Thursday, December 29, 2011

"The Tyranny of Compounding Fees: Are Mutual Funds Bleeding Retirement Accounts Dry?"

With the William Bengen interview, the new Michael Kitces et al. article, and the Special Report on Retirement Income Planning, the December 2011 Journal of Financial Planning is filled with many interesting articles. There is another nice article too that was lost in the initial shuffle for me. It is Stewart Neufeld's, "The Tyranny of Compounding Fees: Are Mutual Funds Bleeding Retirement Accounts Dry?"

Dr. Neufeld looks at how fees divide up the market returns shared by investors and the financial industry over time. First, he outlines the types of fees paid by mutual fund investors, which include not only the explicit management and expense ratio fees, but also a variety of other fees such as trading costs and commissions. He indicates that the average actively managed domestic stock mutual fund pays an annual 1.5% management expense fee, with another 1% added on top for other expenses.


He also summarizes the existing research which tends to show that actively managed mutual funds tend to underperform the benchmark indices by the amount of their fees.


His main focus is to look at how this causes returns to be divided between the financial industry and the investor, both with a historical average stock return, and in rolling periods from the historical data. For the historical average stock return, he finds that over a 50 year investing period, a 2.5% total fee allows the financial industry to capture 74% of market gains, leaving only 26% of the gain for investors.


This is all rather important for safe withdrawal rate studies as well. Studies using the historical index data do not capture the impact of fees on withdrawal rates. If the safe withdrawal rate is 4% when using the pure S&P 500 benchmark index, it could be substantially lower for someone using an actively managed stock fund which underperforms this index. 


Here is a figure I made, which will be described in my upcoming (in a few days) article in the January 2012 Journal of Financial Planning, showing the relationship between fees (or investment underperformance) and safe withdrawal rates over 30 years with an accepted 10% failure rate. This is based on historical data, and a 2.5% annual fee (2.5% underperformance from the benchmark indices) causes the withdrawal rate to fall from 4.3% to 3.1%. [This is always a question: why doesn't the withdrawal rate fall by the full amount of the fee? The answer is because withdrawals are always the same inflation adjusted amount, but as the account balance shrinks, the fee amount gets smaller... it is a percentage of the lower account balance.]

This is potentially a big problem for someone paying high fees on their investments: the 4% rule is not applicable!!



Getting back to Dr. Neufeld's article, I think the last two paragraphs from his conclusion are so valuable that I will quote them here to conclude:


On the basis of the research presented here, I recommend that pension plan fiduciaries be required to select default investments that track broad market indices (equity, money, bond) and that have total fees (MERs) as low as possible, ideally not more than 10 bps. For this to be effectively implemented, an additional requirement is that investments with these characteristics be made available in all tax-deferred retirement plans. If this were a legal requirement, then competition in the marketplace would ensure that many low-cost funds would be formed for potential inclusion in retirement plans. In the meantime, pension plan fiduciaries should work to structure their plans so that more low-cost funds are included.

Investment advisers should also direct clients to low-cost (ideally < 10 bps) index funds unless this approach contravenes the client’s expressly stated investment objectives. To do otherwise is to act against the best interests of the client. Among the general public, financial education is weak and financial literacy is low, and therefore it is easy for advisers to recommend investments that primarily benefit themselves and not their clients. A contribution of this research is to demonstrate the extent to which various levels of fees and expenses are damaging to clients’ portfolios and therefore which investments should be avoided by ethical advisers.