Many people don’t pay too much attention to the costs associated with investing. If we look at both your returns and cost of investing, we can create what is called your net return. Your net return can potentially increase by either improving your return, or lowering your cost of investing.
To illustrate we will use Mr. Lee, a 55 year old investor who has $500,000 in an RRSP account. Mr. Lee has explored the following four options with various costs of investing (increasing at one per cent increments with each option) and service levels:
Option 1: Self managing investments through Exchange Traded Funds (ETFs) – often referred to as couch potato investing. With this approach, you receive no planning or investment advice. This approach is passive as it holds the investments that are in the respective index and are not actively managed. The annual cost of investing for this option can be around 0.5 per cent, or $2,500 in the first year.
Option 2: Working with an advisor owning direct holdings in a fee based account. The fees for this option can fluctuate depending on the advisor and the amount invested. The fee often decreases as the account value increases. The benefit of this option is that an advisor is able to assist you with both planning and your investments. Option 2 is the most transparent with respect to fee disclosure of all options. If Mr. Lee put the $500,000 into a balanced portfolio, it would typically be priced at 1.25 to 1.5 per cent. For our example we will use 1.5 per cent, or $7,500 in the first year. It is important to note that a good advisor is well worth the additional fee over the ETF approach.
Option 3: Purchasing mutual funds is another commonly used investment approach. Mutual funds are actively managed by a portfolio manager that has a specific skill set in the fund(s) that you’re buying. Mutual funds have embedded annual fees called a Management Expense Ratio (MER). In addition to the MER, funds may be sold on a front end basis with addition fees of up to 5 per cent initially, or sold on a back end basis where you are typically not charged a fee initially but would be charged a fee if you sell the fund within the applicable Deferred Sales Charge (DSC) period, often seven years. The fee may be as high as 6 per cent initially if sold in the first year, and declining every year until the DSC schedules is complete. An advisor selling funds may look at Mr. Lee and think his time horizon is ten years and that he may be invested in the funds through the DSC schedule. If Mr. Lee is sold funds on a back end basis where DSC may apply, he is somewhat squeezed into a corner if he is not happy with his performance, or would like to make a change within the DSC period. For purposes of this illustration we will assume that the only fees Mr. Lee pays is the 2.5 per cent annual MER, or $12,500.
Option 4: Mr. Lee has heard about some guaranteed insurance products called segregated funds. The primary difference between mutual funds and segregated funds is that the later is an insurance product. Being an insurance product, the investments can be set up with different maturity and death benefit guarantees. Another feature is segregated funds have the ability to name beneficiaries to bypass probate and public record. In the case of Mr. Lee the funds he has are registered. With registered accounts it is not necessary to purchase an insurance product to get this benefit as he already has the ability to name a beneficiary, his spouse, which also will assist them in avoiding probate on the first passing. There is a cost to have the insurance benefit noted above. For illustration purposes we will assume the annual MER for a basket of segregated funds is 3.5 per cent, or $17,500 annually.
The long term effect on accumulated savings can be quite shocking when different net returns are explored over a ten year period. To help with the illustration, we will make the assumption that investment returns over the next ten years will be six per cent for all four options.
Option 1: ETF approach – net return is 5.5 per cent (6.0 per cent less the 0.5 per cent fee). A net return of 5.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $854,072 at the beginning of retirement. He would have been responsible for all of his choices of ETFs and have no planning advice. Although costs are low with option 1, there is a high degree of involvement to determine timing of when to buy the ETF and which ones to buy.
Option 2: Direct Holdings in Fee-Based Account – net return is 4.5 per cent (6.0 per cent less the 1.5 per cent fee). A net return of 4.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $776,485 at the beginning of retirement. The additional cost of investing over option 1 would more than likely be offset by higher returns with a good advisor. A knowledgeable advisor is also able to provide you financial planning tips, and service that enables you to do other things in retirement.
Option 3: Holding a Basket of Mutual Funds – net return is 3.5 per cent (6.0 per cent less the 2.5 per cent fee). A net return of 3.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $705,299 at the beginning of retirement.
Option 4: Holding a Basket of Segregated Funds – net return is 2.5 per cent (6.0 per cent less 3.5 per cent fee). A net return of 2.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $640,042 at the beginning of retirement.
The above illustrates a one per cent change in the cost of investing for each option – it clearly shows how these small changes can have a material impact on your long term financial success. The same exercise can be done assuming different percentage returns (i.e. four, five, six, and seven).