If you haven’t heard, Albert Einstein is rumored to have admired the power of compound interest, calling it the eighth wonder of the world.
And it’s true!
Compound interest can be your money-making machine for your investments. But don’t get it twisted, compound interest can be a double-edged sword, a witch with a capital B. And that’s why Albert Einstein also said “He who understands it, earns it… he who doesn’t, pay it.”
So if you finally believe in the power of compound interest and have started saving then hi-five!
Yeah for you!!!
Give yourself a great pat on the back for taking the hardest step that most folks don’t do… the first one to get going.
But one thing that can severely derail your efforts is if you are being tortured by management or other fees associated with your investment.
David Huntley, coauthor of the 401k Averages Book stated that the average investment cost for a small retirement plan declined from 1.22 percent to 1.21 percent over the past year, while the average investment cost for a large retirement plan declined from 1.01 percent to 0.95 percent. That’s assuming your fund doesn’t get weighted with additional possible fees. But that doesn’t sound too bad right? But consider this Department of Labor example:
Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent1
That 1% here and another 1% there really starts adding up. If that doesn’t make you cringe, how about this example from Tony Robbin’s Money Master the Game (pg 106-107)
Three friends, Jason, Matthew, and Taylor, at age 35 invest $100,000 each in different mutual funds. They each make a return of 7% however they have found that they are paying very different annual fees of 1%, 2%, and 3% respectively. The impact of their fees cannot be understated.
Jason = $100,000 invested at 7% growth (minus 3% in fees) = $324,340
Matthew = $100,000 invested at 7% growth (minus 2% in fees) = $432,194
Taylor= $100,000 invested at 7% growth (minus 1% in fees) = $574,349
Taylor made nearly double the money as Jason for the same returns and the same investment!
Now don’t get me wrong, I’m more than happy to compensate a fund manager if I’m rolling in double-digit returns year after year. But 76.23% of fund managers failed to beat their benchmarks in the last year, according to an S&P Dow Jones Indices scorecard released in July 20163. S&P further found that 89% of those fund managers underperformed their benchmarks over the past five years and 82% did the same over the last decade. That means we aren’t getting value for what we’re paying for since index funds are exceedingly cheaper.
And way to kick me when I’m down. If I’m losing, let’s say it’s 2008 again and your investment just took a terrible beating, are you really happy to pay your manager that 2% cut when you have already lost so much?
Look at this example from feex.com2. Let’s say you invested $10,000, lost 1% in the market this year, and still had to pay 2% in fees. Now your investment is even lower, and that pretty much eats up all the tax benefits doesn’t it.
- Investment fee – This is the largest component of the fees. Fees for investment management and other investment-related services. This fee is taken directly from your returns that lowers your compound interest effect
- Rule 12-b fees – This fee is used to pay your brokers commission and other services LIKE ADVERTISING. So yeah, you paid for those glossy brochures with the pretty graphs and happily retired folks on boats.
- Account fees – a maintenance fee charge just for having an account
- Exchange fees – a fee to move or exchange from one fund to another – decided you want to switch from Target fund 2050 to Target fund 2045? There is a fee for that.
- Redemption fee – if you want to sell your fund, you have a charge to cash it out. The US Securities and Exchange Commission limits redemption fees to 2%. That means it could cost you $200 just to take $10,000 out of your account! Doesn’t sound like much? Would you like to pay $2000 of your hard-earned money to take out $100,000?
- Tax cost fees – these are administrative or management fees
- Service fees – additional fees charged to participants who take part in a certain feature – like taking a loan against your 401k.
Don’t feel bad if you don’t know what your current fees for your 401k are. They work very hard to keep these fees obscured, probably because of the outrage that folks would have if they really knew the impact fees had on their investments. Even further, investment funds have had the luxury that credit card companies used to enjoy. Being able to place fees and damaging details in the fine print, where the investor isn’t really looking at understanding what is happening. Just as recently credit card companies must tell you the impact of paying only the minimum balance will have, and funds are now also required by the department of labor to disclose to employers the fees they charge. Employers, in turn, must also disclose expenses that are passed onto the participants.
So what’s the resolution?
Decide that you won’t be an unknowing victim of fees any longer and make the commitment to become informed. If you are like most there isn’t much that can be done with your 401k plan options, however, you can make the best of it.
It’s one thing to recognize the situation, make mitigating plans and stay in it because it’s the best move, it’s quite another to think you are on track for retirement to later find out you are unprepared. This is too important to ‘hope for the best.’
- Examine your 401k plan’s summary plan description. This document is provided whenever a participant joins the plan, also looks at the annual report (Form 5500 series) which should give details on the fund’s asset, liabilities, etc.
- Pick funds that work with your risk tolerance, stated past returns, costs/services.
- Always meet your company match AT LEAST. NEVER LEAVE FREE MONEY ON THE TABLE
- Open a Roth IRA or a traditional IRA which will give you much more flexibility in fee structures and types of funds and then max out this contribution
- Once you max your IRA you can add more in your 401k. You only get a specified amount you can contribute each year for retirement tax benefits. Once that time is lost it’s gone so don’t miss it.
- Look at index funds which have lower associated costs and provides a diverse way to follow the market as a whole – besides if the funds can’t beat them, then maybe we should join them
- The Department of Labor suggests that when choosing a retirement vehicle fund to consider fees as one of the factors in making your decision. Just like risk, returns and services available.
- Understand that higher cost funds do not mean better and the cheapest funds do not necessarily mean better either.