23 January 2012
I saw a cool graphic the other day from the U.S. Energy Information Administration. It showed a gasoline pump broken into pieces to represent where the costs are in a gallon of gas. While 77% of the cost is crude oil itself, the rest were taxes and marketing. It got me thinking about the things we buy without knowing the internal costs, and our assumption that we must be getting the best deal available. Yet tax and marketing expenses are built into everything we do; in some cases we could lower those costs, thus keeping more of our own money.
Mutual funds are the prime example of this phenomenon. In the past week, I have looked at several portfolios for potential clients where I knew that there was a less expensive alternative in the exact same mutual fund they had. I am not going to talk about performance, just costs. What many people do not understand is that mutual funds usually have several different share classes and each one comes with its own expense structure.
- "A" Shares. Typically with this share class people will pay an up-front commission and then have an ongoing expense that is lower than "B" and "C" shares but not necessarily the lowest.
- "B" Shares. These are not sold much anymore but I still see them in portfolios. There is no up-front commission but they do have a deferred sales charge that you will pay if you sell out of them early (often before six years). The internal expenses are higher than "A" shares but typically they will convert to "A" shares after the deferred sales charge period (and thus your expenses will decline).
- "C" Shares. This share class typically has a 1% deferred sales charge if you sell them early (often before one year). Additionally, the internal expenses are often larger than "A" shares and "B" shares.
- "I" Shares. Institutional shares are the least expensive (and sometimes they go by other letters than "I"). Even in "I" shares there is varying expense since sometimes larger investors can get a price break over certain dollar amounts.
I am not going into all the detail of how these expenses break out but suffice it to say that marketing costs are a big piece of the puzzle. Marketing is expensive, so buying mutual funds through certain channels will cost you more. The natural question is, how much does this all matter?
Suppose you bought a mutual fund that had a 1% ongoing expense ratio but if you bought a different class of the same fund you could get it for 0.75% (a 25% reduction in fees). If you had $10,000 invested in that fund you would save $25 per year; a $100,000 investment saves you $250 per year. Over 20 years that is $500 in savings (or $5,000 savings on a $100,000 investment), assuming no growth in the fund. But if the fund grows at all your fee savings goes up since the underlying expense ratio applies to the fair market value of the fund on a daily basis. This example gets even better if you can cut those fees in half, to 0.50%.
Everyone needs to be paid for their work. My only point is that you need to understand where the expenses are in your investments and you need to assess if you are getting value for those fees. If you are paying higher expenses but getting great financial planning services from your advisor, it might be worth it. Yet I have found many people are paying higher expenses and getting nothing more than a phone call each year.
Now is a good time to evaluate your expenses since all good retirement plans are based on spending―spend less and your retirement plan looks better. In the world of investing, expenses are much more variable than a gallon of gasoline, so shop around.
About Jon T. Meyer, CFP®
