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.
These 5 Fees Are Wrecking Your Retirement
Eliminating your mortgage is one of the best ways to make retirement more affordable because it removes a sizable monthly bill. While you'll still have to pay taxes and maintenance costs for your home, those expenses are likely to be a fraction of your mortgage payments.
Once your children are independent, you will likely no longer need a several-bedroom house in a good school district with a large yard that can be expensive to maintain. Consider downsizing to a smaller home in a less-expensive neighborhood, and add the proceeds of the sale to your nest egg.
Where you live plays a big role in how much you pay for food, taxes and a variety of other services. Moving to an area where the cost of living is significantly less could allow you to spend down your retirement savings more slowly.
If you and your spouse commuted to separate places each day, it is likely that you each needed a car. In retirement, you might be able to get by with one car, thus eliminating the insurance, gas and maintenance costs of the second vehicle. In walkable communities with good public transportation, you may even be able to get by without a car in retirement.
In retirement, income tax will be due on withdrawals from traditional 401(k) and individual retirement accounts, but you can space out your withdrawals to avoid a hefty tax bill in a single year. Prepaying income tax on some of your retirement savings using a Roth IRA or Roth 401(k) allows you to avoid a big tax bill in retirement.
Investing in high-cost funds reduces your return. Minimizing investment costs is especially important for retirees who are living off income from their portfolio. In this case, selecting the lowest-cost funds that meet your investment needs translates to more money in your pocket.
There are significant penalties if you withdraw money from your retirement account too soon or too late. There is also a reduction in benefits if you sign up for Social Security early, and a late enrollment penalty if you delay signing up for Medicare Parts B and D. Pay attention to important retirement deadlines to avoid paying more than you need to.
Health care is likely to be one of the biggest and least predictable costs you will face in retirement. But there are some things you can do to control your health costs. Consider purchasing a supplemental policy to Medicare to fill in some of the gaps and cost-sharing requirements traditional Medicare doesn't cover. Also, shop for a new Medicare Part D plan every year to make sure you are getting coverage for your medications at the best price.
Retirees have the luxury of being able to travel whenever they want. Traveling is often less expensive if you avoid major holidays and school breaks, and most tourist destinations will also be less crowded.
One of the major perks of growing older is getting discounts at movies, museums and restaurants. While some senior discounts are well-publicized and open to everyone old enough to have an AARP card, others are available only to those who ask. A little research can add up to big savings if you’re willing to admit your age.