# 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.