# What a Drag

John Lim

ONE PERCENT IS THE average annual cost charged by actively managed stock mutual funds. One percent is also the typical fee charged by financial advisors for managing a client’s portfolio. Paying 1% means keeping 99% for yourself. What’s the harm in that?

Here are some pictures of Lower Manhattan. It’s dotted with the skyscrapers that comprise the financial district, home to some of Wall Street’s largest firms. Just the seven largest U.S. banks together are worth more than \$1.5 trillion (yes, trillion). This is just the tip of the financial industry iceberg. Charging 1%, it seems, can really add up.

But let me show you how 1% can affect your bottom line. Imagine you contribute the maximum allowable to your 401(k) plan every year for the next 30 years. I’ll assume the contribution limit increases at 3% each year, as it has for the past three decades. I’ll also assume you invest that money entirely in stocks and earn 10% a year, which is the historical average. How much would you have in your 401(k) by 2051? The answer, assuming you could avoid paying all fees, is \$4,184,000, as you’ll see in table No. 1.

Now, take the same portfolio but subtract 1% in fees for your mutual funds and another 1% in fees charged by your financial advisor. That means your investments would grow at 8% a year, instead of 10%. How much would your portfolio be worth in 2051? The answer: \$2,977,000.

But that’s only half of the picture. We also need to examine what happens during retirement. Let’s assume you and your spouse live another 30 years in retirement. (For a 65-year-old opposite gender couple, there’s a 46% chance of at least one person surviving to age 95.) During this time, you spend down your 401(k) using the 4% rule. I’ll assume a 5% rate of return to reflect the more conservative portfolio one should have in retirement. Meanwhile, annual inflation runs at 3%. The results for the “no fees” and “2% fees” scenarios are summarized in table No. 2.

The “total fees actually paid”—the \$512,000 before retirement and the \$910,000 during retirement—is the dollar amount that was actually subtracted from your portfolio and paid to the mutual fund managers and your financial advisor. You may notice that the difference in nest egg value after 30 years of saving money—\$1,207,000—is far larger than the \$512,000 in total fees paid. That’s due to the effect of compounding. Every \$1 paid out in fees is \$1 less that can compound in the future.

In fact, while the “total fees actually paid” are substantial, they grossly underestimate the true cost of financial advice. What really matters is how much you’re able to spend in retirement and pass on to your heirs or give to charity at the end of your life. Remember that in both the “no fees” and “2% fees” scenarios, the exact same dollar amount—\$927,721—was saved and contributed to the 401(k). The “return on investment” is the sum of your retirement spending and any bequest. This bottom line is summarized in table No. 3.

In our example, the true cost of 2% is more than \$5 million over a lifetime. In fact, it’s even worse than that, since the “2% fees” portfolio ran out of money after just 25 years in retirement. Imagine the stress of watching your 401(k) balance dwindle to zero in your later retirement years.

I know what you’re thinking: A truly no-fee portfolio is simply not realistic. I beg to differ. Today, Fidelity Investments offers two total stock market index funds—one for the U.S. and another covering international markets—that both have expense ratios of zero. Fidelity also has a broadly diversified U.S. bond fund that sports an expense ratio of 0.025%. For a portfolio with 60% stocks and 40% bonds, the blended average expense ratio using these three funds would be 0.01%. That’s pretty close to zero in my book.

What about the services of a financial advisor? If you own a three-fund portfolio and can perform simple arithmetic, do you really need the help of a financial croupier? I would argue not. Now, there are certainly services that financial advisors provide besides portfolio management and those services can be valuable, but you could pay an advisor on an hourly basis for them.

The stark reality is that many people pay far more than 2% to financial intermediaries. Mutual funds are plagued by myriad hidden fees. High turnover in taxable accounts produces significant tax drag. Not many financial advisors will put you in a three index-fund portfolio. How could they justify their fee? Instead, many will put you into complex portfolios with alternative asset classes that not only underperform the simple three-fund portfolio, but also charge even higher fees. And when formerly highflying funds begin to underperform, your advisor may swap them out for funds with better recent track records. Such performance chasing will further detract from your returns. Finally, some unscrupulous brokers or advisors may even churn your account, racking up hefty commissions at your expense.

The solution to Wall Street’s “just 1%” is what I call the three golden rules of investing. First, invest in the entire market using index funds. Second, keep expenses as low as possible. Finally, buy and hold.

Indeed, buy and hold is your best defense against the financial equivalent of Newton’s law of motion. As Warren Buffett put it, “For investors as a whole, returns decrease as motion increases.” By following the three golden rules, you’re all but guaranteed to outperform 90% of investors over the long run.

Just for fun, I also looked at the other side of the equation, namely your “advisor’s portfolio.” Assuming the 2% fees went to a single person, how much would the advisor’s portfolio grow as a result of the fees you paid? I assume the advisor is in the no-fee portfolio earning 10% a year. By the time you reach retirement, your advisor’s nest egg—courtesy of your fees—would be worth \$1.2 million.

John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.

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Chris Sciora
1 year ago

Nice job working through the example portfolio. Since I don’t use a financial advisor, it always seemed that 1 – 2% couldn’t possibly equate to the huge differences in the portfolio value after compounding. That’s because it’s easy to forget – and I did forget – that the fee is applied to the entire portfolio every year, not just the annual contributions.

That’s exactly the problem with the comment from Newsboy equating other professional services with the financial industry. No one pays a doctor, attorney or CPA an ongoing fee for work that was performed years or decades ago, but that’s exactly the arrangement that financial advisors have managed to sell very successfully to investors. It’s a never-ending royalty.

For comparison, imagine paying a realtor 5% when buying a property along with paying 5% for every year you still own the property. Of course the industry has to lie about performance and hides the ball with financial jargon to make it sound reasonable.

AnthonyClan
2 years ago

As noted in the other comments an Advisor can add value, especially for a first time investor and for behavioral management. My beef is how they are compensated. Most of our professional advisors are paid hourly or by the task (accountant, lawyer, etc.). So why the 1%??? Yes there is typically a lot of work up front with a new clients, but thereafter the amount of work requred by the FA diminishes significantly, but the fee stays the same. A pretty sweet setup…for the advisor.

Andrew Forsythe
2 years ago

Terrific article, John. Your numbers present a compelling story.

I believe, as a DIY investor, I will do things imperfectly, but that with the head start I have by keeping costs to a minimum—and advisor costs to zero—I’ll still come out ahead.

Last edited 2 years ago by Andrew Forsythe
Rick Connor
2 years ago

Very well written article John. It really shows the time value of money, and why it is important to start saving early and often. I think there is a third case to consider – people with no plan. In my experience, many folks in the middle to upper middle income brackets start saving at the minimum amount to get an employer match. They gradually increase the amount saved and max out in their late 40’s or 50’s, when kids are grown. That is also when I see people starting to engage with an FP. They are getting close enough to retirement to start to worry. At that point 1% may be worth it.

A recent article (https://www.fool.com/research/average-retirement-savings/) indicated the median retirement account in the USA was \$65,000, as of 2019. Investopeida (https://www.investopedia.com/articles/personal-finance/010616/whats-average-401k-balance-age.asp) shows that Sixty-somethings (60-69) have an average of \$182K in retirement savings.

I’ve followed your investment advice and have done well. But I’ve also come to believe that for some people, they need the assistance of a pro. The key is to find a qualified, independent, full service fiduciary with high integrity.

Newsboy
2 years ago

“First, invest in the entire market using index funds. Second, keep expenses as low as possible. Finally, buy and hold.”

Exceptional data-driven analysis, Jonathan! In an effort to offer a point of contrast, I do think you are likely “preaching to the choir” (or so I believe) with HD’s reader base on your above three points. We are largely financial “self-sufficients” in building our portfolios and managing our investments. We typically possess K-I-T (Knowledge, Interest and Time), which are three critical skills needed for long-term investment planning success. Sadly, I believe there are many who need to plan for retirement (or other financial goals) that do not possess all three of the K-I-T skills in abundance.

Looking at long-term cost for advisor services in your examples does not factor in that past research has also shown the average investor “underperforms” the average 20-year annual return of their U.S. Based equities portfolio (for example, compare 20-yr return of the S&P 500, a benchmark for many U.S. equites-based mutual funds, versus DALBAR’s research on the 20-year “real return” of actual investors typically owning those very same funds. The annual return difference for individual fund investors (over various rolling 20-year periods) has usually been between 2%-5% lower when compared the actual return of a typical S&P 500-focused equity fund in itself, assuming it would have been simply left alone to do it’s compounding magic.

This primarily is due to poor investment decision-making behaviors. Examples include chasing the “hot dot” pitched on CNBC, buying high, selling low, panicking into cash, etc. I would argue that a healthy number of investors are not well-suited for managing their impulsive tendency for self-destructive decision-making. If so, they will likely never get remotely close to your lower “fee based” retirement nest-egg of \$2,977,000 (Let alone your \$4,184,000 “low fee” number) after 30 years of bad decision-making.

In my mind, a behavioral-focused investment advisor is well worth the 1% annual fee typical for their services – but ONLY if she/he can be proactive in helping their clients avoid (or suppress) their proclivity for bad decision-making that typically results in the forfeiture of between 2-5% of their expected annual portfolio return. Practically speaking, I’d like to believe that paying 1% to avoid a possible 2-5% shrinkage in my annual return on my investments is a very sound trade-off.

For context, I gladly pay our family’s doctors, attorney and CPA a healthy amount annually to be proactive with my clan in helping us avoid bad decisions that can put put us in harm’s way. It’s merely a form of an “insurance” premium in my mind – and one I will gladly pay without quarrel.

Last edited 2 years ago by Newsboy
johntlim
2 years ago

I’m always flattered to be confused with Jonathan. 🙂

Jonathan Clements
2 years ago

While I don’t disagree that some investors are their own worst enemy, I want to point out two things:
1) The above article was written by John Lim, not me, so kudos should go to him.
2) The Dalbar study is garbage — and countless folks agree. Please see the links in this section of HD’s money guide:
https://humbledollar.com/money-guide/are-investors-idiots/
Wall Street continues to promote the Dalbar study, despite its clear methodological flaws, and one can only assume that financial firms do so in an effort to scare investors into using high-priced advisory services. It’s shameful — and it’s about time FINRA forced financial firms to disclose that the study is considered flawed whenever they promote its results.

Roboticus Aquarius
2 years ago

Thank you for the Dalbar comments. This has been known for some time, yet the financial press largely ignores the valid criticisms that Dalbar could not refute.

Guest
2 years ago

Americans make so many financial mistakes over their lifetimes due to their long-documented fear of math (sadly, especially women). That’s a primary reason we don’t see more young folks heading into STEM careers. So while it’s easy for those of us who understand math, and more specifically finance, to make decisions that are beneficial to our wallets, tens of millions don’t. I suppose that’s one of several reasons folks hire financial advisers. Fortunately, we continue to see a general trend of lower investing costs over the decades (remember load funds and high stock trading commissions and all the rest!)

Mik Cajon
2 years ago

Great article…