Protect Your Retirement from Killer Fees

At the Atlantic, Matthew O’Brien breaks down how much fees eat into your portfolio:

Those fees don’t sound too bad—just 1 percent!—but this is where our total lack of intuition for how compounding works really hurts us. Let’s try an example: what’s 0.99 to the 40th power? It’s not exactly a calculation you can do in your head. It’s not even one you can estimate. But it’s the kind of calculation that you need to do to figure out how much your 401(k) fees are costing you.

The answer is a lot more than you think. (No cheating with a calculator before we get to the big reveal). Now, let’s say you contribute $3,000 to your 401(k) every year, which is a little more than the national average, starting when you’re 25. Let’s also say that you’re choosing between two investments: the lowest-cost index fund with a 0.08 percent fee, and a typical managed stock fund with, according to Morningstar, a 1.33 percent fee. And finally, let’s say that, though you don’t know it, they both return 7 percent a year, because, as we saw above, most managed funds don’t beat the market.

This 1.25 percent difference in annual fees adds up to a six-figure difference in lifetime earnings. That’s because you don’t just lose the money you pay in fees. You lose the returns you could have had on the money you pay in fees, too. As you can see in the chart below, this compounding effect doesn’t matter much for the first 20 years or so, but really accelerates after that. If you chose the lowest-cost index fund, you’d have $15,000 more at age 45, $55,000 more at 55, and $159,000 more at 65. That would balloon to $257,000 more if you waited to retire at 70.

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Posted by on February 16th, 2014 at 8:26 pm


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