By Mark Miller
CHICAGO, June 26 (Reuters) - Mutual fund costs will be Topic A this fall around many kitchen tables when workplace retirement savers start receiving the new government-mandated quarterly statements spelling out exactly what they are paying for their 401(k)s. But a kitchen table chat is also in order for retirees.
After all, smart portfolio management is important in retirement, too. Retirees draw down assets to pay living expenses. Fees are still being levied on those accounts - and they can have a much larger impact on retirement lifestyles and portfolio longevity than most people understand.
"There's a portion of your assets that are being spent to pay the investment managers" says John Ameriks, who heads up investment counseling and research at Vanguard. "And there's a portion of the assets that are being spent to pay you. When we do drawdown analysis, we just look at aggregate spending. But to the extent the expense ratio is higher, that cuts into what you can spend."
Ameriks ran the numbers recently to demonstrate the impact that investment costs can have on retirees. The results suggest many retirees could get more mileage from their nest eggs by paring costs - either by jumping ship from a former employer's high-cost 401(k) plan, or by ditching high-cost actively managed funds.
Ameriks started with some basic assumptions. An investor retires at age 60 with a $100,000 portfolio, and plans to spend 4 percent of her portfolio balance at the beginning of each year thereafter. She can choose one of three identical portfolios to generate 5 percent before-cost total investment return; the only difference among the three is investment cost - 0.25 percent, 1 percent or 2 percent. For purposes of simplicity, Ameriks assumed reinvestment of all dividends and distributions and no taxes on the returns.
The three portfolios each start with the same $4,000 withdrawal, but diverge sharply from there. By the time our retiree hits 65, the high-expense portfolio is generating a withdrawal 8.3 percent lower than the amount for the low-expense portfolio. After 15 years, the gap widens to more than 20 percent - a huge reduction in spending power.
"The differences sound small to most people," he says. "I'm going to withdraw 4 percent, and I'm going to pay 1 percent in fees. But that 1 percent is equivalent to 25 percent of what you're paying yourself. And what people seem to forget is that expense ratio hits over and over again - year in and year out. It hits the base of your portfolio, and since you're withdrawing a fraction of the base, it's also going to hit your income."
The impact on account balances over time is equally dramatic. Ameriks found that by age 70, there could be a difference of more than $16,000 in the balances of the low- and high-cost portfolios - and by age 90, the difference could be over $45,000. (Learn more about Amerik's scenario at his Vanguard blog:)
Of course, Ameriks' scenario assumes that you aren't getting value in return for higher fees - in the form of higher returns. That's the axe Vanguard grinds in this debate, since it's the leader in low-cost fund investing. But his assumption is backed up by a good deal of independent research, which does show that low-cost passive investing beats active fund management over the long haul.
For example, a 2006 report to Congress by the U.S. Government Accountability Office (GAO) found that a 1 percentage point increase in fees reduced return over a 20-year period on a typical portfolio by 17 percent. And a Morningstar study found that domestic equity funds with the lowest cost in 2005 returned an annualized 3.35 percent over the time period studied, compared with 2.02 percent for the most expensive group.
Jessica Ness, director of financial planning at McLean, Virginia-based Glassman Wealth Services, agrees that low-cost index funds are an appropriate place to start. "Our default always is a low-cost index fund - our managers have to explain how they plan to beat it with something else," she says. But she argues that actively-managed funds offer specific investing strategies that can be very appropriate in volatile markets like the one we're experiencing now.
"Passive investing makes a lot of sense when the bull market is roaring. But we like active funds when the bears are pounding the table, because the manager has the ability to avoid losers. That can help pare the volatility and smooth out the zigs and zags," she says.
A typical Glassman client portfolio will have 15 percent in a passive large-cap fund, with the rest in specialized active funds. Two current favorites aim for high yield with minimal or zero interest rate risk: DoubleLine Funds Total Return Bond Fund , which focuses on mortgage-backed securities; and the Arbitrage Fund, which aims to make money on disparities in the stock prices of companies with pending mergers.
"Vanguard's point about the problems of holding a high-cost investment over time makes sense," she adds. "You just have to know if you're getting what you paid for. And we think there are strategies where you absolutely do. You have to find the flower between the weeds."