An out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said, “Look, those are the bankers’ and brokers’ yachts.” “Where are the customers’ yachts?” asked the naive visitor.
—Fred Schwed Jr.

I’m afraid I have more bad news for you. It seems our estimates are still overly optimistic. Why? Because we have failed to give the Devil his due. After all, in order to match the return of the S&P 500 by indexing, we’re going to have to invest our money with Wall Street, and you had best believe that Wall Street is going to take its cut for giving us the privilege. Someone has to pay for those bankers’ seven-figure bonuses, and that someone is you.

The Elephant in the Living Room

Let me preface this discussion by acknowledging that the greatest transaction cost of all by far is taxes. Uncle Sam will demand his cut as well, sooner or later. It is an inevitability, and you must account for it when making your plans. However, taxes are far too complex and individual in nature for me to cover here, so we’re going to remove them from the equation for the time being by assuming we’re investing in a tax-advantaged retirement account. Of course that presents other pitfalls, as we shall soon see.

Internal Bleeding

Wall Street fees come in all shapes and sizes, and it can be maddeningly difficult to arrive at an accurate accounting of them all, especially in employer-sponsored retirement accounts like 401k’s. Most investors don’t go to any great lengths to figure out precisely how much they are really paying. This is a huge mistake, but sadly all too common, and Wall Street has a strong vested interest in keeping it that way.

The Exponential Function

I’ll wager this oversight wouldn’t be so common, however, if people had a better understanding of exponential growth. I urge you to watch this video on the subject. It has 8 parts. It’s dull. Watch it anyway, over and over again if you must, until you understand it. If all I ever accomplish with this blog is convincing you to do this, it will have been well worth my efforts.

It is exponential growth that gives compounding its extraordinary wealth-building power. However, exponential growth also means that very small changes in the growth rate can have huge effects on the final result. We have already seen this concept at play in part I, with dramatic effect. It means you would be well advised to pay especially close attention to any fee that is computed as a percentage of funds invested.

The main fees and expenses to watch out for when investing in index funds in general, and retirement accounts in particular, are trading commissions, bid/ask spreads, fund fees (also known as “expense ratios”), and custodial fees.

Commissions

Trading commissions used to be a huge expense in the bad old days before the rise of discount stock brokers. Nowadays investors have much less expensive options, but even a deep-discount commission of, say, $10 can’t be ignored entirely, especially when investing such a small amount. Assuming we make only one trade per year at a $10 commission, and can reinvest our dividends for free, we still wind up with about $1,100 less at the end of our career, after factoring in lost earnings and inflation. That’s almost a year’s worth of savings under our original plan! And as you can imagine, this figure can add up to a lot more if we trade more often.

Many mutual fund companies allow commission-free purchases and dividend reinvestments of their own funds, so avoiding this expense can be easy enough if you go that route, but naturally you must weigh this against other factors.

Spread ‘Em

If you have ever looked at a detailed stock quote, chances are you’ve seen three prices quoted — “last,” “bid,” and “ask.” The “last” price is the most recent price at which the security in question actually changed hands. The “bid” represents what a market maker is presently willing to pay for the security, and the “ask” is what they’ll sell it for. The “spread” is the difference between the “bid” and “ask” prices, and it’s how market makers earn their profits. Any time you buy or sell a stock or ETF, you effectively pay half the bid/ask spread as a hidden fee to the market maker. The spread is very easy to ignore, but it eats into your returns just the same, whether you’re paying attention or not.

Spreads vary greatly in size depending on how volatile a security is, and how heavily traded it is. More volatile stocks tend to have higher spreads, in order to protect market makers from losing money in a fast-moving market. Similarly, thinly traded stocks also have higher spreads, as a market maker may have to hold shares for longer than he’d like before finding a buyer.

As a general matter, index ETFs tend to have small spreads, as they are not nearly as volatile as individual stocks, and usually trade at high volume. Do not make the mistake of thinking a small spread is negligible, however.

The Vanguard S&P 500 index etf (NYSE:VOO), for example, has one of the lowest spreads in the entire industry, at a mere .03%. That’s right, less than 1/30th of 1%. You may think that such a low spread can safely be ignored. However, using our example of a 2012 retiree from part III, even this tiny spread would have ended up costing us over $2,000!

Most ETFs have much higher spreads. The Vanguard long-term treasury index ETF (NYSE:EDV), for example, has an average spread of .25%. That would have cost our 2012 retiree over $6,300 in the end, which would entirely consume over five years worth of our savings. Does it sound negligible now?

As with trading commissions, you can often avoid paying bid/ask spreads on your purchases if you buy mutual funds directly from a company such as Fidelity, as they don’t generally have spreads on their own funds. Of course you’ll still pay spreads indirectly when the managers invest in stocks on your behalf. There’s no such thing as a free lunch, as they saying goes.

Expense Ratios

Expense ratios comprise fees that mutual fund companies pass on to you to cover the commissions and other expenses they incur while investing on your behalf, as well as the fund managers’ salaries and fund company profits. They can vary wildly from one fund to the next, even among index funds. So while index funds generally have much lower expense ratios than managed funds, don’t just assume that you’ll be getting low expenses by virtue of the fact that you’re indexing. Not all index funds are created equal.

To put this in concrete terms, expense ratios for commonly available S&P 500 index funds range from .16% for the Vanguard index to a whopping 2.28% for the Rydex index fund. The difference between these two would cut your final retirement savings in half! That bears repeating — simply by choosing poorly when picking out an S&P 500 index fund, half of your retirement fund could evaporate.

You would be well advised to pay very close attention to the prospectus for each index fund you’re considering buying, and the fee disclosures therein. You’d best check the new prospectus that comes out each year for any changes, as well. It will be well worth the small amount of time this will take.

Custodial Fees

Custodial fees are one of the biggest bugaboos out there, simply because so few people even realize they exist. These are fees charged by the administrator of your retirement account. They are charged on top of mutual fund expense ratios, commissions, and everything else.

Nowadays, thankfully, custodial fees for IRAs are largely a thing of the past. IRA providers must compete for your business, after all, as you can open a self-directed account anywhere you like, so costs have been driven down relentlessly in recent years. The few providers that still charge fees generally charge a flat rate of $10 to $75 per year.

The same may not be said for 401(k) providers, however. Unlike with an IRA, you are stuck with the 401(k) provider your employer offers, and high custodial fees are alive and well with these accounts. What’s worse, many 401(k) providers go to great lengths to hide them from you. The result is many workers, mistakenly assuming their employers cover 401(k) fees, have shocking percentages of their retirements drained away over the years by fees they didn’t even know existed.

The industry median for 401(k) custodial fees, according to USA today, is nearly 1.5% — a staggeringly high figure. Don’t think you get a pass if you work for the government, either. The situation with 403(b) plans is much the same.

Death by a Thousand Cuts

Let’s go back to our hypothetical 2012 retiree from part III. If you recall, we ended up with $128,463 in retirement savings based on the assumptions we were working with.

Now, let’s assume we used a company-sponsored 401(k) plan with an industry-standard 1.5% custodial fee. We were lucky enough to have the Vanguard S&P 500 index fund as an option, with its ultra-low .16% expense ratio, so we wisely chose it, avoiding the many managed funds with higher expenses our plan offered. We were also lucky enough not to have to pay any additional commissions or bid/ask spreads for any of our purchases or dividend reinvestments. In short, we got a better deal than most. How did we do?

Oh dear. We have wound up with only $73,497. The 401(k) fees and fund expense ratio has reduced our savings by another 43%. And like I said, we were actually comparatively fortunate. Many others have far more of their savings drained away, without even knowing it.

The Final Reckoning

We have reached the end of our little tour of misconceptions and fallacies about retirement savings. If you recall from part I, we were promised an even $1 million if we followed our little plan. In the real world, however, we have wound up with a mere $73,497 — over 92% less, and all from common mistakes made daily by millions, including many personal finance “experts.”

These sorts of mistakes are easy to make, and easy to overlook, but extremely difficult to recover from. I hope I have convinced you that reading a couple of books and a few blog posts is not enough to prepare for a successful retirement. It is absolutely essential that you educate yourself about finance if you want to have a realistic chance of success.

Cultivating a healthy skepticism couldn’t hurt, either. If you furrowed your brow at some of the numbers I cited above, good! My goal is not to get you to accept my figures. On the contrary, my goal is to convince you not to accept anyone’s figures at face value, including mine. Try running the numbers yourself and see if you reach similar conclusions. Just to give you a jumping off point, here’s the spreadsheet I used to calculate many of the figures and estimates I’ve cited in this series.

Once More unto the Breach

I know I said last time that I had only one more article of bad news to go, but I’m afraid I lied. There’s still one more left. Sorry!

Don’t worry, though — I’m done deflating your expectations of what your returns will look like. Instead, I’m going to have a look at assumptions you may be making about how much you can safely withdraw every year.

See you next time.