What is the Only Thing Worse Than a Stock Market Loss?
High Fees Can Devastate Your Portfolio and Your Chances for Long-Term Success
Stock market losses can devastate a portfolio and your chance for long-term success, but today we’re going to talk about something that could be even more devastating than a stock market loss. You probably think, “What could that be?” because stock market losses can ruin your retirement. The answer is … high fees!
High fees are the thing that can be worse than the stock market loss because think about it: if the stock market goes down, you lose money, if the stock market goes back up, you can potentially recover. When you pay high fees, can you ever recover those high fees that you’ve paid? Of course not, the answer is no because they won’t pay you back your fees. You have to understand what high fees mean.
What You Need to Know About High Fees
At Peak, we are fairly unique in our planning process, in that all we work with are retirees and people nearing retirement. Because our clients are older, most of the new clients we meet with have had an advisor for many years. When we meet with a prospective new client, many times they will say something like, “we really like our current advisor,” “our current advisor is very nice,” “the staff always treats us so well,” “we’ve gone to dinner,” “we go to the same church,” “we’ve been friends for a long time,” and maybe even “our kids hang out together.”
The bottom line is that they really like their advisor as a person, they feel like their advisor is their friend.
At this point, we will then say, “Well, that’s great. You probably wouldn’t have had them as an advisor for the last 20 years unless you really liked them. I am sure they are a nice person, and the staff is probably fantastic.”
And then we say, “But now, let’s talk about your money.” When we say this, the clients usually cross their arms and look a little confused and perturbed, because they know everything about how nice the advisor is, but they really don’t know a whole lot about their own money.
We then ask the client “What are you paying in fees?” The clients often answer in one of two ways:
- They’ll either say emphatically, “We’re paying 1% in fees.”
- The husband will look at the wife and ask, “Honey, what do you think we’re paying?” The wife will usually respond, “I’m not sure, honey, what do you think we’re paying?” The husband will typically respond with “I’m not sure, maybe 1%”?
What do you think both answers mean? It means they really have no idea what they are paying in fees!
We ask them, “Why do you think you are only paying 1% in fees?” and they will almost always respond, “This is what our advisor told us, we are only paying 1% in total fees.” And the truth is they probably are paying their advisor about 1%, that would be common, but in almost all cases, that is nowhere close to the actual total fees they are paying. We have found fees of 1% are often a fraction of what the typical retiree normally pays in total fees, both direct (visible) and indirect (hidden).
But then when we look at their statements, most people we meet with have a number of mutual funds and we see there are a lot of trades being made. There could be two trades a week, ten a week, or even twenty trades a week. But either way, there are a lot of trades being made. We will ask the client, “Why are these trades being made?” Many clients respond that they don’t know why the trades are being made. We tell the client they need to understand why the trades are being made because there is often an added expense associated with a lot of trades.
We then ask the client if their advisor is making all these trades and they will usually say their advisor is not making the trades. We then say to the client, “Well, someone’s making these trades, and if it’s not your advisor, who’s doing that? It’s probably a money manager and do you think the money manager’s going to do all that work for free?” The client thinks about it, and they will usually say, “Of course not, the money manager will want to get paid too.” The typical money manager fee would be about 1%, so the client thought they were paying 1%, but now they see they could be paying 2%.
Many retirees we meet with have 20 or more mutual funds, some having 40 or more mutual funds in their portfolio. We ask retirees, “Why do you have so many mutual funds?” They will usually respond, “For diversification and to reduce my risk because they all won’t go down together.” Retirees have often been taught by their previous advisors that spreading their assets over many funds provides them diversification, the best opportunity for growth, and dramatically less risk. Unfortunately, we have found these things might not always be true.
SEE ALSO: The Two Stages of Money in Retirement
Diversification and Mutual Fund Expenses
In our opinion, based on our research, once you own a good selection of a maximum of 12 equity mutual funds, you likely have sufficient diversification for risk reduction amongst those funds. If you own more than 12 mutual funds, you may not be receiving any measurably beneficial additional risk reduction through diversification. If you own more than 12 mutual funds, you may also hamper your opportunity for growth and dilute your potential rate of return because many of the mutual funds will own the same stocks, and you then have what is called “overlap” which causes an overconcentration of certain stocks in the portfolio. If those stocks don’t perform well, your portfolio performance could suffer and be diluted. Even worse, if the stocks you are over-concentrated in suffer big losses, the whole portfolio could be severely affected. There also can be more fees associated with owning more funds.
Since we are talking about mutual funds, let’s talk about mutual fund expenses. We ask retirees, “What is the average mutual fund cost you’re paying on your funds?” Many of these retirees reply, “We’re not paying any mutual fund costs,” and we ask them, “Why do you think you’re not paying any mutual fund costs?” The retirees may typically say, “Well, because our advisor says the only fee we pay is the 1% fee to them, and/or because the fees for the mutual funds don’t show up on our statements.”
Well, it’s true that the fees for the mutual funds don’t show up on your statements, but you are paying them, nonetheless. Every single mutual fund, whether it’s a loaded mutual fund or a no-load mutual fund, has a mutual fund expense. These mutual fund expenses are deducted at the mutual fund level before you get your portfolio statement, so you don’t “see” the mutual fund expenses, but it’s still there, reducing your potential rate of return. If you own mutual funds, it’s simply not true if your advisor states you are not paying any mutual fund expenses.
The good news is that mutual fund expenses have to be disclosed to you, but if this is the case, why don’t most retirees know what their mutual fund expenses are? It’s because of the bad news: the problem is that a mutual fund expense is often buried somewhere deep in a book you hate to read that is called a prospectus. A prospectus might be 200 pages, printed on thin paper, in very small print, and the mutual fund expense might be on page 178. What if you have 30 funds, will you read through 6,000 pages just to find out what all your fund expenses are? The overwhelming vast majority of retirees will not. So even though you can find out what your mutual fund expenses are, you probably won’t.
The average annual mutual fund expense is 1.23%, as reported by The New York Times on 10/6/2012.
So now, if you add the 1.23% of mutual fund expenses on to the 1% for the advisor and the 1% for the money manager, you are now at 3.23% in potential total fees.
At this point, the color drains from many of the retiree’s faces. They sit back and they start wondering because they finally have been provided with the truth, they start thinking, “I wonder how much I have actually paid in fees over the years?”
Even More Fees: Trading Costs and Transaction Costs
If this wasn’t bad enough already, there’s another cost that doesn’t have to be disclosed to you. Every mutual fund, whether it’s a stock or bond fund, will buy and sell assets that are in the mutual fund each year. Let’s say we’re talking about a stock mutual fund, and the mutual fund manager will sell a certain number of stocks currently held in the mutual fund and will purchase a certain number of new stocks.
This selling of current stocks and buying new stocks is called “turnover.” In this example of a stock mutual fund, the percent of the mutual fund’s stocks that are sold each year and then replaced by new stocks is called the “turnover ratio.” The cost associated with buying and selling stocks at the mutual fund level is called the “trading costs.” Retirees usually think that when their mutual funds are bought and sold by their broker or money manager, the cost of buying and selling the mutual funds are the “trading costs,” but this is incorrect, as the cost of buying and selling the mutual funds are called “transaction costs.”
You will see the transactions of your individual mutual funds being bought or sold by your broker or money manager, and you will see the costs for these transactions on your statements. But you will not see the sales and purchases of the different stocks in each mutual fund, and you will not see the costs associated with these “trading costs” at the mutual fund level.
Digging into Turnover Ratio
It seems normal that a mutual fund manager would sell a few stocks each year that are “out of favor” and buy a few new stocks that “fit the mutual fund better.” So, you would expect there to be a “turnover ratio,” but you may probably expect it to be quite low.
Recently it’s been reported that the average “turnover ratio” for stock mutual funds is approximately 80%. This means that the typical stock mutual fund is selling and then re-purchasing 80% of the value of the total value of the mutual fund each year. This probably seems so counter-intuitive because you have always been told to be a long-term investor, but then the average mutual funds themselves may be selling stocks potentially at an 80% rate each year, which is more of a short-term investment strategy.
With an 80% turnover ratio, a $1,000,000,000 mutual fund is selling 80% of stocks each year, which is $800,000,000. The same mutual fund is repurchasing $800,000,000 of new stocks. This means the mutual fund is buying and selling a total of $1,600,000,000 of stocks each year. Will these $1,600,000,000 in buys and sells create a small amount of cost in the form of commissions and buy/sell fees, or will this create a large amount of costs? Bingo! Potentially a large amount of costs. The bad news is that the mutual funds do not have to tell you what that cost is! So, this is truly a “hidden cost.” Unlike the transaction cost of replacing one mutual fund for another mutual fund which does show up on your statement, this trading cost at the mutual fund level does not show up on your statement.
The good news is that we know that the approximate average annual “trading cost” for a mutual fund is 1.44% as reported by www.Forbes.com on 4/4/2011. So now if you add the 1.44% of mutual fund “trading cost” on to the average 1.23% mutual fund expenses on to the 1% for the advisor and on to the 1% for the money manager, you are now at 4.67% in total potential fees.
One Last Hidden Cost
There is one last cost we must address. It is another “hidden cost” and it is what is called an “opportunity cost.” An “opportunity cost” simply means what you could lose, or give up, because of “something you are doing.” In this case, the “something you are doing” is investing in a mutual fund that holds cash as an asset in the mutual fund. The mutual fund may be holding cash to buy more stocks or bonds, or it may hold cash to be able to make distributions to you and other mutual fund owners. The cash that is being held in the mutual fund will be liquid and will earn a very low rate of return, such as a money market rate of return.
Now here is the problem, you will be paying fees on the total assets in the mutual fund, even the assets that are being held in cash. If you are paying a high level of fees on the assets that are being held in cash, and you are only earning a small rate of return on the assets that are being held in cash, are you getting ahead or falling further behind? You are falling further behind. This “hidden cost” is often called “cash drag” because the cash is dragging your returns down. Just like the “trading costs,” the mutual fund doesn’t have to tell you how much you are losing in “cash drag” because the mutual fund is holding cash.
For example, let’s say your mutual fund has to keep 5% of the mutual fund in cash. That mutual fund now can’t earn a very high rate of return on that cash. They might earn a bank-type return, but the mutual fund gets to charge you fees on all the assets in the portfolio, including the cash. What if you’re only earning a low bank-type return on those assets that are in cash, but they’re charging you 3% in fees, are you getting ahead or falling behind? It simply means you’re falling behind.
The approximate average annual “cash drag cost” for a mutual fund is 0.83% as reported by www.Forbes.com on 4/4/2011. If you add the 0.83% mutual fund “cash drag,” to the 1.44% of mutual fund “trading cost,” to the average 1.23% mutual fund expenses, to the 1% for the advisor, and to the 1% for the money manager, the total potential fees are at 5.50%. Your actual fees could be higher or lower.
Are You a Victim of High Fees?
The majority of retirees we meet with think they are paying 1% in total fees, but in reality, they are paying 2%, 3%, 4%, even up to 5.5% per year in fees, and they didn’t even know it, and they were never told this before.
Even worse, if they own a variable annuity, which is one of the highest cost assets you can own, the total annual fees they are paying could be as high as 6.5%, and this fee is paid every year.
Think about it, if you’re potentially paying up to 5.5% or 6.5% per year in fees, how can you ever get ahead? You really can’t get ahead at this rate; it’s very difficult. You also might be thinking this is just so hard to believe, especially if your broker/advisor told you that you were “only paying 1% in fees.” Unfortunately, you need to believe it because it’s true. Excessive fees can devastate a portfolio; it’s the hidden asset killer.
A recent Harris Poll reported only 39% of Americans thought they knew the fees they are paying. We think it’s closer to 0%. Most retirees believe they’re paying 1% in total fees annually, but we believe they’re really paying closer to 3.5%. Tony Robbins has recently been on a crusade, through lectures, television and radio appearances, even writing a new book to help consumers realize they’re getting killed with hidden fees.
Thomas Coyle wrote in Financial Advisor IQ published on October 26, 2017, that cited Ameriprise, UBS, Morgan Stanley, Wells Fargo, and Merrill Lynch as the “Most Expensive Advice Firms” with advisory and fund fees as high as 3.5%. The 3.5% did not include “trading costs” or “cash drag” and only estimated an average 0.50% mutual fund expense! This is just shocking news!
Did you ever wonder why your return rate was nowhere near what the markets achieved? Well, hopefully, this will shine the light on how your money may be being spent.
A $1,000,000 portfolio, assessed 3.5% fees versus 1.0% fees, levies an additional $500,000 in fees over 20 years. Unfortunately, this is typical of the clients we meet with and very well could be happening to you right now.
For more truths about the stock market, fees, and more, check out our book! In Momma’s Secret Recipe for Retirement Success, we break down what you need to know to have a successful retirement and enjoy financial freedom.