27 – Cultivate by Minding Expenses

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Episode Overview:

The financial service industry is riddled with fees and expenses that hurt the individual investor. Today’s episode is simple, Ken will create awareness of a majority of these expenses that can erode away your lifetime earnings. Getting hypothetical, Ken talks about how a 1% fee could cost you $600,000 over the course of your lifetime. Do we have your attention now? Ken covers all the fees that you will come across, and which ones you should be wary off. Tired of the fine print and obscure fees? This episode for you.

Transcriptions are auto-generated, please excuse grammar/spelling!

Happy day to you. This is Ken Kaufman and I am thrilled you’re here for episode number 27, Cultivate by Minding Expenses. This is all part of the series that I am doing on cultivating your assets and the roadmap to make that happen. Now, if there’s one thing the financial services industry has been good at, it’s this, creating all sorts of costs, fees, expenses. Their motivation, to find ways to pay people to sell their products and to increase their own profitability.

In 2019, I’m so pleased to say that we’re seeing a huge shift in the financial services industry. More and more research is clarifying how truly expensive all of these fees and expenses really are, and how much they are hurting the investment returns of the individual investors. And I’m also pleased that alternative products are being created that either eliminate, or at least minimize as much as possible all these costs.

So today’s episode is really just about one thing, educating you about the most common types, means and ways that your investments are made subject to fees. So first, let’s talk numbers. Now, let’s assume that you’re committed to funding a Roth IRA until you retire, from age 18 all the way until age 65. You’re going to be putting $6,000 a year or $500 a month into this Roth IRA.

That means over the course of all that time, those 48 years, you are putting in $288,000 of your own money. Assuming this grows at an average compounded return of 7% and not making any adjustments for inflation to the contributions or to the total amount once it’s all grown when you turn 65, your total $288,000 investment will be worth $2.1 million. That’s at age 65. That’s incredible. That is the power of compounding. But what if in this investment that you make of $6,000 every year, what if you are charged 1% in fees to your account balance?

Well, guess what happens? At the time you turn age 65, instead of your balance being $2.1 million, it is $1.5 million or it’s eroded $600,000 over this time span from 18 until 65. That is almost a 30% drop or erosion in your overall account value. At the time, 1% seemed like so little, it seemed like not that big of a deal, but wow, it can have a huge impact on your overall outcome and return.

Have I got your attention now? Just to be clear, if you paid 2% in annual fees, this would leave you just 1.1 million of your 2.1 million. Almost a 50% erosion of your total account value. Every percentage point counts, every half percentage point counts. And we could even say that every basis point counts. And when I say a basis point, 1 basis point equals 0.01, or I should say 1% of 1%, or 0.01 of 1%. So if I was to say something like a hundred basis points, that’s the equivalent to 1%. One basis point would be 0.01%. So even getting down to 0.01% can end up making a huge difference in your overall returns.

Now, let’s talk about how these fees are assessed or charged. I’m gonna focus on stock and bond investments here, primarily mutual funds and ETFs, and that includes all types of retirement accounts. I’m not gonna go into detail about the fees and how they could negatively hurt or impact other assets that you may have, like real estate or a business that you own and operate and run where there are fees associated with selling those things or buying those things and managing them. So, again, just focusing on the general stock market bond market that’s represented through mutual funds and ETFs primarily.

The first expense that I want to talk about is the one that’s often the most quoted, and it’s called the expense ratio. And by the way, this includes what are called 12b-1 fees, which are known as marketing costs that are paid to brokers and people who are selling the financial products. The expense ratio can range on a low-cost index, passively invested mutual fund. Remember last episode where we talked about passive investment. You’re not paying for any active management. You can see these fees down as low as 0.04% or 0.03%, and it seems like these mutual fund providers are on a race even down to zero potentially at some point. They’ve been able to drive these costs so low in some of these index funds that are so common and that they’re able to generate liquidity within.

On the flip side, actively managed funds, it’s not uncommon that you would see that these would be 0.75%, 1%, 1.5% percent or sometimes even 2%. The studies and academic research shows over and over that the higher your expense is, the less chance you’re going to be able to get the market return. It eats away at what the active managers are trying to accomplish and hurts their ability to try to beat the market returns. And when you can get these fees down as low as possible, it increases the chance that you’ll be able to receive that market return.

Now, second category here, in expenses. The first one’s expense ratio. The second one is what are called the advisor fees. So this would be if you’ve hired a professional who’s either…who is giving you financial advice and who is helping you make investment decisions. Again, they have their place, and yes, they deserve to be paid for their time and for their effort. And they generally get paid one of four ways. And sometimes, these things directly affect your investment account balances over time.

And in fact, the main one is what’s called AUM or Assets Under Management, or a wrap fee. So you’re gonna hear terms potentially as a wrap fee, Assets Under Management fee, or an AUM fee. What this means is that the advisor is going to be paid a percentage of your account balance each year, or sometimes it’s calculated and debited from your account on a quarterly basis.

And this would be the equivalent of the example that I gave before, where if 1% is coming off of your account balance every year, whether it’s paying an active manager, or your advisor who knows your situation inside and out and is giving you very personalized, stylized advice for your risk temperament and your goals and your objectives, this 1% comes right out of that account balance. And again, it’s called an AUM assets under management or a wrap fee. So if you’re working with a financial advisor, you want to be very clear about how they charge and what impact that can have over the longterm on your investment.

Advisors will sometimes also charge an hourly fee, and that’s generally you writing a check just out of your bank account. It’s not coming against any of the assets that you’re trying to build and grow. They may also charge a project fee. For example, if you said, I want a comprehensive financial plan, they may charge you a flat fee and deliver that plan to you once they’ve done all their analysis and research and put the entire plan together. And then we’re also seeing arise that advisors are starting to charge more like a subscription or a retainer fee, where in order for them to do maybe a bulk of work upfront for you, they will get paid a subscription over time and then they have the opportunity to continue to build a relationship with you and help you with future financial decisions on a subscription type of a basis.

So just be aware, those are real fees. Those last three hourly, project, and subscription or retainer. Generally, those are not charged against your asset balances. Those are just an expense that come right out of your personal monthly budget or annual budget, and they do not hurt your investment outcomes. And to be really clear here, you can tell I’m a fan of less of the AUM and wrap fees and more a fan of you just paying for what you’re getting directly.

Now, the next fee is something that I’m so glad to report over the last decade have become less and less prevalent in the financial services industry, but they’re still there. They’re called sales loads. And generally, they’re known as either a front end sales load or a backend sales load. And to give you an idea, this is how it would work. If you had $10,000 to invest, and the advisor or the broker or the person that was selling you the investment or that you were buying it from, if they said this has a 5% front end sales load, what that means is that 5% would be taken out of your $10,000, and only $9,500 would be invested. The other 5% generally goes to the person, a decent portion, if not most of the portion, goes to the person who is selling you that fund or that investment.

A backend sales load, or also known as a surrender charge, is it works similarly, only that the fee is on the backend of the investment, and generally, the fee starts to ratchet down. Say it’s a 5% backend sales charge or surrender charge if you liquidate in less than one year and take that investment out, it would be a 5%. And then if you were to liquidate in the second year, it would go down to 4% and 3% and 2% and 1% and ratchet down in that format. Again, it’s usually because a big chunk is being paid to the person selling the product upfront, and then the investment company where that money is going is needing to be able to recoup that commission that they paid to the salesperson on the front end if you take the money out before they’ve had a chance to get it on their system and platform and to make the money that they need to cover for that sales commission that was paid.

Again, sales loads, they’re less prevalent now in today’s financial markets, but they are still there and watch out for it. They either get you on the front end or could get you on the back end if you were changing or liquidating your investment for any reason. Next, are transaction fees, and I’ve got these bucketized into a bunch of different categories. Well, really just three. The first one is commissions. If you’re buying stocks or bonds or ETFs, you can be paying commissions. And sometimes even mutual funds have purchase or trading fees, or redemption fees associated with them.

Before you’re getting into any of these, understand what those fees are. And it’s not that the stock or even, you know, the ETF is charging them, often whatever platform you’re trading them on is charging for that, you know. Whether it’s a Charles Schwab, or a vanguard, or a fidelity, or a TD Ameritrade, or you know, go down the list of all the potential brokers, be aware of what the commission costs are. A lot of mutual funds trade with no commission and no fees, but some platforms do charge fees. It just depends on which fund family and which platform you’re working with and what arrangements they’ve made between each other.

Also, it’s not uncommon that buying a specific stock will have a commission associated with it, and there’s cost to do that and then to sell it. And same with bonds. Generally, there are commissions associated with that. So if you’re buying those things directly, you want to make sure that you are minimizing those fees as much as possible.

And the other part that goes with this is there’s always a spread between the bid and the ask price. So, what is somebody willing to sell the stock for versus what is somebody willing to buy the stock for? And there’s a markup right in between those two where the market maker or the dealer is making a very thin or small margin usually, especially if it’s a commonly traded, there’s high volumes of shares being sold and purchased throughout the course of a day or throughout the course of a year. That spread is usually pretty thin, pretty narrow, and generally has very small impact on an overall return, but it can still make a difference if you’re trading a lot and buying and selling a lot within your portfolio. So that’s commissions and trading fees.

Now, there’s another one. I’ll just call these general account or custodian or brokerage fees. The first one is they may charge you an annual fee. There are a lot of brokers, at least I know with vanguard, where if you will sign up to receive your statements via email, they will waive an annual fee, which I think is $12 or $24 a year or something like that. So you want to watch out for annual fees and then do whatever you need to so that you’re not subject to that.

The second one could be an inactivity fee. If you’ve opened the account and then say you’ve liquidated it, haven’t done anything with it, sometimes they can hit you with that. The third one is, dependent on your platform if you’re trading stocks and you’re looking at a lot of technical analysis and those sorts of things, there may be a research fee that you pay, or subscription to be able to access certain data and certain information. Sometimes there are platform fees, depending on how you’re trading, and what platform you’re using, and exactly how you’re engaged in that. There can be paper statement fees, and then there could be transfer fees or account closure fees that you need to be aware of as well. All of this should be disclosed in the paperwork that you get before you ever sign, and you should read it before you ever sign an official document that opens an account.

And then, the last area for fees I want to talk about is within 401k plans. This is a place where sometimes fees can really get out of control. An employer who wants to offer a 401k plan or a retirement plan, like a 403(b) plan or a 457 plan, any of those sorts of things. The employer has certain costs that they have to incur in order to run that plan. They have to file a 5500 form. They have third party administrator costs for properly administering the plan. There are plan document costs that then the third party administrator has to follow that legal plan document in terms of what is and what is not allowed within the plan and all of the details about how it’s going to be administered. There are per participant fees. Sometimes they charge a percentage of assets to cover some of those fees.

Just want you to be aware. Oh, and there are some times annual and quarterly account maintenance fees or account open fees. And so, you’ve got to be really careful with this. And then if you’re going to take a loan, there’s usually a fee to get the loan and then a fee annually for them to continue to administer it. If you borrow from your 401k, not something I’d recommend. I’m sure I’ll hit that in a future episode, but there are a lot of places where they’ll hit you with fees within a 401k plan and sometimes an investment that you could go buy directly from that fund family or buy an ETF on any type of trading platform. Sometimes those investments are gonna cost more within the 401k plan because of all of these costs and the employer may not be bearing all of those costs. They may be passing some of those along to you as the plan participant.

So I just want to give you a heads up that the 401k plans also are not perfect when it comes to fees and there are some great, very well managed plans and some that unfortunately, it seems like they’re set up more to benefit the financial institutions that are offering them than the actual plan participants. Sometimes employers get caught in the middle there not really knowing how to decipher or read through all of that.

All right. So just went through and listed all those fees. Remember the key thing here is that fees can erode your outcomes dramatically and drastically. And this completes our overview of minding your expenses as you try to cultivate and grow your asset. The key thing here is, it’s time to beat the financial services providers and the products they offer by holding these financial institutions and the people who sell their products accountable and responsible for the fees that they charge.

Demand a full disclosure. Ask, don’t be shy. Ask them what everything means. Ask them who’s getting paid what and whose hands are in which pockets and taking and using funds in which ways. It is so important that you know and understand it, again, because it has such an impact. Know what you are buying and then you will give yourself the best chance to maximize your outcomes.

Much, much more to come on this roadmap to cultivating your assets. And I’m looking forward to several more episodes on this topic and then a nice summary round-up of all of these topics put together just in one nice, neat package for you in a final episode on just this Cultivating Your Assets model. Many, many thanks to you for joining today. This is a wrap for episode 27. Happy day.

Links Referenced:

How Fees & Expenses Affect Your investment Portfolio
https://www.sec.gov/investor/alerts/ib_fees_expenses.pdf

 

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Join Chief Financial Officer Ken Kaufman as he helps you track and hack your net worth. For those seeking financial independence, your net worth is one of the most significant measurements of success. Using his two decades of financial experience, Ken Kaufman helps you overcome your financial obstacles and look onward towards a better, brighter financial future.

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