By Mark Miller
CHICAGO, June 26 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
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
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
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
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
"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."