Imagine shopping for a new car. You take a test drive and ask about fuel efficiency. You decide to buy the car and you hand the salesman a blank check. Incredulous, the salesman asks if you want to know the price. Nah, it’s a good car. You’re not concerned about price.
It’s hard to imagine anyone buying a car without asking about the cost, yet every day people purchase investments without giving any thought to the fees they’ll be charged. They may drive out of their way to pay a few cents less for gas or go to great lengths to avoid a $3 ATM fee, but they’re losing much, much more than a few dollars through investment management fees.
Fees typically come in two forms: transaction fees and ongoing fees. Transaction fees are charged each time you enter into a transaction, such as buying a stock or mutual fund. Ongoing fees are expenses you incur regularly, such as an annual account maintenance fee.
Transaction Fees
Trading commissions – You typically pay a trading commission when you buy or sell a stock. The commission compensates your financial professional and his or her firm for acting as an agent for you in the transaction. Some brokerage firms charge rather steep fees for each trade, while others charge very little, depending on the level of service they provide.
Sales loads – Some mutual funds charge a fee called a sales load. Similar to trading commissions, sales loads compensate your advisor for selling the mutual fund to you. Front-end loads are assessed at the time you make your investment. Back-end loads are assessed if you sell the fund within a specified time frame.
Markups – A markup is the difference between an investment’s lowest current offering price among dealers and the higher price a dealer charges a customer. Markups occur when dealers buy and sell securities from their own account, at their own risk. The broker-dealer is compensated by selling the security to you at a price higher than the market price.
Surrender charges – A surrender charge is levied on an annuity if you withdraw from the investment within the surrender period (usually six to eight years). This charge compensates your financial advisor for selling the annuity to you and is generally a percentage of the amount withdrawn. Usually, the longer the surrender period, the better the annuity’s other terms.
Ongoing Fees
Expense ratios – Expense ratios are fees charged for mutual funds and ETFs to cover operating expenses. The expense ratio is calculated annually by dividing the fund’s operating expenses by the average dollar value of its assets under management.
401(k) Fees – The expenses for operating and administering a 401(k) plan may be passed on to its participants. This fee is in addition to the annual operating expenses of the mutual fund investments that you may hold in your plan. Essentially, the provider may charge you a plan fee for the privilege of holding your money.
Brokerage Account Fees – Some brokerages charge fees that are designed to discourage investors from maintaining small accounts for a long time. The best way to avoid these fees is to stay above the minimum deposit thresholds.
Advisory Fees – If you use an investment advisor to manage your portfolio, your advisor may charge you an ongoing annual fee based on the value of your portfolio.
Why Are Fees Important?
Of course, whenever you buying a product or service there will be some kind of cost involved. So why is obtaining low fees crucial to an investment portfolio? Because over time, you could lose about one-third of your retirement money.
In 2014, the SEC released an investor bulletin demonstrating the impact that fees can have on a portfolio. Say you invest $100,000 in an investment portfolio with a 4% annual return and a 1% annual fee (which is actually less than average). Over a 20 year period, that 1% annual fee will cost you nearly $28,000. Why so much? Because as the investment portfolio grows over time, so does the total amount of fees you pay. If you were able to instead invest that $28,000, you would have earned an additional $12,000.
Some people argue that fees don’t matter, it’s all about the returns. While returns are certainly important, the fact of the matter is that no one can guarantee returns, but they can certainly guarantee fees.
To complicate matters, it can be really difficult to determine exactly what kinds of fees – and how much – you’re paying. Even when fees are disclosed, many expenses are embedded within other fees on a statement rather than broken out separately.
What Can You Do?
In some cases, fees are negotiable, so talk to your financial advisor about how to reduce or eliminate them. Reducing your fees by even half a percentage point can yield substantial savings over time.
If you use an investment advisor to manage your investment portfolio, find out whether they are compensated by a flat hourly rate or take a commission on investment transactions. Recently, more investors have been choosing fee-only investment advisors. Advisors who generate their income from trading commissions receive make money on every transaction. This method of compensation means advisors are rewarded for engaging their client in active trading, even if this investing style isn’t suitable for the client. Fee-only investment advice, on the other hand, is not motivated by the frequency of trades, and therefore more likely to encourage trading only when it’s right for the client.
You may not be able to do much about 401(k) fees, but you can choose lower-cost funds in your retirement and regular investment accounts. Check sites such as FeeX, SigFig,or Personal Capital to figure out what you are paying in fees and look for lower-cost alternatives.
Before you decide to pack up and move to a new firm, consider any possible tax consequences of closing and transferring your account. Direct rollovers of 401(k) funds won’t result in taxable gains, but if you have to sell some or all of your current holdings in a regular investment account in order to transfer, you may wind up paying capital gains on the sales.
