Monday, February 21, 2005


Last week, I had a good discussion with a good fellow about his 401-K retirement account. I send him my thanks. I sincerely believe the changes he has made and is making will increase his account balance by hundreds of thousands of dollars over the next 20 years or so. My friend paid me a wonderful compliment by making the changes that I would make.

Old Man's Account
The most striking thing about the original allocation of the account was it was set up as an old man's account. It was set up as if the my friend planned to withdraw the majority of the funds in the next 5 to 10 years. I will come back to this allocation question at a later date. This posting is about mutual fund fees.

Mutual Fund Fees
One change my friend is making is to re-deploy investments in a couple of poorly performing mutual funds. Mutual funds in and of themselves are not bad things; I do not consider them to be an evil invention. Mutual fund companies simply offer a service. One can purchase the service or not.

Years ago, I decided to stop mowing my yard. I can mow the yard and can do a good job but I choose to pay a "professional" landscaping company to do the job. I don't own or maintain a lawn-mower, I don't go buy gas or oil but I do have to pay the landscaping company. I spend a lot more cash getting my yard mowed than the costs of owning and maintaining a lawn mower, but I save a lot of time and my yard looks good. If my yard looked worse than most of the yards in the neighborhood, I would fire the landscaping company.

The good news is that the landscaping company does not charge me the cost of providing the service plus a percentage of the total value of the house. The bad news is that mutual fund companies have typically added a lot of extra fees over the years and their main fee is a percentage of the total account value. In a small account these fess are fair. As the account grows, the cost of providing the services remain about the same but the fees generated grow and grow and grow. If my landscaper tried to charge me enough to cover his costs plus 1% of the value of my house, I would tell him to get lost.

The average person is not aware of the poor over-all investment performance of mutual funds. The average person is not aware of how high the total fees become. You don't take my word. The Security Exchange Commission (SEC) maintains a web site that includes lists of the types of fees charged. The site also includes a Mutual Fund Cost Calculator. The following is an excerpt from the site.


"A Word About Mutual Fund Fees and Expenses

As you might expect, fees and expenses vary from fund to fund. A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858—an 18% difference. It takes only minutes to use the SEC's Mutual Fund Cost Calculator to compute how the costs of different mutual funds add up over time and eat into your returns."

As you can see from the SEC example, the fee expense is greater than the entire original investment in only 20 years! The total fees in 30 years would be approximately double the original investment and triple in about 36 years! Most folks own their retirement accounts for 60 years or more! Add a zero or two to the SEC example and you can see that we are talking about serious money!

When talking about retirement income, we need to be talking about serious money. If you retire at 55 with a one million dollar account and you annuitize it at 5% for 30 years, you can draw $5,367 per month or $64,000 per year. It sounds like a lot of money but it is not. In today's dollars $5,367 30 years from now is the equivalent of $1,800 dollars and after being retired 30 years it is the equivalent of only $650. In the example above even the $650 runs out by the time the age of 85 is reached. (My Mom is young, active and healthy at 81 years. I am thankful that she saved enough to retire comfortably. I wonder if she will.)

There are basically two problems here; accumulating enough for retirement and making the retirement account out-last the retiree. The amount we need to invest will depend on the return we achieve. For sake of this argument lets assume that we can do average. Average has never been a very hard number to hit. Many of us made a "C average" or better in school without working very hard. Lets assume we gradually buy shares in 40 of the big companies that are a part of the S&P 500 index and practice a buy and hold strategy. In other words, we will invest like Warren Buffet; we will buy stocks with cash in our accounts but we will seldom sell a stock. Using this strategy, we will incur very low fees.

Studies show that the average mutual fund that buys shares in S&P 500 companies, under-perform the index on average by the amount of the fees charged by the fund. The average fund charges total fees of more than 1%.

Finally lets use a 25 year old person as our saver, assume he will retire at 55 and live to be 85. How much money does he need to invest? Being conservative people, lets assume the market does less well than its historical average. Lets say the average stock only averages 10% return for the next 60 years. Then our person will need to invest $546 per month in mutual funds to reach the million dollar mark or $442 per month in the stock account. If this young person has $546 per month to invest and puts it into average stocks rather than the average fund the account will have grown to $1,234,664 by age 55.

Taking earnings only, the retiree will be able to take out 37% more per month! The absurdity of paying the fees grows when one examines the next 30 years. Although the law requires the withdrawal of some principle each year, to make the math easy, I assume that the retiree re-invests the principle and spends only the interest. The difference in earnings to the retiree comes to over $2,000,000.


The big irony: most folks invest in mutual funds that have a history of performing below average because they are afraid that they cannot perform above average. However, the mathematical probability is extremely high that one will do much better than average simply by investing a regular amount each month. Mutual funds are a convenient way to accumulate relatively small sums. My problem with leaving large sums in mutual funds is quite simple. Why should anyone give away $2,000,000 of their retirement?