Just like the Plumber, a General Surgeon came to me for advice. He wasn’t sure why, but he had a suspicion that his practice’s 401(k) was not being managed well. He told me that when his practice grew to the point where he needed to set up a 401(k) plan for his partners and staff, he turned to a trusted advisor: his accountant.
The Surgeon had worked with this accountant for many years. He was responsible for filing the Surgeon’s corporate and personal tax returns every year, and was more than willing to set up the new retirement plan. The accountant wasn’t dishonest in that he was transparent about his fees for this work, but he certainly didn’t tell the Surgeon all of the fees were at the very top of the pricing scale within the industry. Additional expenses were then layered in because the accountant was not an investment professional so the 401 (k) business had to be sub-contracted out to another party. This investment advisor not only charged another high fee per year but offered only actively managed funds as investment options which added a further 1.8% expense ratio and additional distribution fees. This was work better suited for a Chartered Financial Analyst (CFA).
The accountant filed all the proper paper work and the 401(k) began to receive contributions from the paychecks of all those in the surgical practice group who chose to participate. Just as in the case of the Plumber [Link back to this first post from this series] who was paying the 5% load, the 401 (k) account took a huge hit each year to cover the cost of account administration charged by the accountant: 4 percent! On top of that, the accountant outsourced investment strategy to a brokerage firm, which charged another 1.5 percent. All the mutual funds that were offered in this 401 (k) carried fees of between 1.5 percent-to-2.0 percent as well as additional distribution fees not readily apparent.
All of these numbers seem small, but for an account worth several hundred thousand dollars, they added up to very large sums—which had to be deducted at the beginning of each year—quickly eroding the overall investment performance of the account.
Not only do these fees harm the principal investment, each individual in this hierarchy— broker, financial planner, investment advisor, or accountant— has his or her own motivations. They may receive incentives from a bank, insurance company or brokerage to sell certain stocks or funds—investments that may be technically “suitable” for you, but are not in your best interest. So the damage to your investment starts to quickly sprawl. But it always begins with hidden fees.
A 5 percent fee, or load, on a $50,000 investment is $2,500. So if you write a check for $50,000, you receive an opening account balance of $47,500. This is what happened to the Plumber and the General Surgeon. They always started off in a hole and needed strong, quick returns just to get back to where they started. The first few months of every year were spent trying to regain this lost ground. This is the tyranny of compounding fees (See “The magic of compound returns is overwhelmed by the tyranny of compounding costs” link). While these fees may seem insignificant, they aren’t. They are actually very punishing. Fees turn good investments into mediocre investments and mediocre investments into bad investments.
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