Millennials Take Note: How A 1% Fee Could Cost You $590,000 In Retirement Savings by Dayana Yochim and Jonathan Todd, NerdWallet
Millennials have decades to save for retirement, but also decades of exposure to avoidable investment fees. NerdWallet analyzed a variety of scenarios and in one case found that paying just 1% in fees could cost a millennial more than $590,000 in sacrificed returns over 40 years of saving.
Millennials have something that everyone saving for retirement covets: Time.
Time is on their side in almost every way related to building wealth. With 30 to 40 years until retirement, the generation born after 1980 has plenty of time to put money aside and for savings to compound and grow. But time can also be a huge drain on this generation’s financial well-being.
A new NerdWallet analysis of how investment fees can eat into the future savings of today’s millennial investors found some staggering numbers. Just like the accelerating effect compound interest has on the growth of savings, the same thing happens — only in the opposite direction — when investment fees compound.
The double blow of investment fees
The impact of fees is twofold: An investor pays an ever-increasing amount in fees as account balances grow, because the fees are based on a percentage of assets. And fees also strike a blow to the portfolio’s returns. That’s because every dollar taken out to cover management costs is one less dollar left to invest in the portfolio to compound and grow. So in addition to paying potentially hundreds of thousands of dollars in avoidable fees, our research shows that an investor gives up many times that amount in lost portfolio returns over time.
To examine the effect of fees on a millennial investor, we looked at different investing scenarios for a 25-year-old who has $25,000 in a retirement account, adds $10,000 to the account every year, earns a 7% average annual return and plans to retire in 40 years.
- In one of the scenarios analyzed, paying just 1% in fees would cost a millennial more than $590,000 in sacrificed returns over 40 years of saving.
- A millennial with the option of investing in either of two commonly held funds can save nearly $215,000 in fees — and, through the magic of compounding, retire nearly $533,000 richer — by choosing the one with fees that are 0.93% lower.
- By assembling a low-cost exchange-traded fund, or ETF, portfolio on his own and rebalancing it once a year, a millennial can retire $345,000 richer than if he uses a target date mutual fund.
- Outsourcing portfolio management to a robo-advisor will cost a millennial investor $232,000 in fees, though the same investor could end up paying nearly twice as much — almost $454,000 — using a target date mutual fund instead.
How the cost of fees accelerates over time
We started our research by looking at how fees fester in a single mutual fund invested in a diversified mix of midsize companies; mid-caps, in Wall Street parlance. To show the impact of fees over time, we used a zero management-fee investment as the baseline for this comparison.
Mutual funds are a staple in many portfolios, including employer-sponsored plans such as 401(k)s. The example below is based on a mid-cap mutual fund with a 1.02% expense ratio, or management fee, that, according to fund-tracker Morningstar, is below average for funds categorized as U.S. mid-cap equity blend.
Because the 1.02% investors pay annually is taken out as a percentage of the portfolio’s value, the larger the portfolio, the more an investor pays:
|Number of years invested||Total fee impact||After-fee investment value||Investment value lost to fee impact|
As is true for every investor, regardless of age, there’s an opportunity cost associated with taking money out of a portfolio to cover fees. The table above shows how the additional decades millennials have to invest amplifies the effect.
Even though the investor continues to get the same 7% average annual return, our analysis shows the percentage of value lost to fees climbs higher as the years pass. In this example, from ages 45 to 65, the loss to fees increases from 12% to over 25%. In all, over the course of 40 years, the impact of fees is more than $592,000.
Fees will take a toll out of any investor’s portfolio, and that acceleration in cost as a portfolio grows is a reminder that Gen Xers and baby boomers should also pay close attention to fees. But millennial investors, who’ve come of age in an era in which low-cost investing products have taken off, can, with a little work, avoid the toll of investing fees far earlier.
“Everyone talks about the benefits of compounding interest, but few mention the danger of compounding fees,” says Kyle Ramsay, NerdWallet’s head of investing and retirement.
“We would not suggest only looking at fees when making investment decisions,” he says. “However, consumers need to think carefully about what they hope to get from an investment service or product, and whether that benefit is worth the fees. As illustrated, 1% versus 0.5% may not feel like much over the course of a year, but when saving for retirement, it could mean the difference between retiring at age 70 versus retiring at 73.”
A millennial’s best defense: Scrutinize actively managed mutual funds
Unlike actively managed mutual funds — where human money managers are in charge of picking stocks and making the buy, sell and hold decisions — index funds and index-based ETFs are programmed to mimic a benchmark index. In an index fund, stocks are bought and sold based on their proportional size in a particular stock market index, such as Standard & Poor’s 500 index. ETFs are index funds chopped up into bite-sized shares that trade like stocks.
Since index mutual funds forgo the salaried and staffed human element, they cost a lot less to run than actively managed funds.
Paying more for a mutual fund that is actively managed would be justified if these funds consistently outperformed their index-based peers. But studies show that roughly 80% of actively managed funds underperform market-indexed funds and ETFs — often by margins that are nearly identical to the extra fees charged by managed funds.
The good news for millennial investors: the number of ETFs grew from 80 to over 1,400 from 2000 to 2014, according to the Investment Company Institute 2015 Factbook. The growing availability of low-fee alternatives gives millennials a significant edge.
A millennial can retire $533,000 richer by shaving 0.93% in fees from a portfolio
We compared the actively managed mid-cap fund with a lower-fee alternative, an ETF that offers similar exposure to midsize companies. The main difference between the two funds is that the ETF has a 0.09% expense ratio — 0.93% less than what the actively managed fund charges in management fees.
We used the same assumptions: a $25,000 initial investment, $10,000 added annually and a 7% average annual return over 40 years. Over time, the 0.93% difference in fees adds up.
The table below shows that by choosing the lower-cost ETF, the millennial investor retires with $533,000 more in his account ($2.3 million versus $1.8 million) and instead of losing 25% of the portfolio’s value to fees, the damage is limited to just 2.5%.
|Number of years invested||Total fee impact