Chapter 6: FEES MATTER
Too often, what makes big bucks for Wall Street makes
little sense for investors.
The miracle of compounding returns has been overwhelmed by the tyranny of compounding costs. ~ John C. Boyle, Founder, Vanguard
How long will it take for your money to double? The “Rule of 72” provides the answer: simply divide 72 by your compounded annual rate of return.
For example, if your investment return is 10 percent, it will take 7.2 years to double your money: 72/10. With an 8.0 percent return, it takes 9 years to double your money: 72/8 = 9.
Let’s examine the impact of fees on your returns. It is not uncommon for annual fees to exceed 2.0 percent for many financial products—variable annuities, mutual funds, and separately-managed accounts, for instance. Many products collect fees directly from the fund’s assets, so shareholders never see an invoice (Wall Street’s true genius) for charges such as management fees, administrative fees, and ongoing asset-based commissions known as 12(b)-1 fees. A 2.0 percent expense ratio (annual expenses/total assets) is a huge burden to overcome. Consider the illustration on the following page.
A picture is worth a thousand words.
In The Random Walk Guide to Investing by Burton G. Malkiel, published by W.W. Norton & Sons, Inc., the author asks whether you would still do business with your financial advisor if he asserted that when you retire, his fee would amount to half your account value? This may sound absurd, but this is exactly what happens (over time) when your investment expenses are high.
Many of Wall Street’s fees are collected silently, directly from fund assets. This is why you’ve never received an invoice for portfolio management or ongoing asset-based commissions for mutual funds, variable annuities and other financial products.
Wall Street does not want you to focus on expenses. You might demand more cost-effective investments—or a new financial advisor. The products with the highest management fees and the highest hidden commissions are the ones with the highest annual expenses.
The Financial Industry Regulatory Authority (FINRA) provides a cost calculator for mutual funds. The calculator clearly identifies the cost of ownership for thousands of mutual funds. It allows you to enter the amount of your investment in the various funds so that you receive a cost estimate tailored to your particular investment, as opposed to a generic example of a $10,000 investment, for instance. You can see the actual dollar amount of sales charges, such as front-end sales charges as well as all ongoing hidden sales charges for your particular investments. Visit http://apps.finra.org/fundanalyzer/1/fa.aspx. NerdWallet is also a good resource to learn about investment fees.
In the next chapter, we will look at fees that advisors charge.
Everyone gets the experience, some get the lesson. ~ T.S. Elliot
Chapter 7: Your Advisor’s Fee – How Much Should You Pay?
Paying advisory fees directly to an independent advisor (fee-based or Fee-Only) is not always less costly than alternatives offered through a brokerage account; however, it does mean that the financial advisor has a legal obligation to always act in your best interests—and that certainly adds value.
Advisory fees vary widely depending upon many variables, such as the type of work being performed and the value of assets-under-management.
So, how much should you pay a financial advisor?
It depends upon whether the advisor truly is adding value. In my practice, I add value by providing customized portfolios of stocks and bonds featuring individual bonds as opposed to bond funds. This is a labor-intensive, yet cost-effective approach that provides benefits—such as giving my clients ownership in individual bonds with stated final maturities, rather than ownership of bond funds. (Also, bond funds are more costly to purchase because they come with management fees and imbedded ongoing commissions that well exceed my fees).
Individual bonds give clients greater control over their unique financial plans. For example, clients with a tax-free appetite benefit from customized portfolios of tax-free bonds, issued in the client’s state of residence, which avoids both state and federal income tax. This just makes good sense, but it can be difficult to achieve this with packaged financial products such as bond funds,
or even exchange-traded funds (ETFs).
As a general rule, advisory fees for comprehensive wealth management (financial planning, planning updates, ongoing advice, asset allocation, rebalancing and investment management of a balanced portfolio comprised of stocks and bonds) should not exceed 1.0 percent for balances of up to $1,000,000. Advisory fees should fall as the value of the assets-under-management rises. For instance, a $2,000,000 account might expect to pay no more than 0.85 percent for comprehensive wealth management. An account comprised solely of fixed-income securities (bonds) should pay even less.
If your financial advisor is compensated by commissions, things get more complicated. Commissions on products such as mutual funds and annuities are not negotiable; they are embedded sales charges. A typical ongoing sales charge would amount to 1.0 percent of your investment’s value annually. Products with embedded sales charges have other expenses, such as management expenses, and these can cause annual operating expenses to be quite high. How high? For mutual funds, as much as ten times higher than the annual operating expenses of an index fund (2.0 percent versus 0.20 percent)—even higher for variable annuities.
This is why it can make sense to replace your brokerage account with an advisory account. You can pay your financial advisor an advisory fee that the two of you negotiate, and you can insist on language in your advisory agreement stipulating that any placement fees or other source of revenue be fully disclosed in writing and credited against the advisory fees dollar-for-dollar.
Insist that your advisor provide a detailed written account of all the
annual fees you incur, expressed in dollars as well as percentages.
Each position in your account should be itemized on a spreadsheet with the corresponding annual expense. Any commissions, front-end loads, back-end loads or level loads, such as 12b-1 fees should be itemized as well so you can clearly see how much of the fees you are being charged—hidden and otherwise—are paid to your advisor.
This may prove to be quite eye-opening.
One major area of fees deserves special attention: 12(b)-1 fees that are embedded in many mutual funds, variable annuities and other products. They are discussed in the next chapter.
Rule #1: Never lose money.
Rule #2: Never forget rule #1.
~Warren Buffet, CEO Berkshire Hathaway
(How To Select A Financial Advisor Series – Ed Mahaffy)
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