Performance matters - but fees do, too

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A recurring theme of these columns is that when it comes to investment returns, fees matter a lot.

Low fees are a major reason for the sterling record of index funds compared with actively managed mutual funds.

For example, in 2010 more than 60 percent of the assets in the Standard & Poor's 500 index funds had expense ratios of 0.10 percent or less, according to the Investment Company Institute, an industry trade group. But the median expense ratio for all equity funds is around 1.4 percent.

I recently got some new numbers illustrating the impact of fees on retirement savings. The figures come from Henry "Bud" Hebeler, the founder and driving force behind Analyzenow.com.

Here's the scenario: Three teachers contribute $250 a month for 35 years earning on average an 8 percent annual return. (It's a high return number but you have to make some sort of assumption with these simulations.) Teacher No. 1 pays 2.25 percent in fees and ends up with $336,320. Teacher No. 2 pays 1.25 percent in fees and accumulates $409,585. Teacher No. 3 pays 0.18 percentin fees (which is possible) and amasses $548,750.

Now look at what the fee gap means for money taken out during retirement, assuming a 4 percent withdrawal rate (a standard benchmark for basic illustrations). No. 1 gets $13,452 a year or $1,121 a month. No. 2 receives $16,383 a year or $1,365 a month. No. 3 is paid $21,950 a year or $1,829 a month.

Sad to say, I don't think enough employers have paid close enough attention to the impact of fees on their plan participants. Instead, the focus has been on adding more investment options.

Here's the thing: No one knows how the markets will do over the next 35 years -- let alone the next year. Yet by negotiating for razor-thin fees for their employee retirement plans, employers can boost the odds of their employees doing decently in a well-diversified portfolio relative to the market's performance.

The good news is that employers and employees will become more aware of fees when the new retirement savings plan disclosure rules come into effect in July. The rules are intended to make fees more transparent. The hope is that employers will feel pressure to shop around for a better deal. I think it's a realistic goal.

That's one way to read the report "Fund Expense Ratios Dropped in 2011: Why the average investor is paying less for fund management,'' by Russel Kinnel, Morningstar's director of mutual fund research.

He looked into the trend toward lower expense ratios paid by the average mutual fund investor over the past decade. The average investor is paying 19 basis points less than 10 years ago. (A basis point is one-hundredth of 1 percent.)

A number of factors account for the modest decline, but a major reason is investors are picking lower-cost funds within a category. For example, if they're going to invest in large capitalization stocks they're increasingly choosing the low-cost equity index fund option. It's a smart move.

Chris Farrell is economics editor for "Marketplace Money." Send your questions to cfarrell@mpr.org.

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