How Much Does 1% Cost You?
The first thing I would suggest for you to do is login to your retirement savings account (IRA, 401k, or any other type) and check the expense ratio of the funds you have your money invested in.
If you don’t pay careful attention, 1% can cost you very dearly on your retirement savings count. Let me show you…
How much does 1% cost you?
Let us assume that there are two ETFs A and B that have exactly the same performance and provide an average return of 8% per year. The expense ratio of ETF A is 0.1% and B is 1%.
If you invest $1000 in ETF A, then for the first year, the cost of owning the fund would be 0.001 * $1000 = $1.
If you invest $1000 in ETF B, then for the first year, the cost of owning the fund would be 0.01 * $1000 = $10.
You may think, what is the big deal? Both of them have the same performance. Why does it matter? I am only paying $9 more for fund B.
Also, keep in mind that you will be paying this fee on year after year. As your investment grows, your fee will also grow along with it.
Cost Over Your Life Time of Work
Let us kick this up a notch. You are 20 years old and have started working.
#1 Your in initial balance is $0.
#2 You contribute $10,000 per year to your 401k on an annual basis
#3 You contribute to your 401k for the next 40 years.
#4 Both ETF A and B have the exact same performance and provide an average return of 8% per year.
#5 Expense ratio of A is 0.1% and B is 1%.
Let us see how much you would have paid in fees for ETF A and ETF B.
For ETF A:
The investment grows at the rate of 7.9% (deducting 0.1% management fees).
In an Excel type, “=FV(0.079,40,-10000)” = $2,523,325.11.
For ETF B:
The investment grows at the rate of 7% (deducting 1% management fees).
In an Excel type, “=FV(0.07,40,-10000)” = $1,996,351.12.
If you invested in ETF B, you just walked away from $526,973.79.
That is a huge chunk of money to walk from.
If you are stuck with high expense ratios, don’t worry! You have identified the problem. You are better than 90% of the people around you. Pat yourself in the back. At this point, you can do one of two things.
#1 If you are the DIY type like me, you can move your investments to ETFs / funds with lower expense ratios. I will show you how I did my asset allocation in a follow up post.
#2 Hire a fee only financial advisor who can help you with asset allocation. Be very clear on what you want to accomplish with your financial advisor and be willing to pay a flat annual fee to get your asset allocation in order. Believe me, spending a few hundred dollars to keep half a million seems like a wise idea to me.
1% costs you too much! My opinion would be to nip it in the bud.
Please leave a comment and share which route you are planning to take.