I have previously discussed a formula for wealth building, with one part of the formula being fees charged on your investments. Although no one wants to pay more investment fees than necessary, few of us really consider how significantly even small fees can add up.
I recently assisted two individuals in setting up their investment allocation. Their brokerage charged a minimum fee of 0.8% on every mutual fund choice, even if the actual fund is a low-cost Vanguard fund such as VTSAX with a 0.05% annual fee. To show how much fees can harm your wealth, I am going to assume that the individual invests $15,000 each year for 20 years and that the mutual fund earns 6% per year before fees. The investor going through this high-cost brokerage with the 0.8% fee will have approximately $530,000 at the end of 20 years. The investor buying the same mutual fund directly from Vanguard or another discount brokerage with a 0.05% fee would have approximately $580,000 after 20 years. As a result, a measly 0.75% in extra fees each year for 20 years will cost the investor $50,000, which is just under 10%(!) of the total balance of the retirement account.
Now, take the same idea but think about the 30 year career of two doctors who are able to save an average of $30,000 per year earning a 6% rate of return. The first doctor doesn’t pay much attention to the fees charged on his investments and uses a high-priced advisor, with the result being average fees of 1.50% per year. That doctor, after fees, ends up with about $1.9 million after 30 years. The second doctor makes sure to buy low cost funds, and consults with an independent advisor periodically at an hourly rate, such that her fees are only 0.50% per year on average. The second doctor, with the same amount invested and same rate of return, ends up with about $2.3 million after 30 years. That 1% of additional fees per year ends up costing the doctor $400,000, or about 20% of his total wealth!
Unfortunately, the individuals in the first situation above are stuck with their brokerage for now, and so we can’t do much to lower their fees while they remain employed. Also, we want to take advantage of any employer match in a 401(k), as a 50-100% rate of return on the match far exceeds the 0.75% per year of unnecessary fees. For them, though, if they have any money to invest above what is required to get the full match in the 401(k), I would next focus on maxing out an IRA (subject to income limits) at a discount brokerage so that I can still get the same tax benefit but purchase investments with lower fees.