How to Add a Half a Million to Your Retirement Account by Cutting not Adding

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

Active v. Passive Investing - What Works and for Whom

The next several posts will attempt to add some clarity as to which strategy may work best for different types of investors.

Its fund managers whom the vast majority of us trust with our long-term stock and bond investments. They choose which stocks and other assets to invest in on our behalf - and decide when the time is right to buy and sell. But, time and again, research has shown that we over-estimate quite how talented fund managers are and how much value they add.

For all the talk of “star” performers, the empirical evidence shows that only a tiny fraction of them outperform the market with any meaningful degree of consistency. In the UK, researchers examined 516 UK equity funds between 1998 and 2008, and found that just 1 percent of managers were able to produce sufficient returns to cover their trading and operating costs.

The remaining 99 percent of fund managers failed to deliver any outperformance - either from stock selection or from market timing (always a suckers bet).

While a tiny number of “star” managers do exist, they are incredibly hard to identify. Furthermore, the research shows it takes over 20 years of performance data to be 90 percent sure that a particular manager’s outperformance is genuinely due to skill.

According to the research, for most investors, it is simply not worth paying the vast majority of fund managers to actively manage their assets. We think we’re paying for better performance and that greater skill will produce superior results. But investing almost always works the opposite way round. The less you pay, the more you keep. Counter-intuitive, but it’s true.

.

The investment industry and the media (think CNBC) tend to focus on historical fund performance. But Morningstar research shows that the most reliable indicator of long-term investment returns is in fact cost. Nobel Prize-winning economist Eugene Fama says: "If you're paying big management fees, the cumulative effect of that, given the way compounding works, is enormous."

So what sort of impact do fees and charges have on the value of our long-term investments? Well, over 40 years, your retirement fund, worth say $500,000 with no fees, would be reduced to just $349,100 with an annual charge of 1.5 percent. If overall charges reach 2.5% - and when trading costs are included, that’s not uncommon - this reduces the value of your retirement fund to less than $280,000.





So, even at 1.5 percent, almost a third of your retirement fund is lost in fees, rising to 44 percent when charges increase to 2.5 percentage points.




The message for investors is clear: keep costs as low as possible or find the one percent of funds that truly outperform over the long-term, this is crucial to a successful investment experience. With the stakes so high it makes sense to seek out the advice of a credentialed investment advisor who will look at the big picture with you.

CBlakely CFP®, CTFA           10/2014

Sources: Transcript of interview with Nobel Prize winning Professor Eugene Fama, Pensions Institute (Cass Business School) Discussion Paper PI-1404, Morningstar