You’ll probably agree that actively managing your entire retirement portfolio is not on your current to-do list. Which is why there are easy mutual funds and retirement target-date funds available that provide diversification and a convenient hands off approach.
According to the How America Saves 2019 Report from Vanguard, 98% of employees were offered target-date funds at the end of 2017. Of those, 77% used a target-date fund and for 51%, this was the only investment strategy used.
These funds take care of everything for you. But what is the cost of holding an actively managed portfolio? They may be easy to invest in, but behind the scenes, someone has to keep an eye on that fund, reallocate every so often and adjust how aggressive or conservative your portfolio is.
And that active management comes at a cost.
In this post I’ll cover exactly what the expense ratio of a mutual or index fund is and exactly how that cost could impact your retirement plans.
Contents and Quick Links
What is an expense ratio?
“If returns are going to be 7 or 8 percent and you’re paying 1 percent for fees, that makes an enormous difference in how much money you’re going to have in retirement.”Warren Buffett
The expense ratio is a reflection of the cost of managing investments within a fund as a percentage of the total value of the assets. For you, it is the cost of investing in the fund and charged as a percentage of how much you own.
The expense ratio formula:
Some funds have higher operating and management costs, and therefore have a higher expense ratio.
But to really understand this question, it helps to understand the difference between an actively managed fund and a passively managed fund.
Actively managed mutual funds
A mutual fund is an actively managed selection of stocks, bonds or other securities with the intention of out performing a particular index. Professional fund managers and analysts decide what to include in the mutual fund and when to buy or sell in order to make high returns for the investors.
Passively managed index funds
An index fund is a passively managed selection of stocks, bonds or other securities which aim to match a particular market index, like the S&P 500. Assets are selected automatically based on what is included in the market index. There is no fund manager or analyst deciding when to buy or sell holdings.
The overall costs of managing a fund is taken out of the fund’s assets. What this means to you, the owner of a portion of this fund, is less earnings. Note that this doesn’t include commission fees when you buy or sell.
If a fund has an expense ratio of 0.5%, then every year, 0.5% in asset values will be used towards management and other fees.
If you invest $1,000 in a mutual fund that earns 5% over the year, instead of earning 5%, you will earn a 4.5% return on your investment.
If you additionally factor in any sales charge when you purchase the fund and the impact of expense ratio to your compounding interest over the years, the cost adds up.
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How to find your expense ratio
The expense ratio for a particular fund should be relatively easy to find. It is often listed along with the ticker symbol, current cost per share, and short/long term performance data.
For example, when I look at Vanguard’s website reviewing their mutual funds, I’m given a list of Vanguard select mutual funds. They are organized in a table by asset class, ie, total stock market, total bond market, or U.S. stock funds. The expense ratio is the third item listed in the table for each mutual fund.
Within my personal employer sponsored retirement account, I can select individual holdings for more information and the expense ratio is included along with data on past performance.
However, I have also found that it can be quite difficult to find the expense ratio. I had a small, actively managed IRA account for a few years. I was advised by family members that this particular firm, and the individual portfolio manager, was very successful and that any management expenses would be more than covered by the gains earned.
This was before I knew any better.
I combed through every quarterly report and couldn’t for the life of me figure out what the management fees were. It wasn’t until I finally rolled everything over to Fidelity so that I could manage it myself that Fidelity provided the clear expense ratio information. And they weren’t pretty.
So if it isn’t immediately clear what the expense ratio is for a particular fund, call the investment firm, or your HR representative, and ask for assistance. As you’ll soon discover, this is a number you’ll want to know.
Common expense ratios
So we now know what an expense ratio is. But what about the numbers? What is an acceptable amount to pay in management fees? Let’s review some common expense ratios to find out.
Expense ratio for stocks
Individual stocks do not have expense ratios. The main expense you pay is commission when you buy and sell individual stocks.
Expense ratio for mutual funds
Since mutual funds are actively managed, they typically have the higher expense ratios. According to this Investopedia article, typical expense ratios for mutual funds are between 0.5% and 0.75%. They can be higher but rarely exceed 2.5%.
Expense ratio for ETFs
Passively managed ETFs (Exchange Traded Funds) tend to have lower expense ratios, with an average around 0.2%. Due to some healthy competition, it’s not uncommon to find ETF expense ratios of 0.04%, or even zero.
Index funds with the lowest expense ratios
Vanguard’s total market index fund, VTI, has an expense ratio of 0.03%. In order to compete with this, Fidelity now offers their own no-cost index funds.
This makes them more accessible within employer sponsored retirement plans. For example, my work offers select funds through Fidelity, but not through Vanguard. While I wanted to select VTI, thankfully I do have a similar selection with Fidelity’s FSKAX, a total market index fund with an expense ratio of just 0.015%.
How does the expense ratio impact your retirement?
There are a couple ways to think about how added investment fees can impact your retirement.
First, any percentage of fees will take away from the amount that you can safely withdraw during retirement. For example, a common retirement rule of thumb is the 4% rule, which states that one can safely withdraw 4% of your retirement portfolio. If you have a 1% expense ratio then this means you can now only safely withdraw 3% from your portfolio. The other 1% just went to management expenses for your fund.
Secondly, that 1% is cutting back on the amount of compound interest you will earn over the years. It doesn’t seem like much, but compounded over 20, 30, or even 40 years, it adds up.
Example of how much money your expense ratio is costing you
The average expense ratio for a “set-it-and-forget-it” target-date fund is 0.51%.
Note: Fees can often be lower than 0.1%. It pays to shop around and check all of your options before you pick a fund to invest in. It’s tempting to just go with an automatic selection upon joining a new company but a little extra time and research can save you a lot of money over the years.
Example: You have two choices for your tax advantaged retirement account.
- A target-date fund that automatically reallocates over the years so you don’t have to think about it ever again. It has an expense ratio of 0.6%.
- A low cost ETF with an expense ratio of 0.05%.
Assuming you open a new account (zero initial balance) and automatically contribute $1,000 to your account every month for the next 30 years, with a 7% rate of return, how much more will you end up paying in fees by going with the target-date fund?
To find out, I used Nerd Wallet’s mutual fund expense ratio calculator.
Over 30 years, the more expensive, managed fund, will cost you over $105,000. Which could be enough to impact when and how you retire.
The cost of a higher expense ratio can cost you hundreds of thousands of dollars in portfolio value. Enough to impact when and how you retire.
The expense ratio of a mutual or index fund is the cost of managing the fund as a percent of your investment dollars.
If you have $1,000 invested in a mutual fund with an expense ratio of 1%, you will pay $10 every year that you own that fund.
Because you likely own this mutual fund within a retirement portfolio, you likely won’t ever notice this missing $10. Which is why management costs are often overlooked.
However, that cost can greatly impact your portfolio over the years.
If you plan to withdraw 4% from your savings every year in retirement, but you already pay 1% in fees, you now have to plan on having enough funds to effectively withdraw 5% instead. Which makes a big impact on when or how you retire.
From a dollar savings viewpoint, if you invest $10,000 in a fund with a 1% expense ratio, earn a 7% rate of return, after 30 years the value will be $56,308. However, if instead you invest that same $10,000 in a fund with an expense ratio of 0.1%, earn a 7% rate of return, after 30 years the value will be $73,872.
By choosing the lower expense ratio, you earn an additional $17,564.
When you add contributions, larger portfolio values and compounding interest to the mix, the savings is in the tens to hundreds of thousands of dollars. Which makes a big impact to your retirement planning.
Which is why it pays to uncover exactly what your expense ratio is for each fund you hold, and research some lower fee options.