Keeping your retirement plan fees low is paramount in a successful retirement plan. Once you know your target retirement asset allocation, the next step is selecting your funds and making sure those mutual funds and/or ETFs are very low cost with minimal expenses. A funds expense ratio is the cost of owning the fund.
Most financial advisors say the standard benchmark of a good retirement expense is 0.50%. Some financial advisors say you should actually strive to be even lower with a 0.25%. I agree with the latter, because, obviously, the lower the better. I am proud to say that my expenses currently sit at 0.08%.
I have an extremely low expense ratio and this is across my entire retirement portfolio, including my employer sponsored 401(k), my personal Roth IRA, and my wife’s Roth IRA. While a 0.08% expense ratio sounds hard to accomplish when the benchmark is 0.25%, its really quite easy to do with low-cost index funds.
I invest solely in Vanguard funds across all of my accounts. The bulk of my holdings are in the Vanguard 500 Index Fund Admiral Class (VFIAX), which has a microscopic 0.05% expense ratio. In fact, I believe that is the lowest possible fund fee on a mutual fund or ETF. You won’t find anything lower than that. My most expensive fund is the Vanguard Target Retirement 2040 Fund (VFORX) at 0.16%, which is still very low and well below the 0.25% benchmark.
According to The Motley Fool, the current average expense ratio of an actively managed mutual fund is 1.50%. This is really high. Its obviously a lot higher than the above benchmark of 0.50% and way more than my personal expense ratio of 0.08%. To help you understand what this actively managed fund fee of 1.50% means, say one year your fund is up 10% on the year, well after expenses its actually only up 8.5% after fees. If your fund is flat one year, you actually lost -1.50% in the market because of your management expenses.
To make the math even easier, I am going to compare the actively managed expense ratio of 1.50% to the 0.50% benchmark most financial advisors aim for. So a full 1% lower. What does that mean for your investments over the long term? Probably a much bigger hit to your potential future wealth than you think.
Future Value with a 1.50% Expense Ratio ($831,000)
Let’s assume you open an account with $1,000, invest $500 monthly for 30 years, and earn 9% annual returns after expenses. Compounded over 30 years, your final investment final would be worth $831,112.91. That’s actually a great return and a hefty final balance. But could you do better simply by investing in index funds versus actively managed funds that are much more expensive?
Future Value with a 0.50% Expense Ratio ($1,000,000)
Now let’s assume you did the exact same as the above, only you earned 10% annual returns versus 9% due to your lower expense ratio. Compounded over 30 years, your final investment final would be worth $1,004,413.54. That 1% expense ratio equates to nearly a $170K difference. The difference in being a millionaire and just shy.
You can’t control the stock market, but you can help aid your investment returns simply by choosing lower cost funds, particularly index funds.