Investing Fees Will Leave You Broke During Retirement

If you’ve been paying attention you probably know that investment fees will reduce the value of your retirement portfolio over time.

For example, Questrade argues that by switching to a lower cost investing platform you could retire 30% richer.

All this is true. Essentially, whatever you pay in fees is foregone wealth. I.e. if your annual fees are 2% and your gross return is 8%, your net return is reduced to 6% after fees.

Remember: fees can be layered (often covertly) into your portfolio in multiple ways – advice fees, investment management fees, tax, operating expenses, and so on. Sometimes the fees are bundled, sometimes they’re charged separately. Buyer beware.

Unfortunately, high fees will do much more damage than leave you ‘less well off’ at retirement. High fees could mean the difference between going broke or not.

Check out the following example for Joe Smith retiring at age 65 with a $1,000,000 portfolio. Sounds like plenty of money for retirement, right? Well, the level of fees mean the difference between Joe eating ham sandwiches and cat food for lunch.

Start with the following assumptions for Joe:

  • Requires a frugal annual income of $40,000, adjusted for inflation
  • Will live until age 95
  • Builds a balanced growth portfolio consisting of 80% stocks and 20% bonds
  • Has a 10% average tax rate

What are the odds Joe goes broke before he dies?

Calculation methodology for the data geeks: Using data made available by https://engaging-data.com/ , the probabilities are calculated by using stock and bond returns between 1871 and 2016. For example, if an investor expects to be live for 50 years in retirement, all historical 50 year periods are analyzed. One historical cycle would be from 1871 to 1922, another one from 1872 to 1923, and so on until 1965 to 2016. Thus 95 different historical cycles are considered (in this example).

The chart below shows the portfolio failure rate, based on historical precedent, for Joe Smith at various fee levels. “Portfolio failure rate” essentially shows how often during the historical periods the portfolio ran out of money before the end of the period (in Joe’s case 30 years).

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Investment fees have a significant impact on the portfolio failure rate. In Joe Smith’s case, the portfolio failure rate rises from 18% when the investment management fee is 0.30% to a whopping 42% when the investment management fee is 2.50%.

Hold up…think about what this really means. Imagine what it would be like to run out of money as a senior citizen.

This is a deadly serious issue and a catastrophic failure of the wealth management industry. The average retiree is getting screwed out of their money leaving them completely broke during retirement. This creates massive hardship, as a broke retiree often has no way of recovering and has to rely on the state, charity or family for food and shelter. Dignity and independence, however, are lost forever.

While the difference between 0.30% to 2.50% sounds very wide, this is the realistic range for investors in Canada.

For example, Cambridge Canadian Equity Fund charges an MER of 2.48%. AGF Global Strategic Balanced Fund charges 2.63%. Mackenzie Canadian Growth Balanced Fund charges 2.29%.

Meanwhile, at the other end of the spectrum, Questrade provides all-in portfolio services for 0.38%. Finally, a DIY investor can combine Vanguard’s FTSE Canada All Cap Index ETF, which has a 0.06% fee and Canadian Aggregate Bond Index ETF, which has a 0.09% fee.

Investors who do a little investigating will better understand their costs and be able to shift from one end of the spectrum to the other.

Bottom line: Pay close attention to fees, as this is one of the few parts of investing that is totally within your control. Over the long run it will have a huge impact to your standard of living and independence.

Compounding and the Self-Funding Portfolio

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Albert Einstein
Aivazovsky Shipwreck, 1856, pencil and gouache on paper

Let’s say you’re 20 years old and have 40 years until retirement. If you’ve been reading this blog you know that you need to start saving and investing early to get time on your side.

You’ve also probably seen growth charts – like the one below – showing how an annual contribution of $10,000 to a portfolio that returns 6% would grow over the years. This illustrates the simple concept that time + return on investment provide exponential growth over the long run.

This is the power of compounding

Compounding describes how an investor gets returns on their initial investment plus returns on the returns on that initial investment. Returns on returns – that’s when your money starts really working for you. That’s when it takes a life of it’s own.

When contributing regularly to a retirement nest egg, there is a point after which your portfolio learns to fly on its own.

In the early days, your portfolio is small. So most of your portfolio’s growth is dependent on your contributions. During this time, investing feels like an uphill battle – it’s more an exercise in saving than generating returns. This is frustrating for many, as the dollar value of annual portfolio returns are small during this period. The vast majority of annual portfolio growth comes from your contributions.

However, over time this eventually changes. At an average annual return of 6%, portfolio returns outpace contributions by about year 13. As you can see in the chart below, once this point is passed, the portfolio becomes self-funding in a way, with the dollar value of annual portfolio returns increasingly outpacing the value of annual contributions. Of course, it is best not to think of the portfolio as self-funding, and you should keep contributing to accelerate future growth.

It isn’t until these later stages that you truly start to see the benefits of compounding.

The chart below shows the same thing as the previous chart, except it shows annual portfolio return and annual contribution as a proportion of portfolio growth. I think this really highlights why people get frustrated in the early years of investing. You can see how in the early years, the only growth is due to your own personal sacrifice. Your friends are spending their paychecks on BMW payments, while you suffer in silence to fund your portfolio with little to show for it.

However, while your friends have a negative net worth 13 years later, you’ve built a portfolio that has really started to take off.

How a High School Student Can Create $1 Million in Wealth

In this article I will explore how a teenager can set themselves up for retirement before even graduating high school. Indeed, it is possible to build over $1 million in future wealth before starting college.

Methodology

Most teenage students can manage part time work during the school year and full time work during the summers. With few expenses, the teen is able to invest every dollar earned. Of course, not all students will fit this profile. Some won’t find work. Others will be required to help with family expenses. But I think – with enough discipline  – many students can make this a reality.

I believe that the more hours you work at a part time job while in school the worse your academic performance. Therefore, I will keep weekly working hours during the school year at a very manageable level.

After all, this whole exercise is about setting up a successful future. That includes future earnings, which is dependent on a good education. So this experiment should not come at the expense of future earnings.

Also Read: Is Your Scarcity Mindset Holding You Back?

Assumptions:

  • Let’s assume that during the school year the student works one 8hr shift per week. 
  • School year is 40 weeks
  • During the summer, let’s assume the student works a 40hr week.
  • Summer is 8 weeks
  • Starts working in grade 9 through to grade 12
  • Earns $15/hr ($1 above minimum wage in Ontario, Canada)
  • No taxes or transaction costs

Based on these assumptions, the student would earn $9,600 each year (see table below) for four years.

But how does he turn this into $1 million by retirement?

Observations

If the student invests the $9,600 at the end of each of the four years and does nothing else, he could have over $1 million by age 65. The chart below illustrates how the investments would grow assuming average annualized returns of 5, 6 or 7%. (These are conservative estimates given long term historical returns are close to 10%.)

Of course, $1 million in the future will be worth less than $1 million today due to inflation. The chart below adjusts the investment returns to account for an annual inflation rate of 2%. Still, the student’s initial investment ($9,600 × 4) is worth between an estimated $166-430k by age 65 in today’s dollars.

That is more than most 40 year olds currently have saved for retirement. Can you imagine what this might look like if the student kept investing throughout his life?

The message here is simple. Start investing as young as possible and let the power of compounding grow your wealth.