Here’s an incentive to build up the habit of diligent saving and investing when you’re a young adult.
The quicker you grow your portfolio, the sooner you’ll benefit from an investing industry pricing bias that favours bigger accounts over small ones. I talked about how this affects do-it-yourself investing using online brokers in my last blog post. Here we’ll look at the economics of paying an adviser.
Mutual funds will almost certainly be an adviser’s choice for young adults with small accounts (most advisers would say anything under $50,000 is puny and lots would say less than $100,000 is also small). If that’s the case, then the adviser’s compensation will be folded into the fees the client pays to own mutual funds. The typical cost of owning a mutual fund sold by an adviser would be 1.5% to 2.5%, depending on the type of fund. Clients never pay that out of pocket. Rather, fund companies deduct these fees from the returns generated by their products (fund returns are always reported on a net basis) and then hand a portion over to advisers who sell their products. Advisers must share these payments, called trailing commissions, with their firms.
Let’s imagine someone has saved and invested regularly over the years and at age 45 has built a $150,000 portfolio. Now, a new and more economic pricing option may be available.
It’s called fee-based pricing and it works as a percentage of the client’s assets. One percent is common, though by no means universal. On top of that 1% you have to add the cost of owning whatever investments you have in your account.
Exchange-traded funds would add an extra 0.15 to 0.65 percentage points in most cases. F-class mutual funds, designed for use in fee-based accounts, might add an extra 0.5% to 1.5%. Using low-cost mutual funds from some of the low-profile blue chip companies out there might add 0.5% to 1%.
If you run the numbers, you’ll see that the fee-based account can work out to be cheaper than the starter mutual fund account. If you pay less to invest, you keep more for yourself. Imagine two accounts, each with $150,000 in them. One account has an all-in fee of 1.5%, the other a fee of 2%. After 10 years, the lower-cost account would be an extra $11,887, assuming returns for both accounts of 7% before fees. Now you see the point behind building your account in order to qualify for lower fees.
Next week, we take a look at the dangers of investment fraud for older investors.