How High Fees Turn Even Wise Investments into Bad Investments
The driving purpose behind the new financial services reforms just proposed by the U.S. Department of Labor is to reduce the wealth-draining hidden fees and commissions that most investors aren’t even aware of. Whether you have a privately managed brokerage account or a mutual fund account through your company’s 401(k) program, these fees and commissions suck $17 billion out of the retirement plans of Americans each year, according to studies by the U.S. Dept. of Labor and the White House Council of Economic Advisors.
There are many financial products that don’t have excessive fees. But here’s the problem. Many who work in the industry actively steer investors away from these products because the advisors are paid more when the fees are high. So in a sense, your advisor may actually be your adversary. The system has created zero-sum financial planning. If you win, your broker doesn’t. If you broker wins, you lose.
The problems exist today because many, if not most, advisors and brokers are not required to act as your “fiduciary.” A fiduciary is required to manage the assets of a client for the benefit of the client and not for his or her own profit.
There are different types of regulations depending on how a firm is organized. Though all firms are overseen by the regulators to some degree, the type of regulation and amount of protection it affords the client varies a great deal. For example, many firms are only required to recommend products that meet a “General Suitability” standard, which is very different however from a fiduciary standard. These advisors are not required to select the lowest fee products. They are allowed to recommend portfolios that may contain the same investments as the low cost offerings, thus satisfying the client’s goals and risk tolerance but which have higher expense ratios, buried fees, and pyramid pricing to maximize the advisor’s income while significantly eroding the returns of the client.
But there’s clearly another motivation. Many steer investors into “actively managed” accounts where an investment professional personally makes frequent transactions in order to increase portfolio gains based on ongoing trends. The premise for this is that actively managed accounts will earn more because the manager keeps a close pulse on the market and dumps stocks that are losing value in favor of those that are on the rise. But is the true? The graph below from Vanguard’s “A Case for Index Fund Investing” shows that actively managed accounts rarely, if ever, beat the earnings from passively managed index funds:
Based on the compelling evidence, one would assume there’s far more money invested in index funds than actively managed funds, but that’s not the case. As this NPR story details, the amount invested in high-cost, underperforming actively managed funds is six times the amount invested in low-cost, low-risk index funds.
So why would a manager put their clients’ funds into accounts that underperform index funds? Actively managed accounts can charge higher management fees and thus have higher expense ratios which provides greater financial reward to the firm. In some cases, brokerage firms provide incentives to their employees to “move” certain stocks. So while you think you are your broker’s client, in fact, you may not be first in his or her mind when it comes to managing your money.
I often hear “what’s the harm?” In other words, why care about hidden fees and commissions if the client’s account is growing? Because these fees and commissions are not insignificant. They cause tremendous harm. In the same way compounding interest can generate enormous profits over the course of 10, 20 or 30 years, compounding fees and commissions can significantly erode those profits. In my next post in this series “Stacking Fees: the New Pyramid Scheme,” we’ll discuss how much money is at stake.
If you would like to comment or have a question, please email me at firstname.lastname@example.org.
Come back on Sept. 18, 2015 to read the next installment in this series: Stacking Fees, the New Pyramid Scheme that’s Rapidly Eroding Your Retirement–The Escalating Costs of Fee