Monday, October 31, 2011

Halloween Horrors: The Devastation of Compound Fees

Everyone has heard of the magic of compound interest. It has a corollary: that is, the devastation of compound fees.  The idea is: suppose you pay 1% of your account balance each year as a fee.

For a lot of people, this could still be a good idea.  If you receive good advice that gets you into a better asset allocation and keeps you from making costly mistakes with your investments, then the fees could more than make up for themselves.

What I am referring to here is merely comparing the case where someone is able to earn the exact indexed investment returns to someone whose returns fall below the indexed returns by an amount represented through 1% of the portfolio balance. In this regard, the 1% could be interpreted as a fee or as just general underperformance.

But the impacts can be extreme.  The following two tables are in the style of what I describe in my recent paper, “Getting on Track for a Sustainable Retirement: A Reality Check on Savings and Work” from the October 2011 Journal of Financial Planning. Please see the paper for more explanation about what I am up to here.

Table 1 and Table 2 look at various strategies for a 40-year old with different current wealth accumulations, in terms of what retirement age is "safe" in the worst-case scenario from history for different future savings rates, asset allocations, and retirement income replacement rates. The only difference is that no fee is included in Table 1, and a 1% fee is included in Table 2.

This 40-year old is making plans for potentially living through age 100, and so will have to pay the 1% fee for 60 years. Comparing directly the numbers in Tables 1 and 2, one can see how much higher the retirement ages increase as a result of the fees. For instance, consider someone with a 60% stock allocation, 85% replacement rate target, 3 multiples of salary, and a 20% savings rate. In Table 1, this 40-year old found that 65 is the “safe” retirement age. But Table 2 shows that with the portfolio underperformance, this age increases by 5 years to 70.   

The other direction to observe in the tables is how much higher the savings rate must be for the same retirement age. Again with this same scenario, in Table 1 the 40-year old could have retired at age 70 with a 10% savings rate rather than the 20% savings rate required in Table 2. 

This is the devastation of compound fees: the 1% account balance fee would require the 40-year old to save an extra 10% of salary over a 30 year period to age 70, or to otherwise work an additional 5 years, just to be able to pay the 1% fee over the 60 year period between ages 40 and 100.

The reason for these extreme differences from the seemingly small 1% fee, is that it is taken from your portfolio balance. Think of it this way: if your portfolio is currently 10 times your salary, then you would have to save 10% of your salary to pay the 1% fee from the portfolio. Those two amounts would be the same.

Happy Halloween!