WHILE TALKING recently to an estate-planning client about investments costs, she showed me a letter from her financial advisor stating that he charges her 1% of assets a year. Maureen didn’t understand that she also pays each mutual fund’s annual expenses, a portion of which is also paid to her advisor. Her fund expense ratios average 1.14%, which includes a 0.25% 12b‑1 fee that her advisor pockets. Result: Maureen’s total cost is 2.14% a year, with 1.25% going to her advisor.
Investors who need an advisor face myriad possible fee structures. Some advisors charge fixed or hourly fees. Some take sales commissions that reduce the overall amount invested or returned. Others charge a percentage of assets under management. Yet others levy some combination of these. When Maureen was younger, with a small but growing portfolio of $25,000, paying an advisor 1% of assets, equal to $250, was an efficient way to get a few hours of an advisor’s time. Now, 30 years later, she has a portfolio closer to $1.5 million. The 1% fee generates $15,000 a year for her advisor. Maureen suspects that a flat annual or hourly fee would be fair to her advisor without being unfair to her.
While Maureen may be able to negotiate a lower advisory fee, she can only influence the expense ratios on her mutual funds by changing funds or buying a different share class of her existing funds. The major components of expense ratios are management fees, 12b-1 distribution fees (if any) and other administrative costs, such as those for accounting, legal work and shareholder reporting. Management fees are the amount retained by the fund sponsor for selecting the securities that make up the fund. Marketing and distribution 12b-1 fees are annual payments of between 0.25% and 1%, and are typically paid to financial advisors and others whose clients invest in the funds. Another cost borne by investors, though not included in the expense ratio, is the transaction costs incurred by the fund when it buys and sells securities. The higher the fund’s turnover rate, the higher the cost that the fund’s investors effectively pay.
There’s wide variation in expense ratios and their component parts. Expenses tend to be higher for stock funds than bond funds, and higher for actively managed funds than index funds. Maureen’s expense ratios average 1.14%, with management fees at 0.72% and administrative costs at 0.16%. According to the Investment Company Institute, average asset-weighted stock fund expense ratios fell from 1.08% in 1996 to 0.84% in 2015, as investors flocked to lower-cost funds. But investors have plenty of room to cut expenses further—and lowering costs could dramatically increase how much their money grows over time. How low can expense ratios get? At Vanguard Group, renowned for its low-cost funds, expense ratios average 0.18%.
Matthew Sullivan is a Boston-based lawyer, consultant and entrepreneur who has been captivated by personal finance for nearly 30 years. He enjoys cycling and international travel.