Fees Matter . . . a lot.

Minimizing cost is critical to achieving long-term investment success. Unlike future performance of your investments, costs are predictable and controllable. Countless studies and mathematical analyses have shown that higher costs do not lead to higher returns. Dollars spent on management fees, trading costs, and taxes are dollars lost to the investor. Market rewards are finite and investment expenses come off the top before the investor gets their share. Smart investors should be concerned with finding investment products, with low fees.

In one recent study of mutual fund performance (Financial Research Corporation, 2002, Predicting Mutual Fund Performance II: After the Bear) the predictive value of several fund metrics were examined. The possible indicators of future returns that were examined included: a fund’s past performance, Morningstar rating, alpha, beta, as well as expense ratio. It turns out that the fund’s expense ratio was the most reliable predictor of its future performance. In other words, low-cost funds delivered better performance. This was true for all of the periods considered by the study.

John Bogle, Founder and Former CEO of the The Vanguard Group talked about another study when he spoke in 2003 to the Society of American Business Editors and Writers. The study quantified the relationship between the total costs of equity funds and their returns by looking at the returns of 803 diversified U.S. equity funds. Using the Morningstar database, each of the funds investment returns along with its costs were compared. The average expense ratio for these funds was 1.3%, and their average portfolio transaction costs were estimated at 0.7%, for a total of 2.0%. The funds were then divided into quartiles by cost (fees). The results included these important facts:

-The high-cost quartile of funds, with all-in expenses of 3.4%, provided an average annual return of 6.8%.

-The low-cost quartile, with expenses of 1.0%, provided an average annual return of 10.2%, earning an advantage of 3.4 percentage points per year.
-On a fund-by-fund basis, the inverse correlation between cost and return was remarkable: minus 0.60%.

-Funds with the highest costs also assumed the highest risks, generated the highest turnover, and produced the poorest tax-efficiency.

-Funds with the lowest cost had an even greater advantage in risk-adjusted return and an amazing advantage of 4.0% per year in after-tax return.

Fees as they impact returns are also the subject of an article by Nobel Laureate, William Sharpe: The Arithmetic of Active Management in Section 6.2( http://www.golio.net/Chapter6.html). Here’s what Sharpe concludes:
If "active" and "passive" management styles are defined in sensible ways, it must be the case that

(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar
These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.

As an individual investor, how can you reduce fees? Using a low cost mutual fund provider should allow you to assemble a portfolio with an expense ratio on the order of 0.20%. Fixed income investment (bond) requirements for your portfolio can be satisfied using a short to intermediate term US Government bond fund. An S&P500 or Wilshire 5000 index fund can be a good choice for the stock portion. Other low cost index funds can provide further diversification if desired.

The average mutual fund has an expense ratio of about 1.30%. Fees of this magnitude result in significant drag on your portfolio performance. The figures and analysis below provide an estimate of how much can be gained from using low fee funds rather than average or high fee funds.

The figure labeled “Effects of fees while saving” considers an investor that invests $2500 per year for 40 years and earns 7% per year on the total investment. The 5 curves illustrate the effect of fees on the portfolio value. Fees of 0.2% are typical of low cost index funds. Managed funds average over 1% fees. Some managed funds have fees as high as 5%. Over a 30 year investment period, the cost to an investor investing in funds with a 1% fee is over $32,000 compared to the investor using mutual funds with a 0.2% fee. Compared to an ideal “no fee” return on investments, the investor gives up over 16% of the gains on his/her own money over this period of time. The investor takes all of the risk, but pays over 16% of their gains to the mutual fund company.

At the end of 40 years, 1% fees have cost the mutual fund investor over $93,000 compared to the low cost investor. The investor has now paid almost 30% of his/her investment gains to the mutual fund company.

The figure labeled “Effect of fees in Retirement” illustrates how fees affect a retiree during the distribution phase of investment history. The figure assumes a retiree starts retirement with a $1M portfolio, spends $45K the first year and adjusts this spending upwards by 3% per year to match inflation. The unspent portfolio is assumed to earn 7% return per year. The investor who is invested in mutual funds with 0.2% fee survives over 40 years in retirement. At a 1% fee level, the retiree runs out of money in year 34. An investor using mutual funds with a 4 % fee runs out of money in year 22.

The road to investment success is improved when expenses are minimized. Your portfolio performance is driven primarily by

- your saving rate,

- your asset allocation and

- amount of time in the market.

Personal values and frugal living drive your saving rate. Asset allocation is a matter of establishing your personal risk-return comfort level. Time marches onward for all of us. This leaves little or no reason to diminish your returns through commissions and fees. Even a 1.00% management fee costs a lot in terms of reduced nest egg and retirement income. Spending the small amount of time required to learn about financial markets and managing your own retirement assets should reap significant rewards.

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How do you define retirement?

I was recently discussing retirement planning with a group of engineers and asked if they could help me with an informal “show of hands” poll to determine how long before they planned to retire. Before I could even start the poll, someone asked, “What do you mean by “retirement”? People laughed, but it wasn’t a facetious question. In fact, it’s a very good question and one that each person needs to answer before they start retirement planning.

When does retirement start? A few decades ago, people worked full time until they stopped. But today, according to surveys more and more people are looking at retirement as a process rather than as an event. Some studies indicate that as many as 90% of Baby Boomers want to continue to work beyond conventional retirement age. Rather than stopping full-time work abruptly, we see a trend toward either working part time or cycling between periods of work and periods of pure leisure. Still other workers are planning to leave a high-pay, high-stress career for a low-stress labor of love. These people plan to work until their mid-50’s or 60's, then transition to part time or temporary work (possibly a change of career) then retire completely. They are planning a “transitional retirement”. The only problem with this view of retirement is that it makes the point when retirement begins difficult to define, and that presents a retirement planning challenge.

Retirement planning is complicated further by the fact that people don’t have the same ideas about how they want to spend their time in retirement. Some people want to travel the globe. Some want to sit on their porch in their rocking chair. Some want to cultivate family and friends while others hope for solitude. Some anticipate involvement in causes as a volunteer while others hope for peaceful seclusion.

Here's some background history on retirement age/lifestyle. Prior to the Social Security Act of 1935, most people were not able to retire until they became too frail or sick to work. Since then, the average age of retirement has dropped monotonically every year until very recently. Between 1950 and 2000, the average age at retirement dropped from about 67 years old to under 62. About 60% of Americans over 65 consider themselves completely retired. It is no accident that the age when Social Security benefits are first available corresponds exactly with the average age of retirement. According to the US Bureau of Labor Statistics, nearly half of all seniors would be below the poverty level without social security.

Retirement trends among technical workers do not vary that much from those of the general population. According to the National Science Foundation, engineers and scientists with BS or MS degrees quit working full-time at an average age of 62. Those with a Ph.D. do not stop working full time until age 65. It is interesting that the number of technical workers who work only part-time increases for all degree earners between the ages of 55 and 65 – transitional retirement.

Of course no one vision of retirement is right or best, but regardless of the vision, surely one goal they all have in common is the need to achieve a level of financial independence. Financial independence provides freedom for wage slaves. What one chooses to do with that freedom – recreation, leisure, volunteer, part-time work, or change of career – is entirely up to them. Even if you choose to die in your cube, financial independence makes certain aspects of the job easier to take.

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LBYM: Live Below Your Means

In the absence of generous, reliable pension benefits, all successful retirement plans depend on your ability to develop a portfolio of investments that will fund your retirement lifestyle. For most affluent technical professionals, this means that successful retirement planning begins with learning to live below your means (LBYM). If you get this component of retirement planning correct, the rest will fall into place. If not, no advice will help you. Exceptions to this rule are lottery winners and recipients of large inheritances. Unfortunately, I know of no way to guarantee you win the lottery or are born into wealth. The critical impact of LBYM principles on retirement planning is easy to understand. You will never have any money to invest if you spend it as fast as or faster than you earn it. So the LBYM principle is required before any investing can take place. If you do live by this principle, then you are either investing regularly or burying money in jelly jars in your back yard. Be sure to practice the former and your retirement plan will stay on track. You might be concerned about exactly how you allocate your investments, but these issues are neither as complex nor as critical to the ultimate goal as many inexperienced investors believe. Instead, the optimum investment portfolio is as much a matter of personal comfort as it is a specific set of investments. As long as you've learned the LBYM principle and make regular investments, you are likely to find efficient investment vehicles that will insure a safe and successful retirement.

There are two major components of LBYM: 1) maximizing means and 2) living frugally relative to those means. The first component is related to career path and job choices while the second is related to spending and living habits. Both are important. Even more important, however, is the realization that the LBYM principle is only a means to an end. If the achievement of an LBYM lifestyle and comfortable retirement requires that you become a miserly curmudgeon, you have missed the point. It is possible to put too much emphasis on either of the components above. Ruthlessly driving your career to ever-higher salaries may not be satisfying or comfortable for you. Similarly, an obsession with the cost of every luxury or comfort item may keep you from enjoying life. Balance is the key to an LBYM lifestyle and a happy and successful retirement.

Although the LBYM principle is simple and obvious, violation of it appears to be the major cause of failed retirement plans. It is not always as easy to apply as it appears. For many, it seems impossible. In a consumer-oriented world with advertisers encouraging us to buy something at every turn, it is not surprising that many become materially focused.

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