It’s true – a 1% fee can end up costing 40% of your retirement nest egg.
One of the lessons I’ve learned after spending more than 30 years in the investment business is that the system is designed to maximize the revenues of the service providers (the Agents, in industry parlance), rather than providing the best possible outcomes for investors (the Principals). This is not to say that the entire system is rotten, or that the agents are all crooks. In fact, just the opposite is true.
Based on my own observations and my research into the way the system works, most of the agents in the investment business are honest, hard-working people who truly care about the welfare of their clients. The real problem is the business model that these agents must operate under. The dominant business model in use today is based on a compensation structure that rewards one thing above all else – asset gathering. There are few, if any, incentives for activities that maximize client outcomes.
The majority of investment firms operating today offer some form of sales contests that offer rewards like free trips to exotic places, shiny new cars, or big cash bonuses to the agents who generate the most revenue from their clients. I am not aware of any firm that offers similar rewards to agents who produces the best outcomes for his clients. If they do exist, I would like to hear about them.
Perhaps the most tangible example of what I describe as a warped incentive structure is the way fees are calculated. Most investment advisers, fund managers, and wealth management firms base their fees on the total amount of money they manage. In industry parlance this is called the AUM fee model, or Assets Under Management.
The reason why this model is so popular in the business is that it’s simple for the firm to calculate, and easy for the client to understand. The average AUM fee is 1%, with a range of 0.5% to 2.5%. Clients view this as a small price to pay for expert advice and management. But in reality, it’s much more expensive than it seems. Here’s why.
Let’s assume that a 30 year old investor starts out with an account worth $25,000. Every year she adds $2,500 of new money to the account. Assume her account grows by 8% every year. After 35 years, when she reaches 65 years of age and wants to retire, her account will be worth $766,200.
Now let’s introduce an AUM fee of 1% per year. You would think that her total cost for this advice would be 1% of the amount of her retirement account of $766,200, or $7,662. That seems pretty reasonable, right? But that’s far from the actual cost she will incur, due to what Jack Bogle calls “the tyranny of compounding costs.”
Her actual cost at the end of 35 years is not $7,662, but $178,639, leaving her with just $587,561 in her retirement account. In other words, the 1% AUM fee she paid actually cost her 23% of her retirement account. But the high cost of investing doesn’t stop there.
The 1% annual AUM fee is what the adviser gets, but there are several additional fees and expenses that are paid to other agents along the way. I’ll be conservative and lump all of these together into one additional fee of 1%, which brings the total annual cost of investing to 2%. This reduces the value of her retirement account from $766,200 to $452,612. In other words, she paid $313,588 in fees and expenses to the agents who handled her account. She put up 100% of the money, took 100% of the risk, but she only got 60% of the profits. Does that sound fair and reasonable to you?
As I said, it’s not the financial adviser’s fault that the cost of investing is so high. It’s the business model that’s the problem. And investors are now pushing back against a system that is designed to benefit the agents at the expense of the principal. There is a rapidly growing movement in the investment business, away from the old, expensive business model and towards a cheaper, more efficient model that is driven by computer algorithms. It’s called Robo-advice, and the industry hates it. Instead of paying 2% per year in fees and expenses, a Robo-adviser charges as little as 0.3% per year. This option may not be the best solution for all investors, but it’s a giant leap in the right direction, and it’s forcing the traditional players to lower their fee structures or risk being left behind.