ANNOUNCEMENT: If you haven’t yet caught up with the latest on our 7 Millionaires … in Training! ‘grand experiment’, now’s the time! We have (finally) selected our 7 MITs and this post will bring you up to date with what they (and you) need to review if you really want to get rich. Click here for more …
One of the main reasons that people provide for saving via their 401(k) rather than investing elsewhere is the tax benefit: the money that you (and, your employer via their ‘match’) put into your 401(k) is in ‘pre tax dollars’.
But, keep in mind that there is a hidden ‘tax’ on your 401(k) because of the types of investments that you are forced to choose from: mutual funds.
That hidden ‘tax’ is fees, which the Division of Investment Management in their December 2000 “Report on Mutual Fund Fees and Expenses“ says averages 1.88% (if you amortize the sales commissions over 5 years … if you commit to holding the fund for 10 years, without topping up or selling down, then the average fee drops to 1.52%).
These fees have been trending up (they averaged 1.79% in 1992), so may very well be higher now.
Well the report says:
The growth of the fund industry has been accompanied by a debate over the appropriate level of fund fees. The focus on fund fees is important because they can have a dramatic impact on an investor’s return. For example, a 1% increase in a fund’s annual expenses can reduce an investor’s ending account balance in that fund by 18% after twenty years.
Scott Burns in his latest book (Spend ’til the End) says:
While annual expenses of, say, 1.4% [as we now know, this is an underestimate] for a mutual fund may seem reasonable, paying them is equivalent to being hit with a tax that exceeds 35% – the highest marginal federal income tax rate.
While this last part of the statement is a bit, how shall we say, sensationalist (the ‘tax’ comes at the end, so you are still better off than paying tax on the ‘input’ … so, this is an argument against high -fee Mutual Funds, not 401k’s … you’ll have to go here for that!) the principle is correct ….
… as Scott goes on to point out:
This is not obvious. Wall Street tells us the cost is modest because common stocks can be expected to return an inflation-adjusted 9.1% a year, and 1.40 percent in fees is only 14.6 percent of this expected return. And, if our manager is worth what we pay her, she’ll make a higher return.
Well, that’s why we invest in Mutual Funds … to get the Fund Manager’s expertise!
But does it work? Not according to Scott:
The reality is different. First, most managers fail to beat their appointed benchmark. And they tend to trail it by an amount equal to their expenses. The greater the expenses, the greater the investors’ loss of return.
There you have it … solid reasons NOT to invest in most Mutual Funds, and – as Scott recommends in his book – “invest in equities only via Index Funds” …
… except that these aren’t going to work for you either!
Because you have to focus on RETURNS first and FEES and TAXES later!
The clue comes in the expected 9.1% return for ‘common stocks’ less any fees that you have to pay (even the paltry .10 to .20 percent that you will pay on some low-cost Index Funds).
Will this 9% Net Return (equivalent to a 11.25% – 12.15% net return, depending upon your tax bracket, + employer match, which will tend towards an extra 1% – 3% annual return, IF you are investing via a 401k) get you to Your Number?
If so, then heed Scott’s advice and invest in Low-Cost Index Funds (preferably via a 401k or other tax-advantaged vehicle).
If not, then start looking for where else you can increase your income and/or investment returns (preferably via a tax-advantaged vehicle), or you simply won’t make it!