long run, are unable to beat the markets by the cost of their services. For those looking for investment help, there are several cheaper alternatives. First, a low-cost mutual fund company like Vanguard offers investors advice on constructing a diversified portfolio. Second, there are low-cost and simple online tools that make investing a snap. For those considering a traditional fee-only adviser, forget paying 1 percent. While that may be standard, there are plenty who charge 0.5 percent or less.
- Management fees. Mutual fund fees also eat away at a retirement portfolio. Low-cost index funds typically carry an expense ratio of 10 to 25 basis points. Actively managed funds can easily cost 100 basis points or more. Studies have shown that actively managed funds rarely beat the market over the long run. It's also impossible to predict which funds, if any, will beat the market in the future.
- Transaction costs. The expense ratio doesn't include a mutual fund's cost to buy and sell shares. For actively managed funds, these transaction costs can be significant. John Bogle, the founder of Vanguard, estimates that transaction costs add an additional 50 basis points in costs to actively managed funds.
- Commissions. While fee-only advisers don't earn commissions on the investment products they sell, commissioned brokers do. These fees typically amount to more than 5 percent of the amount invested. Commissions are in addition to the management fees charged by the mutual funds.
- Unnecessary taxes. Actively managed funds often generate significant tax liability. While these taxes are of no concern in a tax-advantaged retirement account, they can represent a significant drag on performance in a taxable account. In contrast, index funds typically do far less buying and selling. The result is less taxable income and lower transaction costs.