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How half a percent can ruin your retirement

Mutual fund fees can eat up a chunk of your retirement savings -- and you might not even be aware that it's happening.

By MSN Money Partner May 5, 2011 9:31AM

This post comes from partner blog The Dough Roller.

 

Last year one of my largest expenses was one I never saw. I didn't get a bill for it. And I didn't have to pay it, at least not directly. But it still cost me a small fortune. I'm talking about investment costs in the form of mutual fund expenses.

 

Mutual fund expenses present two big problems. First, because you don't actually get billed for them, it's easy to forget about them. The cost comes out of your investments, so you never have to write a check for the expense. 

 

The second problem is that even small expenses can add up over time.  

 

Because we save and invest for retirement over several decades, even half a percent can have a huge impact on our retirement. In fact, an extra half a percentage point paid in mutual fund fees can be the difference between a comfortable retirement and living on a shoestring budget.

Here's why expenses are so important. The difference between paying, say, 0.5% and 1% in fees for your mutual funds is enormous over a 40-year investment period. Here's the math, assuming you start with nothing and add $1,000 a month to your retirement savings (take a guess at the difference before you read on):

 

Average return

Balance after 40 years

8.00%

$3,514,281

7.50%

$3,042,721

 

Given the effect of even 0.5% on retirement savings, there are two things we need to do:

  • Determine the cost of our retirement investments.
  • Depending on the results, make changes to reduce our costs.

Determining the cost 

If you have invested in just one mutual fund, determining your investment costs is easy --just look at the fund's expense ratio. If you don't know where to look, simply get the ticker symbol of your fund (which should be on your last statement) and enter it into the Google search box or look it up at MSN Money. For example, when you enter VEIEX (a Vanguard emerging market index fund I've owned since 2002), this is what you find.

 

As you can see, the expense ratio is 0.35%. That means that for every $100 invested in the VEIEX fund, you'll pay 35 cents in expenses each year. Post continues after video.

If, like many people, you own more than one fund, you'll want to calculate your weighted average cost. To do that, for each fund you own perform the following calculation:

Amount invested in fund / Total invested in all funds x Fund's expense ratio

For example, if I had $10,000 invested in VEIEX and a total portfolio of $100,000, my calculation for VEIEX would look like this:

$10,000 / $100,000 x .35% = .035

Perform the same calculation for each fund you own, and add up the results. What you'll get is the weighted average cost of your funds.

 

And if you hate math, track your portfolio in Morningstar (it's free), which calculates the weighted average cost of your portfolio for you (here are the details).

You should aim for a weighted average cost of no more than 0.5%, in my opinion. If your costs are significantly higher, keep reading.

 

How to reduce the cost

There are several ways to reduce the cost of investing for your retirement:

  • Invest in index funds. Index funds generally have significantly lower expense ratios than do actively managed funds. Because index funds track an index like the S&P 500, you don't have to pay for the cost of investment managers to evaluate and pick stocks. And the performance of index funds generally beats managed funds over the long haul anyway.
  • Invest in ETFs.Exchange traded funds typically have a lower expense ratio than identical mutual funds. You do have to pay a brokerage fee to buy ETFs, but unless you are an active trader, the fee should be less over the long term than the extra expenses you'd pay for a mutual fund. 
  • Reduce trading costs. If you are a fairly active trader, you must watch the transaction costs of your investment activity. There are plenty of low-cost online brokers to choose from. I use Scottrade because it has branches everywhere, but you can find even less expensive brokers like OptionsHouse and Zecoo.

More on The Dough Roller and MSN Money:

 

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