Fees can take a big bite out of retirement fund contributions

Personal Finance

Making an annual contribution to a retirement plan? A recent study could give you pause. It says that more than half of the average person’s IRA contribution is being eaten away in fees.

“People need to understand that fees are lethal,” said Mitch Tuchman, chief executive of a self-help portfolio management website called MarketRiders, which conducted the study of fees. “They are a hidden tax that people have no idea they’re paying.”

The study focused on the $1.88 trillion in retirement money that’s invested in mutual funds. (An additional $2.3 trillion in retirement money is invested in certificates of deposit and insurance products. The study did not attempt to assess the effects of fees on that portion of retirement savings.)

Using data published by the fund industry’s primary trade group, the Investment Company Institute, Tuchman estimated that fees paid by the average investor amounted to roughly 2% of assets -- or some $2,180 annually.

The average saver contributes $4,000 annually to an IRA, which means that a whopping 54% of this contribution is eaten up by fees each year.

Allan S. Roth, a certified financial planner and Colorado-based wealth advisor, has also analyzed investor fees and believes that Tuchman’s conclusions are on the mark.

“Fees are a huge deal,” said Roth, who sponsors a website called “The more you save, the bigger the impact.”

Fees hit diligent savers the hardest because mutual fund fees are calculated as a percentage of your assets. Thus, a person with a $10,000 account would pay just $200 annually if he or she were paying 2% in fees, while a person with a $100,000 account pays $2,000 for essentially the same service.

“Even though 1% or 2% seems like a little bit, it’s 1% to 2% of all of your money every year,” Tuchman said. “That’s a big portion of your investment profits.”

In fact, it’s about half of the average investor’s “real” return, Roth said.

The typical investor can figure on a 7% to 7.5% average annual return in a diversified portfolio, Roth said. But about 3% of that return is eaten up by inflation. If you earn 7%, your return after inflation is just 4% on average. Now pay 2% in fees and roughly half of your return is gone.

What does that cost you in real money? The answer depends on how much you save and for how long.

Tuchman estimates that a 35-year-old who puts $4,000 in IRAs each year will lose roughly $1.1 million to high fees and lost investment income by the time she’s age 76. (That assumes a 7.5% average annual investment return. If she saves more, or earns a better return on her money, the cost is higher.)

So, what’s the solution? Both Tuchman and Roth recommend the same course: Buy only index mutual funds or so-called exchange traded funds, which mimic the returns of a broad market index.

Index funds and ETFs typically charge paltry fees because there’s no “management” required. They simply buy all the stocks that make up a set index -- such as the Standard & Poor’s 500 -- and hold them.

The only time these funds will trade the stocks they own is when a company disappears from the relevant index as the result of a merger, acquisition, business failure or change in the index structure.

(That’s a benefit to people who invest outside of retirement accounts too, Roth notes. That’s because actively managed funds trade stocks, generating capital gains that investors have to pay tax on each year. Because index funds don’t trade, they don’t generate taxable gains. Their shares appreciate, just like the others. But you have to pay tax on the gains only when the stock is sold.)

What if you’re investing in a 401(k) plan that doesn’t offer index funds or ETFs? At least find out how much you’re paying, Tuchman suggests.

To do that, look up your fund at Morningstar, an investment research and mutual fund rating firm headquartered in Chicago.

At the top of the page, you can enter the ticker symbol for any fund you are invested in to access a full report. Near the top of the fund report page is a button for “expenses.” Click on that and you can find out what percentage of your assets are being paid out to manage the fund.

Now multiply the amount you have invested in that fund by the relevant fee to find out how much you, personally, pay annually. If you had $100,000 in the Vanguard Mid Cap index fund (VMISX), for example, you’d discover the total fees paid in 2009 amounted to 0.14% of assets. That works out to a cost of $140 a year.

On the other hand, if your assets were invested in Van Eck Multi-Manager Alternatives (VMAIX), an actively managed fund that tries to beat market performance, you’d be paying 2.3% of your assets, or $2,300 annually.

“The investment advisor does no more work to manage a $25,000 IRA than he does to manage a $250,000 IRA, but the customer is charged 10 times more because of the asset-based fee model,” Tuchman said.

“So the closer this investor gets to retirement, the more he’s paying in fees,” he said. “It’s like pressing on the brakes when you start getting near to your destination.”