Have you ever gassed up your car only to find out later you went to a gas station charging way more than all of the others? I did this recently, and it was infuriating. The most frustrating part was the gas station had their street-side sign turned off. So, I pulled in and gassed up without thinking about the price. It did hit me when I swiped my card that the price seemed high. But I wasn’t going to get in my car and search for another gas station. I left thinking I paid way too much. Two minutes later, I drove by another gas station. My suspicions were confirmed, similar to fees.
I did not make up this story to draw a comparison to investment fees. But it sure fits. If you’ve paid someone to manage your portfolio, chances are you weren’t entirely sure what you were paying. Jason Zweig of the Wall Street Journal recently wrote about an SEC* survey where investors were asked about six common types of fees. For each type, about 25% couldn’t say whether they paid it or not. More than 20% were under the impression that they weren’t paying any fees whatsoever**. It’s like the gas station turning off their street-side sign-no one knows what the real price is! Even if you have a general idea that you’re overpaying, it’s a massive hassle to go and find another advisor. So, you pay the fees. Even if you’re not sure what they are, you keep paying the fees.
Well, this article will make you change that. In my first post on fees, I wrote about the problem with the standard AUM (assets under management) fee. Wall Street typically charges you a % of your assets, and it’s wrought with problems. The average all-in fee is around 1.5%-even if you have a portfolio of nearly $2,000,000. Remember: your advisor may charge 1%. But your advisor then puts you into funds that also charge .5%-1%. Over the course of your retirement, this can result in 1/3 of your money leaving your account. Here are three ways investment fees hurt you more than you realize.
1.) Asset-based fees are structured to take a HUGE chunk of your wealth over time
As I’ve written elsewhere, the sheer amount of fees Wall Street charges each year are enormous. For anyone who has saved over a million dollars, investment fees are potentially their biggest expense in life every year. At a portfolio value of $2,500,000, the typical Wall Street fee*** is about 1.4%-this is $35,000. Each and every year. Have 3,4,5Mil+? You are likely paying your investment firm more money than the average American household makes in a year.
What I want to explain here is that the annual fee isn’t your biggest problem. The real problem is how this fee results in 1/3 of your money (or more) leaving your household throughout a 30-year retirement.
Let’s take a more in-depth look.
Starting with compound interest, let’s pretend that your $2,500,000 portfolio diversified portfolio maintains a healthy stock exposure and earns 7%/year. After thirty years, you’re looking at over $19,000,000. Now let’s incorporate the industry median 1.4% fee. Your advisor might charge 90 bps (.9%), and the funds you’re invested in cover the remainder (.5%). You now end up with $12,800,000. That’s right, paying for financial advice in this way means that you forfeit 1/3 of your money over your 30-year retirement. Now, let’s compare the asset-based fee with the flat retainer fee. Obvious disclaimer: This is an illustration and is in no way a guarantee of future performance.
In the picture above****, you can see just how positive of an impact flat fees make. To be clear, the above example is a very simplified illustration. It’s unlikely that a retiree would be able to simply invest for three decades without taxes or personal spending taking a dime. But even if we include a $10,000/mo withdraw from this portfolio, the flat retainer fee is still saving you nearly $2,000,000! Point being, a flat fee can help you keep your wealth yours regardless of what your next few decades look like. 1%+ asset-based AUM fees result in a wealth transfer from you to your advisor.
I won’t dive too deep into this, but also consider the current investment environment. Interest rates are low. Stocks are at an all-time high. So, if an investment firm hands you a risk tolerance questionnaire and places you in a 60% stock/40% bond portfolio, it’s possible that your annual return could be 4-5%/year over the next decade. Once you take inflation out, that 4-5% could become 1-2%. Finally, after a 1.5% Wall Street fee, you could see almost no real return.
To really drive home what kind of deal you’re making with Wall Street, remember: You’re the one who worked, and saved, for decades to get to your current position. You’re the one who provided 100% of the capital. You are the one taking 100% of the risk. Yet, you are forfeiting an enormous chunk of your wealth in investment fees. I firmly believe if everyone understood this dynamic, very few would pay the standard 1-2% annual investment fee.
2.) Asset-based fees affect Oil and Gas professionals more than most
Three things have changed in the world of investing over the past few decades.
There has been a big trend away from commissions and a big trend towards asset-based fees. Prior to being able to purchase a stock or fund on your iPhone in 30 seconds, you needed a broker. Today, it doesn’t make much sense to pay a commission for any stock trade or mutual fund. And it certainly doesn’t make sense to purchase life insurance or annuities with large commissions.
The amount of millionaires in America has drastically increased. Thirty years ago, there were about 1-1.5 million households that had achieved a net worth of one million dollars. Credit Suisse estimates that America added that many millionaires in 2017 alone. There are way more people with significant assets than there were 20-30 years ago when the 1% annual investment fee became popular.
Defined contribution retirement plans have overtaken defined benefit retirement plans. Plain English-way more people have a 401k with a match rather than a pension. Wall Street can’t bill your monthly pension in retirement. So, not only do more people have wealth today, but it’s now in vehicles that are easier for financial firms to charge fees inside of.
What’s my point in all of this? For the typical Houston retiree, avoiding annuities and large commissions used to be the main problem. Now, avoiding $30,000 annual investment fees is the main problem. Paying the typical Wall Street fee on a portfolio of $250,000 isn’t the end of the world. However, if you have spent an entire career in Oil & Gas, you likely have significantly more than that. Result? Your fees are a lot higher.
With your company benefits likely including a healthy 401k match, a stock plan, and potentially deferred comp and a pension, you & your employer are likely saving tens of thousands of dollars every single year through these different vehicles. Over a 3-4 decade long career, this can turn into a substantial nest egg regardless of your position and title. As a result, you need to pay more attention to investment fees if you’ve spent your career at a company with all of these benefits. You will likely pay a college-tuition-sized fee every single year if you’re paying anywhere near the standard 1% annual fee.
3.) Asset-based fees don’t allow pre-retirees to access advice without hurting future Roth IRA contributions.
The last issue to beware of comes into play if you change companies in the middle of your career. Whether it’s for a promotion or a merger that involves a severance package, changing companies brings a host of financial questions along with it. For many, it means rolling your 401k over to an IRA. This is not necessarily a bad thing. For most retirees, it can make a lot of sense. However, if you’re 45 and you’re planning to work for another decade or two, you may want to think carefully before exiting an employer-sponsored 401k.
Why? Backdoor Roth contributions are one big reason. Let’s pretend that you’re either taking a promotion at a different company or you’re taking a severance package from Anadarko. If you’re planning on working for another 15-20 years, keeping your assets in a 401k might be a great move. Even if your household income is over $200,000/year and you think you’re ineligible for Roth IRA’s, you can still complete a backdoor Roth each year. You simply contribute $6,000 ($7,000 if you’re over 50) into an IRA for both you and your spouse. With a high income, this is not a tax deductible contribution. You can then convert that traditional IRA into a Roth IRA. Since it wasn’t a pre-tax contribution to begin with, you don’t owe taxes on the conversion. Think about the long-term benefits. If you have 15 years of putting $12,000-$14,000 (for both you and your spouse) annually into a Roth, you’re going to enter your 60’s with significant assets that are growing tax-free.
But, if you rollover your old 401k into an IRA, it triggers the backdoor Roth into being a taxable event. This ruins the effectiveness of the backdoor Roth. When I work with clients in this situation, it makes sense to stay in the 401k. As long as the 401k has low cost index options, we can build a globally diversified portfolio quite easily. We are then free to take advantage of the backdoor Roth.
Fees are critical. Taking time to do your research now can save you a fortune throughout your life. We love compound interest. Let’s make sure it’s working for us rather than against us. You can schedule an intro call to discuss your situation here.
*SEC=Securities and Exchange Commission, not the overrated college football conference-sorry A&M grads. I miss the old Big 12 (Kansas State grad) and couldn’t help myself.
**Narrator: They were wrong.
**** AUM Fee is calculated at 1.2% instead of the 1.4% industry avg to adjust for the ~.2% expense ratio in the Flat Fee portfolio