Supersize Your Nest Egg By Wringing Out Excess Fees
What’s the single biggest impediment to your retirement security? Well, aside from not saving enough, I’d say it could very well be the high fees that many retirement investments charge that zap returns and stunt the eventual size of your nest egg, not to mention reduce the income you can draw from it during retirement.
For example, a recent study of investment choices in more than 3,000 401(k) plans with more than $120 billion in assets by two law school profs—Yale’s Ian Ayres and the University of Virginia’s Quinn Curtis—found that on average participants paid almost a full percentage point more in annual fees than they would for low-cost index funds.The most expensive funds charged more than a percentage point and a half a year more than index funds. In some cases the heftier charges effectively erased the 401(k)’s tax-deferral benefit.
While this study focused on investments within 401(k) plans, the fact is that high fees can undermine the growth of your savings in all types of retirement accounts: 401(k)s, IRAs and taxable accounts. Just how big an impact can onerous fees have? Here’s an example.
Let’s say you’re 25 years old, earn $50,000 a year, receive 2% annual raises, contribute 10% of salary to your 401(k) and earn 7% before expenses on your savings. If you shell out 1.5% of assets annually in fees, by age 65 you would have a 401(k) balance of roughly $739,000.
But look what happens if you cut the amount you pay in expenses by a half a percentage point to 1% a year. Your 401(k)’s balance would increase to almost $830,000. Take an even harder line on fees and reduce them by a full percentage point to 0.5% a year, and come retirement time your 401(k)’s value would total some $934,000, or just shy of seven figures.
The drag of high fees doesn’t stop at retirement, however. You may be drawing on your retirement investments for a good 30 or more years after you call it a career. The more you shell out in high charges during retirement, the less income you’ll be able to draw from your retirement investments without running a higher risk of outliving your savings.
To get a sense of just how much fees can affect the amount of income you can draw from your savings during retirement, I suggest you check out the retirement withdrawal calculator on Morningstar head of retirement research David Blanchett’s site. Among other things, you can plug into the calculator different mixes of stocks and bonds and expense levels. The calculator then uses Monte Carlo-type simulations to estimate the probability that you’ll be able to draw a given level of income throughout a 30-year retirement.
So, for example, if you assume you want an 80% chance of your savings lasting at least 30 years and you invest your retirement savings in a 60% stock-40% bond portfolio with annual expenses of 1.5% a year, the calculator estimates that you would have to limit yourself to an initial withdrawal of about 3.5% of assets that you would subsequently increase with inflation.
Cut that 1.5% fee by a half a percentage point to 1% a year, however, and you can withdraw 3.8% of assets, while maintaining the same 80% probability of your savings lasting at least 30 years. Lower expenses by a full percentage point to 0.5% a year, and you can withdraw 4%. That translates to a nearly 15% boost in annual income compared with expenses of 1.5%.
Of course, rather than increasing your initial withdrawal rate after paring expenses from, say, 1.5% to 0.5% annually, you could choose to keep withdrawals the same and invest more conservatively, which might be a better option if you want more assurance your savings won’t run out during retirement. Instead of stashing 60% of your nest egg in equities, for example, you could lower your stock stake to 20% and still have an 80% chance that your savings will last 30 or more years.
The takeaway: Trimming expenses can increase your odds of achieving a more financially secure and enjoyable retirement. In the hypothetical scenarios I just laid out, lowering annual expenses from 1.5% to 0.5% annually throughout both work and retirement years could increase the inflation-adjusted income one could draw from a 401(k) in retirement over 30 years by more than 40%, from just under $26,000 a year to more than $37,000.
I’m not claiming that you’ll be able to duplicate these savings exactly. The results you’ll get will vary depending on how much of your saving you do through a 401(k), what your plan’s expenses are and how diligently you stick to low-cost investment options both within and outside your 401(k). Nor is it a given that lowering expenses will translate dollar for dollar into higher returns. Some funds may be able to justify their higher expenses with outsize gains. Still, to the extent that you can stick to lower-cost investments, you should be able to build a larger nest egg during your career and draw more from it in retirement than you would with investments charging higher fees.
Fortunately, there are a number of ways to save on investment costs. For example, the Ayres-Curtis study found that even 401(k) plans that contained investments with bloated fees often had some lower-cost alternatives. “You may be able to allocate your savings in a way that minimizes the impact of fees,” says Curtis. The Department of Labor regulations that kicked in back in 2012 mandating greater fee disclosure to 401(k) participants can help you identify the less expensive investment offerings in your plan.
And even if a shortage of low-cost investment choices prevents you from significantly lowering expenses within your 401(k), you’ll have much more opportunity to downsize fees in traditional and Roth IRAs and other accounts by choosing low-cost investments like index funds and ETFs. And while fees aren’t the only thing you should take into account when investing your retirement savings, Morningstar research has shown that funds with low fees generally outperform those with loftier expenses, and found that low fees are the most dependable predictor of future performance.
So the next time you’re reviewing your retirement investments, see if there’s a way you can save on fees. You’ve worked hard for the money you’re stashing away for retirement. Why not get the biggest investment bang possible for your savings buck? (6/27/14)
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org.