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Benefits of Low Fees in Group Retirement Plans

LOWER FEES MAKES A

DIFFERENCE Understanding the impact of fees on the performance of your investment portfolio

By Jim Yih


Welcome After being in the financial industry for over 20 years, I have done copious amounts of research on ways to improve returns on my investments and my clients’ investments. I have come to believe there are three keys to success:

1. Have a plan that keeps you disciplined 2. Monitor and rebalance your investments from time to time 3. Make sure you understand the fees you are paying.

The focus of this report is on fees and the impact fees have on your returns. The great news is that there are many opportunities and advantages within Group Retirement Savings plans to lower fees and take advantages of higher returns and rewards. I know the markets for the past few years has frustrated many investors and although I cannot control or predict the markets, I am committed to more education, research and service for our clients. I hope you enjoy this report on fees and understand the role of your group retirement plan and the benefits and importance of lower fees. Good Research Leads to Good Decisions I’ve always believed that good research leads to good decisions. However, research does not guarantee consistent success. At the end of the day, there is no such thing as perfection in the investment industry. Instead, success is about increasing the probability of being right more often than wrong (and everyone is wrong sometimes). It’s also about increasing the probability of winning more often than losing (and everyone loses sometimes). Lowering fees is a sure fire way to improve the odds of investment success.

JIM YIH Group Retirement

Consultant Financial Education

Specialist


Improving returns Investors go to great lengths to try and improve the performance of their investments.

- In some cases, they hire financial advisors, stockbrokers or other investment professionals to invest for them thinking a professional can do much better.

- In other cases, they try to do some research to give them the edge on

picking the next winning stock or investment. - Some people spend a lot of time trying to predict the direction of the

economy, gold prices, interest rates and yes, even the stock market. Some investors try to guess when the market is poised to go up, bounce back from recovery or manifest into the next big bull.

- And of course, many investors seek hot tips from the people they trust like

family, coworkers or even the bosses’ wife’s brother-in-law who works for someone who has special ‘insider information’ that will make everyone rich.

Sadly, despite the effort, very few investors every find the competitive edge with these strategies. Even worse is the fact that investors tend to ignore the one key to giving them a true competitive advantage when it comes to investing successfully which is simply lowering the fees they pay. Yes, it’s true, fees are one of the biggest determinants of performance and investors have more control over fees than they think. What kind of fees are we talking about? The management fee is the fee charged by the investment to cover the costs associated with investing the assets of the fund. For some accounts, they call this a discretionary fee or a portfolio fee. For workplace savings plans, they call this the Investment Management Fee (IMF). In the mutual fund industry, they call this fee a Management Expense Ratio (MER).


These terms are meant to encompass all of the costs associated with the management, operations and distribution of the investment. It would includes costs associated with legal, accounting and marketing costs. The average MER in Canada of all funds is about 2.5%. It is important to note that all rates of return from the mutual fund industry are published net of fees. For example, if the fund shows a 8% return in the paper, it actually earned 10.5% but the MER was removed already. Disclosed but imbedded Although fees are disclosed, most are not visible day by day. When you pay a fee directly, you are more aware. When it’s imbedded, you may not realize you are paying the fee. On a $10,000 portfolio, you are paying $200 to $250 per year in fees. If your portfolio grows which you hope it does, then your fee grows accordingly. On $50,000 you could be paying $1000 to $1250 per year in fees. I see people who go to great actions to avoid paying $1.50 interact fees when they take money out of the bank machines but yet they are oblivious to the fact they are paying hundreds or thousands of dollars in portfolio or mutual fund fees. A 25% reduction in fees can mean hundreds and thousands of dollars back in your pocket instead of someone else’s. Just because you can’t see the fee you are paying every year does not mean you should ignore this significant fee. The irony is an imbedded fee means investors have to pay more attention to fees and not be afraid to ask questions. Does higher fees mean better products? For most products and commodities, there is a perceived relationship between the price you pay and the benefit you get. For example, you will pay more for a Mercedes Benz than you will for a Hyundai but you would also expect that a Mercedes is a better car in terms of engineering, safety, options and quality. The same might be true for clothing, shoes, appliances, computers, furniture, etc. In other cases, however, we recognize that paying more for something does not necessarily translate to better quality. One example might come from the explosion of ‘no name’ options. In our house, we often buy no name Jello, which saves us about 20% because it really tastes the same as the brand name. Other’s might do the same with pasta noodles, chicken noodle soup, cereal, etc. Some might say these are small ticket items but does this same philosophy apply to any big ticket items like your investments? In the investment world, the evidence is very clear, higher fees means you have a higher probability of lower returns, not higher returns. If you don’t believe this, here’s some of the evidence . . .


The math of net and gross returns Most investors and advisor talk in the world of net returns (net of fees). If you are doing some financial or retirement planning, you have to use some projected rate of return for your calculations. Do you use 3%, 5%, 7% or some other number? Everyone has their own idea of what a realistic return should be but let’s assume a 5% return. In most cases, you are probably assuming that number is a net return (after fees and expenses). If the fees you are paying are 2.5%, then you need a 7.5% gross return to achieve a 5% return. That’s as simple as the math gets. The equation is simple:

Investors’ NET return = Gross return – fees If you had a lower fee, then the net return would be greater. Or if you had a lower fee you would need a lower gross return to achieve the same net return. It’s just math. Let’s look at some more math. Given a 2.5% fee on a 7.5% gross return, one third of your return goes away in fees and you, the investor, gets to keep only two thirds of the gross return. Does that split seem appropriate to you?

Target Net return

Gross return needed

Percentage of the gross return that goes away in fees

Percentage of the gross return that goes to the investor

1.00% 3.50% 71.43% 28.57% 2.00% 4.50% 55.56% 44.44% 3.00% 5.50% 45.45% 54.55% 4.00% 6.50% 38.46% 61.54%

5.00% 7.50% 33.33% 66.67% 6.00% 8.50% 29.41% 70.59% 7.00% 9.50% 26.32% 73.68% 8.00% 10.50% 23.81% 76.19% 9.00% 11.50% 21.74% 78.26%

10.00% 12.50% 20.00% 80.00% 11.00% 13.50% 18.52% 81.48% 12.00% 14.50% 17.24% 82.76%


The math is worse with negative returns. As you can see from the chart, the lower the return, the worse it is for the investor and the better it gets for the financial institution that charges the fees. Investors still have to pay the fees when the portfolio loses money. In other words, it the investor sees a 10% loss, that means the portfolio only lost 7.5% but after the 2.5% fee is paid, it added to the loss of the investor. When compounding works against you Compound interest has often been described as the eighth wonder of the world. Compounding is a mathematical phenomenon simply because your earn money on your earnings as well as your original investment and the biggest benefit to compounding comes from time. Unfortunately, when it comes to fees, the math of compounding can actually work against you. Fees drag performance, especially over a longer the time frame. Think of the fees you pay as a 2-pound weight on your ankles. In a short sprint, good runners might be able to overcome the disadvantage. However, wearing that 2-pound weight can be a real disadvantage the longer the race goes. The odds of winning in a marathon with that handicap decrease dramatically. What if the weight was 3 pounds or 5 pounds or more? What if you had to pull a tire equivalent to 33% of your body weight? How competitive would you be? Fees have less of an impact over shorter periods because of the randomness of performance over short periods of time. Higher fees decrease the probability of success. Here’s some of my research to prove it.

- Over 1-year time frames, there is very little correlation between fees and performance in the short term. For example, in the Canadian Equity Category, one-year returns for the funds ranged from a low of 7.9% to a high of 124.8%. Fourty nine percent (49%) of the above average funds had high MERs and 51% had low MERs.

- Fees matter more over longer time frames. When you look at 5 and 10-

year returns, there is a greater chance that the above average funds had lower MERs. For example, over 10-year periods, 72.5% of the best funds were lower MER funds and 27.5% were higher MER funds. For 5-year periods, 61% of the best funds were low MER funds and 39% had high MERs. It appears the longer the time frame, the higher the correlation between low fees and better returns.

For more background and details of this research, visit Retire Happy Blog http://retirehappyblog.ca/mutual-fund-fees-do-matter/


The long-term impact of fees So remember fees have a greater impact on performance, the longer you go because of something known as ‘regression to the mean’. The variability of returns tightens up and lower fees gives a greater competitive advantage over the long term. Here’s some more calculations that may make you think about the long term cost of fees: Let’s compare 2 investments. The first investment has a 2.5% annual fee while the second investment has a 1.5% annual fee. Let’s assume both investments have the same gross return of 6%. Here’s how the two investments look after 25 years AFTER 25 YEARS Investment 1 Investment 2 Original investment: $10,000.00 $10,000.00 TOTAL FEES PAID $10,118.20 $6,999.56 30.82% Actual Value after fees: $22,790.93 $29,413.89 $6,622.96

On a $10,000 investment, that’s an extra $6,622.96 in your pocket instead of someone else’s directly resulting from a fee savings. Does active management justify higher fees? Some from the financial industry may be quick to jump in and suggest that a fee of 2.5% may be justified if they can deliver higher returns as a result of adding value though active management of the investment – better research, buying low and selling high, and adjusting portfolio allocations. This may sound like a great story but statistics would suggest otherwise. According to the Standard and Poors Indicies versus Active Funds Scorecard (SPIVA) only 19.6% of Canadian Equity Funds were able to outperform the S&P/TSX in 2010. The number decreases over 3 and 5 year periods to 11% and 2.5% respectively.


Percentage of Active Funds that beat the index

Comparison Index One-Year Three-

Year Five- Year

Canadian Equity S&P/TSX Composite Total Return 19.64% 10.94% 2.53%

Canadian Small/Mid Cap Equity S&P/TSX Completion Total Return 32.56% 18.52% 28.57%

Canadian Dividend & Income Equity S&P/TSX Canadian Dividend Aristocrats Total Return 10.35% 6.45% 0%

U.S. Equity S&P 500 Total Return Index C$ 35.21% 21.59% 14.13%

International Equity S&P EPAC LargeMidCap Total Return C$ 9.30% 16.67% 11.63%

Global Equity S&P Developed LargeMidCap Total Return C$ 5.77% 14.66% 15.44%

Source: Standard & Poor’s. Data current as of December 31, 2010. Charts are provided for illustrative purposes. Past performance is not a guarantee of future results.

How much better does the index do? Below you will see two trailing return charts. The first is the trailing 10 year returns for the TSX and the second is the 10 year trailing returns for the Average Canadian Equity Mutual Fund over the same time frame.


Visually the charts look almost identical. What was most interesting to me was some of the detailed numbers:

TSX Average Canadian Equity Mutual Fund Difference

Best 15.59% 13.21% 2.38% Average 9.23% 8.15% 1.08% Worst 2.84% 2.35% 0.49%

If you look at the difference between the average annualized returns of the index vs the average of all funds, there is a 1.08% difference. Why is that over 10 year periods, the index has outperformed the average of all mutual funds? In fact, the data is consistent over different time frames. Trailing 5 year returns:


Best 22.08% 17.74% 4.34% Average 9.15% 7.97% 1.18% Worst -1.91% -1.59% -0.32%


Trailing 1 year returns:


Best 63.42% 44.17% 19.25% Average 10.16% 8.49% 1.67% Worst -38.20% -37.84% -0.36%

One of the issues might have something to do with the fees or Management Expense Ratios (MER) charged by mutual funds. How much of this difference in these examples has to do with the fact that mutual funds charge fees? I would say fees definitely have something to do with the difference. Since the data is simplistic, it can be dangerous to jump to the conclusion that fees are the only cause for the underperformance of mutual funds compared to the index. If we go back to the SPIVA report, the data is similar:

Report 3: Equal-Weighted Fund Returns, Year End 2010

One-Year Three-Year (Annualized)

Five-Year (Annualized)

Canadian Equity 14.56% -0.51% 3.88% S&P/TSX Composite Total Return 17.61% 2.09% 6.51% Difference 3.05% 2.60% 2.63%

The price for advice Before financial advisors get too upset at this data, it is important to disclose that I believe most people need the help of financial advisors because they lack the passion, skill, desire, time or effort to be able to manage investments and portfolios on their own. If you need an advisor to help you manage your portfolio, then you will have to expect some level of higher fees to compensate the advisor for their services. The do-it-yourself investor can find ways to dramatically lower their fees using Exchange Traded Funds (ETFs). One of the reasons these fees are so much lower is because they mimic indices and are more passive. Another reason the fees are low is because they do not pay any compensation to advisors. Advisor compensation can be a very significant part of mutual fund fees and portfolio fees. Therefore it is important for investors to be aware of the fees they are paying the advisor and it’s also important for advisors to be ready to justify their fees with their value proposition.


Unfortunately for investors there are far too many cases where they are paying for help but they are not getting much value in exchange. They are not getting financial plans. Their portfolios are being managed with a long-term buy and hold strategy. There just is not value being delivered and that’s can be a significant problem with the commission-based model of compensation. Summary As the title of this report describes, FEES DO MATTER. Fees drag performance down. It’s kind of like running a race pulling a tire behind you. The bigger the tire, the longer it takes to finish the race. The problem is the probabilities work against you. Most active managers don’t beat the indexes. So you have the certainty of paying higher fees with a low probability of success. That’s not putting the odds in your favour. One of the best analogies I’ve heard (from Mike at Oblivious Investor) is taking 100 pieces of paper and numbering them from 1 to 100. Put all 100 pieces into a hat and now you have 2 options: 1. The first option is to pick a number out of the hat without looking and you will

win an amount of money equal to the number on the paper. Pull out a 20 and you get $20. Pull out a 4 and you get $4. Pull out a 82 and you get $82.

2. The second option is you get $80 automatically Most people would choose the second option because it the probabilities are in your favour. Lowering the fees is a certain way of increasing the probabilities of increased returns. It does not guarantee higher returns but increases the probabilities dramatically. Anyone who argues that fees don’t matter is probably trying to sell you something and justifying the higher fees because of their compensation. That’s OK as long as they can justify the value they deliver for that fee. The bottom line is it’s tough to argue against lower fees. Lower fees is better for investors. It’s that simple and for that reason, investors need to pay more attention to fees.

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