Administrative Costs

Posted January 2009; Revised January 2015 John Spitzer & Todd Houge

Administrative costs are vitally important in wealth management. In this section we show the impact of small costs, and discuss some cost areas you need to watch carefully: Mutual Funds Costs, Financial Advisor Costs, and 401k Plan Costs.

Small costs have a large impact in wealth management for two reasons. First, you don’t have much to work with. Consider stocks – the historical average real rate of return (taking out the part representing inflation) for stocks is about 7% per year, so a “small” charge of 1% per year represents a substantial reduction in the realized return. Returns on bonds and money market investments are lower, so the relative impact of the same “small charge” would be even greater. Second, the time horizon for wealth management is usually quite long. Retirement savings invested today by a 30 year-old worker may remain invested for 30, 40, or even 50 years.

Impact of Small Costs

To illustrate the impact of a “small costs,” suppose you invest $10,000 at age 30, at a 7% real return rate, and hold it to age 70. At age 70 you would have:

$10,000 x (1.07)40 = $149,745

If I make the same investment but pay 1% in additional fees every year, the realized real return per year is 6% rather than 7%. So, at age 70, I would have:

$10,000 x (1.06)40 = $102,857

You would have almost 50% more than I. Want to trade? As noted by John Bogle, “in wealth management, you get what you don’t pay for.”

Mutual Fund Costs

Mutual funds have an assortment of fees – Loads, Management Fees, Turnover Costs, and Tax Costs. You need to watch all of them.

Loads

There are several types of sales charges, known as “loads” that can be found in mutual funds. A front-end load is a one-time charge made at the time of the investment. By law, the amount of this charge can be no more than 8 ½ percent[1] of the amount invested; the average maximum front-end load was 5.3% in 2013 [2]. Some advisors have argued that this charge dwindles to insignificance if you hold the fund for a long time. We disagree.

Consider the example above where you invest $10,000 in a portfolio that yields an average 7% per year real return. After 40 years, you would have

$10,000 x (1.07)40 = $149,745

If, however, you pay a 5% sales load at the time of the investment, only 95% of our $10,000 is actually invested, and after 40 years you would have

0.95 x $10,000 x (1.07)40 = $142,257

Which do you like? Any way we look at it, if you pay a 5% load you will end up with 5% less than you would receive if you didn’t pay that load.

Other funds have sales charges that you incur when the fund is redeemed (back-end loads). In some cases, the charge is reduced or eliminated if you hold the fund for a specified term.

Then there are funds that assess sales charges during the time that you hold the fund. These are called 12b-1 fees, and they are assessed on a daily basis. The 12b-1 fee rates are typically between 0.25% and 1% per year[2]. Class B and Class C shares typically have 12b-1 fees[3].

Not all mutual funds have sales charges. The funds that do not have sales loads are called no-load funds.

To our knowledge, there is no evidence that funds with sales charges perform better than funds without such charges. Since sales charges without any offsetting benefits represent a pure drag on performance, the wealth management gurus are in strong agreement that you should avoid funds with sales loads. We concur.

Management Fees

Mutual funds also have management fees, which range from less than 0.10% per year to over 3% per year. In general, index funds have lower management fees than actively managed funds. The average management fee rate for actively managed funds is about 0.74% per year; the management fee rate for several of the large, broad market index funds is less than 0.20% per year[2].

Do the actively managed funds have sufficiently higher returns to offset their higher management costs? Many of the wealth management gurus have strong belief that they do not – Burton Malkiel and John Bogle come to mind as being in that category – and others are quite skeptical. The enormous variation in stock returns over the years makes it difficult to answer this question definitively, but the statistics show that most managed funds fail to perform as well as the indexes. On the other hand, there have been managers who have outperformed the market for reasonably long periods of time.

In our view, while we don’t rule out the possibility for a manager to beat the index over a long period of time, we are generally skeptical. We would also point out that you have to find that manager who will outperform, and there are lots and lots of funds asking for your investment.

A final word of caution about index fund fees – just because a fund is an index fund doesn’t automatically mean that it will have low management fees. There are some index funds with rather high management fees. As you would guess by now, we recommend avoiding such funds.

Turnover Costs

Most mutual funds have turnover costs – as they buy and sell assets, they incur trading costs. Because they have higher turnover, the actively managed funds also incur more transactions costs compared with index funds. It is difficult to determine the level of these costs, but some research has indicated that they can be significant.

Tax Costs

In addition, if the fund is held outside of a tax shelter, the owner of an actively managed fund incurs taxes each year on any net gains realized by the fund. These gains are usually classified as short-term gains (which are taxed at ordinary income rates rather than the lower long-term capital gains tax rate).

Financial Advisor Costs

Financial advisors can provide you with useful services. But, if you use a financial advisor, you need to know how they charge for their services. There are 3 common approaches: commissions on sales of products, a charge calculated as a percentage of assets under management, and hourly rates.

Commissions

Some financial advisors sell products to their customers (such as mutual funds, tax deferred annuities, and insurance policies), and receive compensation in the form of commissions on those sales. The sales load on mutual funds (discussed above) is an example. Many of these advisors advertise that they do not charge fees. This statement is technically true, but misleading – you still pay.

Most of the wealth management gurus view this form of compensation as representing an inherent conflict of interest – the advisor has an economic interest in promoting products with higher compensation and relatively little interest in promoting products that do not provide any compensation. We concur in this assessment.

Percent of Assets

Other financial advisors calculate their fees as a percentage of assets under management. Many of these advisors call their compensation “fee only” to distinguish it from sales commissions. A common percentage is 1% of the first million dollars under management, with a declining percentage above that point[4].

We agree that the “percentage of assets” approach aligns the interests of the advisor with the interests of the investor in a much better fashion than the commissions approach (where the interests may be opposed to each other). We disagree, however, with those who argue that the alignment is near-perfect with the “percentage of assets approach.” From a purely economic stance, we think the interests of the advisor are most closely aligned with keeping the balances under management.

To illustrate, suppose you have a $500,000 portfolio under management and the advisor is contemplating a strategy that might increase your portfolio by $5,000 but might also cause you to close your account. Let’s see … a 1% fee on a $500,000 portfolio is $5,000 – about the same as the $5,050 fee on a $505,000 portfolio. But if you close the account, the revenues to the advisor drop to zero. (You might be wondering what circumstances could possibly fit this scenario. It’s the case where the investor has become knowledgeable enough to manage her own portfolio – closing the account and eliminating the 1% fee will increase it’s value in one year by $5,000.)

We see one other potential difficulty with the “percentage of assets” approach – if you have a reasonably large portfolio, the actual fee can be rather large. In our illustration above, the fee for the $500,000 portfolio is $5,000 every year. That’s OK – if you are receiving $5,000 of service every year.

Hourly Rates

There are a few financial advisors who use hourly rates. We like this form of compensation – there are none of the potential conflicts that commissions pose, and the charge is commensurate with the advisor’s time. The one difficulty with this approach that we have observed is the size of the hourly rates that many advisors charge. Frequently they are higher than the rates charged by attorneys, which we consider high enough, yet the financial advisors seldom have anything like the specialized training that attorneys possess.

401k Plan Expenses

Another source of “small costs” (and sometimes more than small) costs is the administrative expenses of your company’s 401k Plan. These plans take resources for administration – keeping track of the accounts, handling the payments, etc. – and the costs of this administration must be covered. Ideally, you want your employer to pick up those costs. Some do, but some don’t. If you are paying part of the cost, you want those costs to be as low as possible. Unfortunately, it is quite difficult for you to identify the administrative costs that you bear in your 401k Plan. About all you can do is to push your administrative personnel to do what they can to achieve low costs for the employees.


References

  1. Mutual Fund Fees and Expenses. Shareholder Fees – Sales Loads. SEC, http://www.sec.gov/answers/mffees.htm#salesloads
  2. 2014 Investment Company Factbook: Mutual Fund Fees and Expenses. Investment Company Institute, http://www.icifactbook.org/fb_ch5.html#mutual
  3. Class B Mutual Fund Shares: Do They Make the Grade? FINRA, http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/MutualFunds/p005975
  4. Horowitz, J. (Sep. 22, 2009). RIAs drop asset management fees to lowest level in a decade. Investment News, http://www.investmentnews.com/article/20090922/FREE/909229985