How to Avoid the Negative Compounding Effect of Fees on Your Account
Despite the recent awareness around fees in today's environment, it can still be challenging for investors to know what and whom they are paying.
I was reminded of this recently when we had the pleasure of welcoming a family in as new clients to our firm. When they first reached out to us, they knew something was not right with their investment situation. After reviewing their statements and a discovery call, we quickly found out why. They were being overcharged and underserved. It turns out their fees were roughly 2.12% per year. At the same time, the level of service they were receiving included one phone call per year, online access and statements.
In this article, my goal is to unwrap the fee structure that this family experienced, highlight the long-term negative impact and then provide an awareness that can help you avoid this situation.
Moreover, while this article focuses on the experience of a single family, we have seen the same cost structure apply directly to institutions as well, whether an endowment, foundation, ERISA retirement plan or other types of institutional assets.
The step-by-step on how to give up 25% of your market returns to your advisor (not recommended!)
The family mentioned above did not realize they were charged fees on fees. One layer included an advisor fee of 1.40% per year with limited services. Unfortunately, industry expertise, full client engagement, risk management, along with estate and financial planning were not part of the offering.
The second layer of fees was the underlying costs of the investments held in the portfolio—which was new information to the clients. Even though they had a diversified mix of “institutional” mutual funds in their account, the average expense ratio of these investments was 0.72%, which was added to the 1.40%.
Without digging deeper into other potential underlying fees such as trading costs and custodial fees, the total costs were 2.12% per year. (1.4% + 0.72% = 2.12%)
Assuming a 9% long-term average return(1) in the stock market, these clients had been giving up almost 25% of return per year in fees. Unless there is some other form of benefit or return the client is receiving, this is retirement money down the drain. In Peter Fisher’s 2018 article in Forbes titled, “Why Conflicting Retirement Advice is Crushing American Households,"(2) he points out that the annual cost of conflicted investment advice in the US is $17 billion per year. The scenario outlined in this article is case in point.
The Negative Compounding Effect of Fees
The diminishing effects of the high fees & low service model outlined above are significant. To illustrate, I have provided a compare-and-contrast to what I believe is a more reasonable fee structure of 0.85% in total fees. (This includes an advisor fee of 0.75% and underlying investment fees of 0.10%.)
After backing out the fees for both scenarios, the difference in future account value after 20 years of saving and investing is $343,000.
If you are an institution, add a zero or two to the end of each number for a better comparison on the effects to your business, organization, non-profit, endowment, foundation, or other.
Is the “advisor” adding $343k worth of value? That amount would more than cover health care costs for a married couple throughout their retirement years, according to recent studies(3).
To be clear, advisors can add significant value to a client relationship. Vanguard produced a research piece called the Advisors Alpha®(4) that makes the case that an advisor can add significant value beyond the fee they charge. However, it comes through a combination of wise stewardship and planning, portfolio construction and tax efficiency. In short, it is much work that deserves fair compensation. The challenge with the scenario outlined above is that any advisor would have difficulty justifying their value at that fee level when their only service is setting up an allocation and checking in once a year.
How You Can Avoid This
Having open and honest communication with your advisor is essential. Here are a few questions to ask that can help you determine if your advisor is acting in your best interest and has a compelling service and fee offering:
Fees & Services: What services will I receive and how much will it cost?
Service and fee schedules should be clearly outlined so you can determine what you are receiving and how much you are paying. You will be able to measure the potential "Advisors Alpha®." A contract should explicitly outline fees and the commitments being offered such as discretionary investment management, planning services, meetings per year, insurance reviews, risk management, estate planning, reporting and more. If you are an institution this will look slightly different, but it will still be the same idea. If your advisor cannot tell you exactly how they are going to serve you and what their charges will be, it might be best to keep looking.
Investment Fees: What is the fee for the underlying investments held in my account?
This question will help you asses the total fee that you will be paying and not just the advisors fee. Typically these investment costs can be minimal for accounts that use individual stocks, bonds, Exchange Traded Funds (ETFs) and index funds. However, for accounts that use actively managed mutual funds, insurance products or Separately Managed Accounts (SMAs), these fees can add up and take a toll on your long-term return.
Are you a Fiduciary: Are you a legal, written Fiduciary in all matters?
If your advisor is not a legal, written Fiduciary in all matters, beware that they have the flexibility to not apply Fiduciary standards in serving you. If they are a Registered Representative, Investment Representative, Broker or Insurance related, there’s a good chance they do not have to act in your best interest.
Are you an Expert: Do you have credentials or an advanced degree in your field of practice?
Your advisor should continue to learn and grow throughout their career. Legally, all advisors and brokers must have individual licenses such as the Series 6, Series 65, Series 7, etcetera. This does not make an advisor an expert. It is merely the cost of admission and is the SEC and FINRA's attempt to ensure there is some form of standard in the industry. Look for credentials such as CFA, CFP, CPA, or CIMA and for advanced degrees such as Master’s in Financial Planning or Master of Science in Finance. In short, credentials and advanced degrees help demonstrate the continued efforts of an advisor to learn and stay on top of trends in an incredibly complex and dynamic profession.
If you have questions about this article or any personal or institutional financial needs, we would love to help. Please do not hesitate to reach out to our team.
(1) According to the Chicago Booth Center for Research in Security Prices, from 1/1/1926 to 12/31/2017 the compound annual returns for US stocks were 10.0% and for international stocks, 8.0%. In this article, I have assumed an arbitrary and straightforward 9% average return solely for illustration. This does not constitute investment advice and should not be relied on as such. http://www.crsp.com/resources/investments-illustrated-charts
(3) https://www.fidelity.com/viewpoints/personal-finance/plan-for-rising-health-care-costs