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We scrimp and save to fund our RRSP and TFSA contributions and meet the goals of our retirement plan, so why is it that so few of us really understand the fees we are paying on our investments? Despite increased transparency and fee disclosure, many investors remain in the dark about fees and how much of a bite they take out of long-term returns.
“It’s only 2%, that’s just a couple of bucks out of a hundred!”
When it comes to investment fees, you are about to see these are very costly words!
Assume you are 25 years old and maximize your 2021 annual TFSA contribution limit of $6000. You are busy and don’t know much about investing, so you stop by your local bank and they recommend one of their “top-performing” mutual funds.
The bank gives you a glossy brochure highlighting the fund managers vast experience and dutifully informs you of the “management expense ratio” (MER) built into the fund. This 2.35% annual fee seems reasonable to you. Everybody has to get paid and you tip a restaurant server 15%, so this is a relative bargain! No one does any math; the whole matter is soon forgotten and becomes routine. In fact, you barely notice this built-in fee on your annual statement.
Fast forward 35 years and you are now 60 years old and ready for retirement. Your $6000 in that “top- performing” mutual fund has returned 5% annually (before fees) and grown into the tidy sum of $14,987.
Unfortunately, your lack of financial knowledge meant that you had no idea of an alternative investment; something called an index ETF. Buying an index ETF is dead easy and you could have done it yourself with an online brokerage account. Your annual fee would have been much lower at around 0.35%.
If we re-do the math with the same parameters ($6K for 35 years at 5%) and use a 0.35% annual fee, you can see that your investment in an index ETF would have grown into the much tidier sum of $29,446!
Doing some much simpler math ($29,446 minus $14,987) reveals that your retirement fund is $14,459 lower than what it could have been – half of your total gain has disappeared with that little 2.35% fee!
But wait…. How can a mostly set-and-forget index fund return the same as a highly managed “top performing” mutual fund? The answer is that index funds often match or outperform “managed funds” with much higher fees regardless of whether the market is stable or volatile. In our example, the mutual fund would have had to beat the index fund by at least 2% every year in order to return the same amount.
You can always find exceptions and some managed funds may have success over a couple of years. However, very few are consistently able to beat the returns of the index over the long term. When you factor in their low cost and ease of maintenance, the decision to rely heavily on index ETFs is a no-brainer for most investors.
Canadian DIY investment guru Larry Bates has created this online calculator to instantly show how fees can cut into your investment returns.
Our passion at Enriched Academy is to inspire everyone to improve their financial literacy and take control of managing their money. In this example, a little financial education would have done wonders for your retirement planning. The same can be said for many aspects of personal finance – saving, budgeting, passive income generation – so make sure to get the financial knowledge you need to make the right choices for today as well as build your plan for a secure financial future.