The Investment Fees You Don't Realize You're Paying
Despite zealously monitoring the cost of items such gasoline, groceries and even wireless data plans, many Americans have no idea of the expenses in their investment accounts.
According to a survey released in October by investment management firm Rebalance IRA, many Americans incorrectly believe they pay no fees in their retirement accounts. Rebalance IRA asked 1,165 baby boomers between ages 50 and 68, all with full-time jobs, how much they were paying in investment fees. Forty-six percent believed they paid nothing, and 19 percent were under the impression that their fees totaled less than 0.5 percent. In fact, according to data cited by Rebalance IRA, employees have retirement account expense deductions averaging 1.5 percent per year.
As the survey shows, underestimating investment fees is a common problem. Many expenses are embedded within other fees on a statement rather than broken out separately. Others are presented in a way that may confuse even the most intelligent people. In some cases, that obfuscation is by design. Here are some tips for navigating the maze of investment fees and expenses.
Understand Your Investment Strategy
Before even evaluating the various fees in your accounts, review some of the basics: What are your retirement goals? What is your risk tolerance? Are your investments held in qualified accounts, such as 401(k)s or individual retirement accounts?
The answers to these questions often have a bearing on how much you will pay in fees, says Isaac Presley, portfolio manager at Cordant Wealth Partners in Portland, Oregon. "The first step is to figure out what kind of strategy you are pursuing -- the behavioral part. Get a strategy, stay with it, and be disciplined about it," he says.
From there, investors should drill down into the specifics of their account holdings. For example, an actively managed mutual fund may have high portfolio turnover, or frequency of trading within the fund.
That's a particular problem in taxable, non-retirement accounts, which is why it's crucial to consider expenses in the context of investment strategy, Presley notes. "If you own a fund in a taxable account and there's a lot of turnover, you're subject to more frequent taxable events, and you'll probably be left with a bigger bill at year-end," he says.
Understand How your Adviser Gets Paid
There are plenty of ways financial advisers and brokers make money. It's up to investors to understand fee structures. For example, many of the traditional brokers get paid a commission when they buy or sell investments in your account. Others, such as registered investment advisers, take a percentage of assets under management, or in some cases, a fixed fee.
When hiring someone to manage your accounts, ask how he or she is compensated, says Jeff Rose, founder and CEO of Alliance Wealth Management in Carbondale, Illinois. "That question is so important because you'll quickly see how upfront an advisor is. If they are willing to share that they get a commission for selling you stuff, if they charge you hourly or charge you fees," he says. "If the adviser is not able to answer that question in a manner that makes you comfortable, or that you can leave that meeting and explain it to somebody else, then chances are, you should find another adviser," Rose adds.
Mark Cortazzo, senior partner at Macro Consulting Group, a Parsippany, New Jersey, wealth advisory firm, says prospective clients should be on alert for unusual ways advisers present fees. He cites an example of an adviser breaking out fees on a quarterly basis to make them appear low.
"On a half a million dollar account, they said they were only charging 0.37 percent per quarter. That's 1.5 percent per year," he says. Cortazzo, who charges many clients a fixed fee to manage portfolios, says that was triple the amount he would have billed that particular client in the flat-rate program. "But because they expressed it as a fraction of 1 percent per quarter, they weren't comparing apples to apples," he says.
Understand mutual fund fee structures
In addition to monitoring mutual fund turnover ratios, understanding various share classes can also save you money. However, investors should be aware of trade-offs. For example, Class A shares may charge a front-end load, which is deducted from the initial investment. But they may have lower 12b-1 fees. These are marketing fees wrapped into a fund's overall expense ratio. Other share classes have similar types of trade-offs.
Blair duQuesnay, chief investment officer at ThirtyNorth Investments in New Orleans, says many people are not aware of internal expenses, such as 12b-1 fees, in mutual funds they own. "The first piece of advice on mutual funds would be to check the share class. Usually they are labeled A, B, C, R or I. You can go on Morningstar.com and see the same exact fund, in various share classes, and see the differences in the internal expense ratios and the differences in the performance of each share class. You want to look for the lowest-cost share class of that mutual fund if possible," she says.
Frequently, the available share class depends upon the amount being invested, and there is not a one-size-fits all approach. "That's where the devil is in the details, because depending on the size of the investment, one share class may make sense over the other," duQuesnay says.
Understand the Kind of product you are buying
An investment, such as a mutual fund, exchange-traded fund or annuity, is a product that has been developed and packaged by a company. That doesn't necessarily mean it's wrong for you, but it does mean you should do some detective work to sniff out the fee structures.
When buying a mutual fund, Cortazzo says, investors should understand that their costs may depend upon who manages and sells the fund. "What we see frequently: You'll have a mutual fund company that is doing investment advisory, and sometimes there's an overwhelming skew toward their own proprietary funds, which might not be as inexpensive as some of their competition or counterparts," he says. "If your asset manager is the same name as the mutual funds that you own, I would take a deeper look into that."
Annuities can be particularly difficult to decipher, Rose says. "You can run illustrations all day long, but some of these are 50-some pages, and you have to have a Ph.D. to make sense of half of it," he says. If a financial adviser is showing you an annuity, Rose recommends cutting to the chase and asking to see the place in the illustration or contract that outlines your fees. "It's just getting down to the bottom line," Rose says. "Ask your adviser, 'If I put in $100,000 today, what happens three years from now if I want to pull my money out? What would that look like?'"