I’ve been trying to come up with a scenario that fairly
represents the difference one percent makes over our investing lifespan using as an example, two employees who systematically put the same amount of money away for
retirement and then spend down those assets during about two decades of
retirement.
The Scenario
It starts with two 30 year old employees who work until their full retirement age of
67. The first 20 years they invest in an 80/20 portfolio of stocks to bonds,
starting with nothing and adding $750 a month (1/2 of the current contribution
limit). At 50 years old, the mix is changed to 50/50 and again using 1/2 of the
current contribution limit plus the catchup provision, which totals $1,000 a
month. Finally, our representatives live another 18 years in retirement, so at
67 the portfolio allocation is again changed, this time to 20/80 stocks to bonds.
It is also assumed during retirement they each receive monthly cash distributions from the
portfolio. The return figures used are historical averages (see notes for
detail) and inflation was taken into account using a 2 percent annual increase.
There is one key difference in the two portfolios, one was
charged 27 basis points (0.27%) in fees using a passive funds strategy and the
other was charged 1.27 percent for an actively managed funds portfolio. Effectively
a one percent difference over the 55 years our investors were invested.
The Results
Over the first twenty years, from ages 30 to 50 the
portfolios grew to $374,506 for the passive portfolio and $332,515 for the
active portfolio, remember the only difference affecting return is the fee. Over
the next 17 years leading to retirement, the passive portfolio ends up with an
inflation adjusted $1.27 million while the active portfolio maxes out at $1.01
million. Again the difference is only due to fees. At 67 our retirees begin
taking monthly withdrawals, the passive investor takes $6,500 a month for life
and dies at 85 with about $430,000 left for heirs, charity or her dog. The
active investor cannot take as much or the portfolio would be depleted prior to
age 85 and instead takes $5,788 a month so that the portfolio is worth zero at
death.
The one percent cost difference to an investor under this
scenario over a 55 year period is well over $500,000. Over the 37 years of employment
that little one percent fee difference accounts for a 30 percent difference in
the amount of capital growth in the portfolios. During retirement the difference
in fees is the difference between taking $78,000 out each year and having some
capital assets left – comfy with some breathing room - or taking $69,450 out
each year with nothing left at the end – live past 85 and its Social Security.
These results are only one of near infinite scenarios
depending on when you start investing, how long you work, how much you put
away, etc. The important takeaway is that lower fees mean better return probabilities
for investors, irrespective of your age or dollar amount of your assets. In other
words the less you pay the more you keep. This post does not even take into
account that active fund managers have underperformed passive funds across most
fund categories over longer-term time periods (10-15 years), making the case
for low-cost passive investing even more compelling.* Although in theory the
case for active management seems intuitive, the actual track record of most actively
managed funds is underwhelming.
As always, seek the help of an accredited professional when
it comes to your financial future.
CBlakely CFP®, CTFA
04/2015
Notes:
Inflation assumption - 2 percent per year. Historical returns: 80/20 portfolio
8.92% annually, 50/50 portfolio 7.71% annually and 20/80 portfolio 5.72%
annually. Time value calculations used monthly compounding, and retirement calculations
used sequential cash flows all with the same value (annuity).
Although the
author (me) believes in the veracity of the formulas and results, these numbers
have not been subjected to review and may contain errors.
Source: *The Case
for Index Investing – Vanguard White Paper March 2015
