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Mutual Fund Fees Explained

The low-down on mutual fund fees

One of my newer clients was reading her fund prospectuses (prospecti???) recently and asked me to explain how the various fees work.  After getting over my initial surprise that someone actually reads the fund prospectus (just kidding, I know you all do!), I figured that this was a topic that might be of interest to some other people out there.  After all, there is a lot of talk in the financial media about mutual fund fees – but I also find many people misunderstand how they work.  Fund expenses are complicated stuff, and although I will try to explain in simple terms, please forgive me if I cause your eyes to glaze over.

Management Fees.  These fees pay the manager of the fund (Vanguard, Pimco, etc.) to do their job.  The fund manager selects the investments that go into the fund.  Theoretically, the more the manager is doing (the more ACTIVE he is), the higher the fees are going to be.  An index fund typically has the lowest fees, because the fund’s investments are already selected for it.  All the manager has to do is buy and sell shares of stocks to mimic the holdings that comprise the index which the fund tracks.  This can largely be done by computer, so costs and fees are minimal.  A fund manager who researches and selects stocks will have higher costs to pay for his analysts and research tools.  And researching small companies, or overseas companies, or specialty market segments tends to be more difficult and expensive than researching large well known companies.

It is important to realize that management fees are paid for by the fund itself – not by the investor.  So if a fund advertises a return of 8%, that implies that the fund earned 8% after all its internal operating expenses were met.  While it may be surmised that if the same fund didn’t have its 1% in management fees it WOULD HAVE earned 9% – this is a somewhat flawed logic, since without the expenses that fund would not have existed in the first place.  See below for further discussion of the impact of fees on investor returns.

Sales Charges (aka “loads”).  These are fees which go directly to compensate the broker who sells the fund.  They are essentially a sales commission paid by YOU the investor.  Front end loads (typically identified as Class A) are paid for up front by the investor.  If you buy a fund with a 5% front end sales charge (load) for $1000, then $50 is taken out of your investment to pay the selling broker, leaving you with a $950 investment.  Level load funds (typically identified as class C) have fees usually of about 1% per year deducted from the investors account to pay the broker.  Over many years level load is more expensive – but since you paid less up front it is easier to sell the fund without any loss.

Most fee based or fee only investment advisors (as opposed to commissioned advisors) do not accept commissions on mutual fund shares, which means these sales charges will normally be “waived”.  If you are paying your advisor a fee for his services, make sure you are not also paying a commission.  That would be double dipping, and would not be appropriate in most cases.

12b-1 fees.  OK this may be the least understood (and least discussed outside the industry) of all mutual fund fees.  Many funds have a small annual fee called a 12b-1 fee listed on their prospectus.  This is a fee that is remitted to the brokerage firm that hold the shares and is supposed to pay for paperwork, marketing services, etc.  It is often used by commission brokers to pay an additional annual commission to the salesman.  However, these fees may also be used by custodians (such as TD Ameritrade) to offset the costs of including a fund in a No Transaction Fee trading platform.  In this case, the additional fund cost (typically about .25%) may be more than offset by the fact that an investor does not have to pay a trading cost or commission every time he buys, sells, or rebalances his portfolio.

Trading Costs.   The direct cost to the fund of executing transactions (buying and selling stocks or bonds) is not included in either of the above.  And it is almost impossible to determine what the trading costs of a fund are.  They are not listed in the prospectus.  As with management expenses, these are costs paid for by the fund before quoting any returns to investors – so these are not expenses you pay directly.  However, it is sensible to surmise that the more a fund manager trades in and out of stocks, the higher his trading costs.  Those who don’t mind reading a fund prospectus can look to the Turnover rate to estimate how often a manager trades.  A fund with a 10% turnover rate sells about 10% of his holdings in a given year.  This would be pretty low, and suggests the manager holds onto an investment for an average of 10 years.  A fund with a 100% turnover rate would on average sell every holding (and replace it with a new one) every year.  This would be a very high turnover ratio.

Tax Costs.  Don’t ignore the tax implications of a fund you own.  The more a fund buys and sells shares, the more likely you will be to see taxable capital gain distributions at the end of the year.  You will receive a 1099 and pay tax on these distributions.  Index funds tend to have fewer capital gain distributions – but not necessarily so!  High turnover funds are more likely to spin off taxable gains than low turnover funds.  And of course, you don’t have to worry about tax implications if your fund is owned in an IRA or 401k.

So is the lowest cost fund always the best choice?  Many in the media seem to take this simplistic approach, but it is not necessarily so.  It is true that most managers of your typical domestic stock funds fail to do any better than a similar index fund.  This is often attributed to the fact that the investments the fund holds needs to beat the index by the amount of the fee just to result in a tie!  Few managers seem to be able to generate these results solely by “picking” large cap US stocks.  So for exposure to these stocks, an index tracking mutual fund or ETF might be the best approach.  However, in more nuanced and complicated segments of the market (international, emerging markets, fixed income, alternative strategies) a good manager may be worth his keep even after considering fees.  This does not necessarily mean he will generate outsize returns.  In fact, a manager can just as well add value by avoiding trouble spots and reducing risk and volatility.  To support this premise, studies have shown that  active managers historically have enjoyed their best years (vis a vis their benchmark index funds) when markets are losing money.

Fund expenses are important – but they should not be the only consideration when choosing an investment to add to your portfolio.

Investment News article mentions Financial Pathways

Financial Pathways was mentioned in a recent Investment News article: 

 

Investment News is a leading weekly trade publication for investment advisors.  The article speaks to the somewhat unique way Luba and Jim work together on most client accounts at Financial Pathways.  In many other firms with multiple advisors, the client works with a single individual.  Luba and I have just found it more comfortable (and liberating!) to work together on most client accounts so we are both familiar with the details of each clients’ situation.  We believe it serves our clients as well, as they never have to wait for “their advisor” to return from vacation or return a phone call, or worry about what happens if one of us gets run over by a bus.

 

Financial Pathways Participates in Online Financial Planning Advice Forums

I have been participating for the past several months in several online services which provide free online financial planning advice to the public on topics ranging from budgeting and debt management to investments and retirement planning.  I consider it a form of pro bono financial planning, as many of the questions seem to be coming from young people just starting out, or people in rather difficult financial straits.

  1. Jim on NerdWallet
  2. Jim on Brightscope

I thought that some of the questions I answer may be of general interest to my newsletter readers, or you may know someone who could benefit from the advice.  Feel free to peruse my postings (and those of other participating advisors). The sites offer some great information.

Tax Diversification for Retirement Funds

The advice you are given throughout your working career is to save for retirement in tax deferred accounts, such as your 401k or IRA.  This makes sense.   By putting money in your 401k, or by making tax deductible contributions to your IRA or SEP IRA, you are able to invest more money than if you had to pay the tax man BEFORE investing.

Tax Deferral: Too Much of a Good Thing?

Perhaps then it is not a surprise that many retirees find themselves with almost all of their assets sitting in tax deferred retirement accounts.   Unfortunately this can cause its own problems.  In retirement, every dollar you take out of an IRA or 401k will be taxed as ordinary income.  If your roof or air conditioning needs replaced, you may need to take an additional distribution from your IRA to pay for it.  Since you know tax will be due on that distribuiton at the end of the year, you may need to take out an additional 20 or 25% just to pay the tax bill at the end of the year.

Retirees with substantial nest eggs in their retirement accounts may also encounter a tax problem due to Required Minimum Distributions.  The IRS requires that you begin withdrawing money from your tax deferred retirement accounts in the year you turn age 70 1/2.  The required distribution is based on IRS calculations of your expected longevity.  If you were a prodigious saver or effective investor during your younger  years, you may find that the IRS is making you take more money than you need to live on – and you will need to pay tax on that money as it comes out.

The answer to this problem is tax diversification.  Direct savings into a variety of account types.  Contribute up to the employer match in your employer 401k without fail.  After that, consider your options.

To Roth or Not to Roth?

If your taxable income is very high, then it probably makes sense to maximize your pre-tax contributions to 401k or other employer account.  If not, it might be better to put any money over the employer match into a Roth IRA.  Why?

  • While you don’t receive a current year tax deduction on your Roth contribution, that deduction isn’t worth so much iif your current taxable income is low.
  • Money will grow TAX FREE.  When you take the money out in retirement, you will owe no tax at all.
  • t is easier to access funds in a Roth for emergencies, college tuition, etc.  Since you already paid tax on the money you put in, you can remove those same funds without tax or penalty, even before the magical age of 59 1/2.
  • There are no Required Minimum Distributions from a Roth IRA. If you don’t need the money you can leave it in the Roth and let it grow until your kids inherit the account.  (and your kids will continue to reap the benefits of a Roth).

You can even convert traditional retirement accounts to a Roth – but that is a complex topic for another article.

Pay Tax Now for Flexibility Later. 

In addition to the Roth, I find that retirees with money saved in taxable investment accounts have much more flexibility when creating a retirement income and tax plan than those who only have 401k’s and IRA’s.  In an ordinary investment account we can utilize tax strategies that will take advantage of favorable tax rates on dividend and capital gain income.  We can sell investments that are down, creating losses that offset the tax impact of gains elsewhere in the portfolio.  It is often possible for the retiree to access money from a taxable investment account if needed for emergencies without generating any additional tax liability.   We can take money out at our own pace – the IRS will not force us to take income we do not need to live on.

Plan Ahead to Minimize Retirement Taxes.  

Choices you make during your peak saving years can have a profound impact on your tax burden in retirement.  A sound financial plan can help your optimize your tax situation – potentially saving you thousands or tens of thousands of dollars per year in retirement taxes.   Call Financial Pathways to discuss your own options, and for an overall retirement plan review.

 

The above is not to be considered legal or tax advice. 

 

Investment Risk in Retirement

The financial crisis of 2008 demonstrated clearly the devastating impact that investment losses can have on a retirement portfolio.  Many people who were almost ready for retirement saw their nest eggs cut in half in the course of a year or less.  Many people were forced to either delay retirement or scale back their lifestyle expectations as a result.

Recent retirees and those who are just about to retire are among those at the greatest risk from investment losses.  “Why is that?”, some might ask.  “The market came back since 2008, and investors who left their investments in place did pretty well.”  It is true that investors who left their stock portfolios intact did see their investments recover and go on to reach new highs - but the math works differently for retirees who must take distributions from their savings.

Lets consider our familiar investors, Bob and Don.  Both are recently retired, and both are starting to withdraw $3000 per month from their $500000 investment portfolios.

Bob is invested in a moderately aggressive portfolio, averaging 7.5% return over 20 years of retirement, while Don is invested in a fairly modest risk managed portfolio earning just 4%.  In the first year of their retirement, Bob’s portfolio loses 35%, after which it begins to quickly recover at 10% per year.  Don, in contrast, earns 4% every year.  Here is how the math works:

Bob’s Portfolio                Dons Portfolio
Balance % return Investment Return Withdrawal Balance %  return Investment Return Withdrawal
$500,000 $500,000
$289,000 -35% (175,000) (36,000) $484,000 4% 20,000 (36,000)
$281,900 10% 28,900 (36,000) $467,360 4% 19,360 (36,000)
$274,090 10% 28,190 (36,000) $450,054 4% 18,694 (36,000)
$265,499 10% 27,409 (36,000) $432,057 4% 18,002 (36,000)
$256,049 10% 26,550 (36,000) $413,339 4% 17,282 (36,000)
$245,654 10% 25,605 (36,000) $393,872 4% 16,534 (36,000)
$234,219 10% 24,565 (36,000) $373,627 4% 15,755 (36,000)
$221,641 10% 23,422 (36,000) $352,572 4% 14,945 (36,000)
$207,805 10% 22,164 (36,000) $330,675 4% 14,103 (36,000)
$192,586 10% 20,781 (36,000) $307,902 4% 13,227 (36,000)
$175,844 10% 19,259 (36,000) $284,218 4% 12,316 (36,000)
$157,429 10% 17,584 (36,000) $259,587 4% 11,369 (36,000)
$137,172 10% 15,743 (36,000) $233,971 4% 10,383 (36,000)
$114,889 10% 13,717 (36,000) $207,329 4% 9,359 (36,000)
$90,378 10% 11,489 (36,000) $179,623 4% 8,293 (36,000)
$63,415 10% 9,038 (36,000) $150,808 4% 7,185 (36,000)
$33,757 10% 6,342 (36,000) $120,840 4% 6,032 (36,000)
$1,133 10% 3,376 (36,000) $89,673 4% 4,834 (36,000)
$0 0% 0 0 $57,260 4% 3,587 (36,000)
$0 0% 0 0 $23,551 4% 2,290 (36,000)

Bobs Average Return:        7.5%                                                        Don’s Average Return:     4%

Here are a few important things to notice:

Note that despite the rapid growth of his portfolio after that first year, Bob NEVER FULLY RECOVERS FROM THE LOSS and never catches up to more conservative Don!  The reason is the distributions he has to continue taking from the account to pay his living expenses in retirement.

Bob’s average rate of return during the entire 20 years was 7.5% while Don’s return was 4% – but Don’s money lasted 3 years longer than Bob’s.

As financial planners, helping our clients manage risk is an extemely important part of what we do.  When the stock market keeps setting new records – it is also one of the hardest parts of our job!  It is hard to persuade our older clients to be satisfied with modest returns in a lower risk portfolio when they hear their neighbors boast of 30% returns.  But the very definition of planning implies a focus on the future rather than the past.  And we simply cannot know for certain that 2014 or 2015 will not turn out more like 2008 than 2013.  Plan for the worst – hope for the best.  Your retirement and investment plan needs to be built to survive whatever the future throws at you.

Important Takeaways:  

  • Recent or soon to be retirees need to be especially prudent about investment risk.
  • Never risk more than you can afford to lose.
  • Don’t be greedy.
  • Don’t be fooled by markets which seem calm and stable – market sentiment can change in a heartbeat, and world events will always be completely unpredictable.
  • A lower rate of return can actually provide more money to spend in retirement if it allows the investor to sidestep significant market losses.

 

Putting Investment Returns in Perspective. 

Small Numbers – Big Difference.

What is the difference between a 3% return and a 7% return?  4%?  Doesn’t sound like much, does it?  But these small numbers can have a tremendous impact on your retirement portfolio over time.

Let’s consider two savers, Bob and Don.  Bob has contributed $1000 per month to his 401k for the past 25 years, and invested in a blended portfolio of stocks and bonds which has earned an average of 7% per year.  Don in contrast, is extremely risk averse.  He has invested the same amount of money, but parked it all in his 401k stable value fund, which earned a steady if unexciting 3%.

So Bob earned 4% more than Don – what difference did that have on their portfolios over 25 years?

  • Bob’s portfolio ($1000/month invested for 25 years at 7%) would have grown to $810,000.
  • Don’s portfolio ($1000/month invested for 25 years at 3%) would have grown to $446,000.

In order for Don as a risk averse investor to accumulate the same retirement nest egg as Bob, he would have had to save $1820 per month at 3%, almost twice as much as Don had to save in order to achieve the exact same result.

Risk averse investors take note:  You may need to contribute a higher portion of pay to your retirement plan than your more aggressive co-workers if you hope to achieve the same long term accumulation goal.

 

 

Returns quoted are hypothetical in nature and do not reflect actual returns on any investment.  Although riskier investment assets have outperformed conservative investments over most long term periods in the past – there is no guarantee this will continue to be the case in the future.  

 

Health Care Planning and Obamacare Tax Credits

I was brushing up on the Obamacare rules today and found a very useful caculator from the Kaiser Foundation which will tell you exactly how much income you can make and qualify for health insurance tax credits (aka subsidies) based on family size and income.  This is important stuff for the self employed and middle income families paying for their own health insurance.  For instance, a family of five in New Jersey making $109,000 per year can expect the government to pay almost $9000 toward their insurance premiums in the form of tax credits.  But if someone in that family gets a $1001 raise, or if a child gets a part time job after school and makes a couple thousand bucks, they will get $0 in subsidies.  That raise and or taking that job will cost this family (which is struggling with high cost of  living in NJ as it is) $8000 per year.  A family in this position is far better off not taking the job or forgoing the raise.   “Sorry son.  I understand you want to get that first job and start working for a living, but we just can’t afford it right now!”

We are also finding this to be fertile ground for early retirement planning.  Those who retire before the age of 65 often need to purchase individual health insurance policies, which can be quite costly.  However, early retirees with money in both taxable and tax deferred retirement accounts are often able to keep income low during the first few years of retirement by deferring Social Security and using taxable investments rather than tax deferred accounts.  (withdrawals from 401k and IRA accounts are taxable income).  By carefully managing retirement income during these early years, many retirees can likely qualify for very valuable health care subsidies.  In some cases, the government will pay for your entire health insurance bill – even as you sit on a very large retirement account!

It might even make sense to forgo the COBRA insurance offered by your employer.   Why?  Because the premiums you pay for a COBRA policy are not eligible for tax credits unless you buy your policy on healthcare.gov.

The law is a dream for financial planners.  It is complicated, cumbersome, and difficult to understand – but offers great opportunities for those who incorporate the law into their financial planning efforts.   Complicated may not be good public policy, but it is more job security for financial planning professionals!

Debit Card Security Concerns

credit card security

Debit cards are very popular.  Unlike credit cards, you have no statement to pay.  If you don’t have cash in your account, you can’t buy anything – so they act as a sort of budget enforcer.  There is no temptation to “let the balance ride” at the end of the month, which can result in a snowball accumulation of debt.

But for all the benefits, there are also significant additional theft risks.  As this article at Bankrate.com points out, debit cards offer signficantly less fraud protections than credit cards.  Since money comes directly from your bank account, it is gone before you discover the fraud.  With credit cards, the money is only gone from the card issuer account – not yours!  Typically card companies will immediately credit your account if a fraudulent charge is made pending any fraud investigation.  With debit cards, you need to wait and hope for the bank to replace money into your account.

I am not recommending throwing away your debit/ATM card – but be smart and cautious when using them.  The Bankrate.com article does a great job explaining the risks.  I myself was surprised at the innovative ways crooks can steal card data!

Best Practices for Emergency Reserve Funds

Where will you find the funds to handle a financial emergency or major unexpected expense? 

As a Certified Financial Planner(tm) I am always concerned that my clients be prepared for all manner of financial emergencies.  One way to be prepared is to maintain an adequate emergency reserve fund.  The most commonly offered advice seems to be based on a very simple rule of thumb:  Keep 6 months of expenses in liquid cash savings such as a bank savings account or money market.  But the reality is that things are not so simple.  Why not?  Simply because some folks are better equipped to absorb unexpected expenses than others.

But before going into the nitty gritty of HOW MUCH money to set aside, let’s consider the question of how best to build and manage those reserves.

Starting, Adding To, Using, and Replenishing Your Emergency Fund. 

Lets say you have no emergency fund at all.  So you will start to divert money from each paycheck to go into savings. How much?  As much as you possibly can until you reach your emergency savings goal.  Go through your budget carefully and cut out all unnecessary expenses.  Spending $8 / month for lunch?  Pack and put $8/day ($168/month) in your emergency fund?  No eating out.  No vacations, basic cable (or cut the cord), Trakphone instead of Smartphone, you get the idea?  Too many people relax and stop saving as soon as the pressure of unpaid bills lets up.  This is ill advised.  Not having adequate emergency funds is a financial disaster that just hasn’t happened yet.

So if you are careful with your money and do the heavy lifting on the budget, you will soon meet your saving goal.  If no emergencies have occurred, you can relax a little on the budget.  Maybe direct some of what you were saving into long term retirement or college savings, while spending a little more on discretionary fun stuff.

If you need to tap the reserves however, you need to immediately go back to work replenishing those reserves as quickly as possible so you are prepared for the next emergency.

How Much is Enough?

So how much emergency savings is enough?  This depends on how you answer the following:

  • Do you have other liquid assets (non-retirement investments, etc.) which you could tap in an emergency without incurring taxes, penalties, surrender charges, etc.?
  • Do you have large untapped lines of credit available (unused credit card or Home Equity Lines of Credit)?
  • Is your job and income source secure and stable?

The more yes answers you offered to the above questions, the fewer months you need in traditional emergency reserves.  If you answered no to all or most of the questions, you should probably be aiming for a goal of at least 3 months income in liquid savings before you let up on the aggressive saving habits.

Have Credit Card Debt?   So you have substantial high interest credit card debt?  Here I become flexible.  Interest on credit card debt is devastating to the budget.  And if you pay down (and stop using) credit cards, you can always use those cards again in an emergency.  So I am willing to accept that paying down credit cards can be an acceptable back door way to build a source of funds for emergencies.  The risk is that if your credit is bad, the banks may reduce your credit line as you pay off your balances.  But that may be a risk you need to take.

Investing Your Reserve Funds.  While traditional advice has been to keep emergency reserves in ultra safe and liquid bank accounts, I now permit my financial planning clients to consider investing some of their emergency funds into their non-retirement investment accounts.  While one would rather not have to sell investments to cover an emergency spending need – I may be willing to accept that risk rather than accept tying up substantial sums of money earning today’s 0 interest rates.  The portion of the account that may be needed for emergencies can be invested in lower risk short term bonds or other conservative investments.

Will Your Health Care Expenses Exceed Social Security Income?

Article suggests retirees will soon devote 100% of their Social Security to health care.

In another sign that health care costs are out of control, an article in Investment News, a widely read publication in the advisory industry, suggests that middle income retirees may see overall health care costs exceed their total Social Security checks within a decade.  Is this the last straw for your retirement dreams?

The premise of the article is based on analysis of the newly created Retirement Health Care Cost Index, devised by a provider of financial planning tools.  The projection is based on the average Social Security checks for a married couple of $1294 for the higher earning spouse and $817 for the lower earning spouse.  By the time that average couple has finished paying for Medicare parts B and D (prescription coverage) as well as a Medigap policy and common out of pocket medical costs, health care is already consuming 69% of that couple’s social security check.  Within 10 years, that percentage is forecast to increase to 99%.  Read the rest of the article here…

So will we really be living to pay for health care costs and nothing else?  Well, not necessarily.  First, the article suggests that health care costs will continue to increase at 5-7% over time, while Social Security will increase by 2%.  While this may be based on recent trends, there is no certainty those trends will continue.  Both college and medical costs are already running up against a ceiling based on people’s ability to pay.  People are reluctant to reduce medical or college outlays when prices increase (which is exactly WHY those prices keep rising) – but that reluctance has limits.  Higher costs ultimately reduce demand, and reduced demand dampens further price increases.  I don’t expect prices to stop rising, but I do expect the pace of increase to slow down.

In addition, most retirees find that day to day a good Medigap policy combined with Medicare part B and D, cover most of their health expenses (not counting long term care!).  In New Jersey, there is also state aid available for lower income seniors (regardless of asset levels) in the form of the Pharmaceutical Assistance for the Aged and Disabled program which may pay 100% of their prescription drug costs and part D premiums. Under this program, “lower income seniors” would include most seniors whose primary source of taxable income is Social Security.  If you or a loved one is a senior with income under $26,130 for a single or $32037 for a couple, you can apply for PAAD benefits.  Learn more at http://www.state.nj.us/humanservices/doas/services/paad/

So while perhaps overstating their case, the article does make a very good point – retiree health care costs are significant, and Social Security benefits are an insufficient source of income for a sound retirement.  Health care costs, Medicare surcharges, and supplemental insurance do absorb a sizable (and growing) chunk of many Social Security checks, leaving little left over for rent, utilities, and food.

What does one do about it?  Plan carefully before leaping into retirement.  Maybe you need to work a few more years.  Maybe you need to save a little more.  A sound financial plan can ensure that you are prepared for whatever the future throws your way – including rising health care costs.  Haven’t created your plan yet?  Our Fee Only Certified Financial Planners™ have the experience and specialized knowledge required to help. Call us for a free retirement readiness checkup today.