Mutual fund fees and expenses Archives - The Chicago Financial Planner

Annuities: The Wonder Drug for Your Retirement?

January 17, 2022 by Roger Wohlner 12 Comments

Annuities: The Wonder Drug for Your Retirement?

Annuities are often touted as the “cure” for all that ails your retirement. Baby Boomers and retirees are the prime target market for the annuity sales types. You’ve undoubtedly heard many of these pitches in person or as advertisements. The pitches frequently pander to the fears that many investors still feel after the last stock market decline. After all, what’s not to like about guaranteed income?

What is an annuity?

I’ll let the Securities and Exchange Commission (SEC) explain this in a quote from their website:

“An annuity is a contract between you and an insurance company that is designed to meet retirement and other long-range goals, under which you make a lump-sum payment or series of payments. In return, the insurer agrees to make periodic payments to you beginning immediately or at some future date.

Annuities typically offer tax-deferred growth of earnings and may include a death benefit that will pay your beneficiary a specified minimum amount, such as your total purchase payments. While tax is deferred on earnings growth, when withdrawals are taken from the annuity, gains are taxed at ordinary income rates, and not capital gains rates. If you withdraw your money early from an annuity, you may pay substantial surrender charges to the insurance company, as well as tax penalties.

There are generally three types of annuities — fixed, indexed, and variable. In a fixed annuity, the insurance company agrees to pay you no less than a specified rate of interest during the time that your account is growing. The insurance company also agrees that the periodic payments will be a specified amount per dollar in your account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as your lifetime or the lifetime of you and your spouse.

In an indexed annuity, the insurance company credits you with a return that is based on changes in an index, such as the S&P 500 Composite Stock Price Index. Indexed annuity contracts also provide that the contract value will be no less than a specified minimum, regardless of index performance.

In a variable annuity, you can choose to invest your purchase payments from among a range of different investment options, typically mutual funds. The rate of return on your purchase payments, and the amount of the periodic payments you eventually receive, will vary depending on the performance of the investment options you have selected.

Variable annuities are securities regulated by the SEC. An indexed annuity may or may not be a security; however, most indexed annuities are not registered with the SEC. Fixed annuities are not securities and are not regulated by the SEC. You can learn more about variable annuities by reading our publication, Variable Annuities: What You Should Know.”

What’s good about annuities?

In an uncertain world, an annuity can offer a degree of certainty to retirees in terms of receiving a fixed stream of payments over their lifetime or some other specified period of time. Once you annuitize there’s no guesswork about how much you will be receiving, assuming that the insurance company behind the product stays healthy.

Watch out for high and/or hidden fees

The biggest beef about annuities are the fees, which are often hidden or least difficult to find. Many annuity products carry fees that are pretty darn high, others are much more reasonable. In general, the lack of transparency regarding the fees associated with many annuity contracts is appalling.

There are typically several layers of fees in an annuity:

Fees connected with the underlying investments. In a variable annuity there are fees connected with the underlying sub-account (accounts that resemble mutual funds) similar to the expense ratio of a mutual fund. In a fixed annuity the underlying fees are typically the difference between the net interest rate you will receive vs. the gross interest rate earned. In the case of an indexed annuity product the fees are just plain murky.

Mortality and expense charges are fees charged by the insurance company to cover their costs for guaranteeing a stream of income to you. While I get this and understand it, the wide variance in these and other fees across the universe of annuity contracts and the insurance companies that provide them makes me shake my head.

Surrender charges are fees that are designed to keep you from withdrawing your funds for a period of time. From my point of view these charges are heinous whether in an annuity, a mutual fund, or anyplace else. If you are considering an annuity and the product has a surrender charge, avoid it. I’m not advocating withdrawing money early from an annuity, but surrender charges also restrict you from exchanging a high cost annuity into one with a lower fee structure. Essentially these fees serve to ensure that the agent or rep who sold you the high fee annuity (and the insurance company) continue to benefit by placing handcuffs on you in terms of sticking with the policy.

Who’s really guaranteeing your annuity?

When you purchase an annuity, your stream of payments is guaranteed by the “full faith and credit” of the underlying insurance company. This differs from a pension that is annuitized and backed by the PBGC, a governmental entity, up to certain limits.

Outside of the most notable failure, Executive Life in the early 1990s, there have not been a high number of insurance company failures. In the case of Executive Life, thousands of annuity recipients were impacted in the form of greatly reduced annuity payments which in many cases permanently impacted the quality of their retirement.

Insurance companies are regulated at the state level; state insurance departments are generally the backstop in the event of an insurance company failure. In most cases you will receive some portion of the payment amount that you expected, but there is often a delay in receiving these payments.

The point is not to scare anyone from buying an annuity but rather to remind you to perform your own due diligence on the underlying insurance company.

Should you buy an annuity?

Annuities are not a bad product as long as you understand what they can and cannot do for you. Like anything else you need to shop for the right annuity. For example, an insurance agent or registered rep is not going to show you a product from a low cost provider who offers a product with ultra-low fees and no surrender charges because they receive no commissions.

An annuity can offer diversification in your retirement income stream. Perhaps you have investments in taxable and tax-deferred accounts from which you will withdraw money to fund your retirement. Adding Social Security to the mix provides a government-funded stream of payments. A commercial annuity can also be of value as part of your retirement income stream, again as long as you shop for the appropriate product.

Annuities are generally sold rather than bought by Baby Boomers and others. Be a smart consumer and understand what you are buying, why a particular annuity product (and the insurance company) are right for you, and the benefits that you expect to receive from the annuity. Properly used, an annuity can be a valuable component of your retirement planning efforts. Be sure to read ALL of the fine print and understand ALL of the expenses, terms, conditions and restrictions before writing a check.

Approaching retirement and want another opinion on where you stand? Not sure if your investments are right for your situation? Need help getting on track? Check out my Financial Review/Second Opinion for Individuals service for detailed guidance and advice about your situation.

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Filed Under: Annuities Tagged With: Annuity, Equity-indexed annuity, Financial plan, Financial Planning, Investing, Investment management, Mutual fund, Mutual fund fees and expenses, retirement, Retirement planning

401(k) Fee Disclosure and the American Funds

January 16, 2021 by Roger Wohlner 45 Comments

With the release and subsequent repeal of the Department of Labor’s fiduciary rules for financial advisors dealing with client retirement accounts, much of the focus in recent years has been on the impact on advisors who provide advice to clients for their IRA accounts. Long before these rules were unveiled and then repealed, financial advisors serving 401(k) plan sponsors have had a fiduciary responsibility to act in the best interests of the plan’s participants under the DOL’s ERISA rules.

Starting in 2012, retirement plan sponsors have been required to disclose the costs associated with the investment options offered in 401(k) plans annually.

As an illustration, here’s how the various share classes offered by the American Funds for retirement plans stack up under the portion of the required disclosures that deal with the costs and performance of the plan’s investment options.

American Funds EuroPacific Growth

The one American Funds option that I’ve used most over the years in 401(k) plans is the EuroPacific Growth fund. This fund is a core large cap foreign stock fund. It generally has some emerging markets holdings, but most of the fund is comprised of foreign equities from developed countries. The R6 share class is the least expensive of the retirement plan share classes. Let’s look at how the various share classes stack up in the disclosure format:

Share Class	Ticker	Expense Ratio	Expenses per $1,000 invested	Trailing 1-year return	Trailing 3-year return	Trailing 5-year return
R1	RERAX	1.58%	$15.80	23.86%	9.51%	11.22%
R2	RERBX	1.56%	$15.60	23.89%	9.52%	11.24%
R3	RERCX	1.12%	$11.20	24.43%	10.02%	11.74%
R4	REREX	0.81%	$8.10	24.81%	10.35%	12.08%
R5	RERFX	0.51%	$5.10	25.19%	10.69%	12.42%
R6	RERGX	0.46%	$4.60	25.27%	10.74%	12.47%

3-and 5-year returns are annualized. Source: Morningstar Data as of 12/31/2020

While the chart above pertains only to the EuroPacific Growth fund, looking at the six retirement plan share classes for any of the American Funds products would offer similar relative results.

The underlying portfolios and the management team are identical for each share class. The difference lies in the expense ratio of each share class. This is driven by the 12b-1 fees associated with the different share classes. This fee is part of the expense ratio and is generally used all or in part to compensate the advisor on the plan. In this case these advisors would generally be registered reps, brokers, and insurance agents. The 12b-1 fee can also revert to the plan to lower expenses. The 12b-1 fees by share class are:

R1 1.00%

R2 0.75%

R3 0.50%

R4 0.25%

R5 and R6 have no 12b-1 fees.

Growth of $10,000 invested

The real impact of expense differences can be seen by comparing the growth of $10,000 invested by a hypothetical investor on December 31, 2010 and held through December 31, 2020.

The $10,000 invested in the R1 shares would have grown to a value of $19,580.32.
The $10,000 invested in the R6 shares would have grown to a value of $21,880.57.

This is a difference of $2,300.25 or 11.7%. The portfolios of the two share classes of the fund are identical, the difference in performance is due to the difference in expenses for the two share classes. If you think of these as two retirement plan participants, one whose plan uses the R1 share class and the other whose plan uses the R6 share class, the first investor would have 11.7% less after ten years due to their plan sponsor’s choice regarding which fund share class to offer.

This analysis assumes a one-time investment of $10,000 and the reinvestment of all distributions. Morningstar’s Advisor Workstation was used to perform this analysis.

Share classes matter

The R1 and R2 shares have traditionally been used in plans where the 12b-1 fees are used to compensate a financial salesperson. This is fine as long as that salesperson is providing a real service for their compensation and is not just being paid to place the business.

If you are a plan participant and you notice that your plan has one or more American Funds choices in the R1 or R2 share classes, in my opinion you probably have a lousy plan due to the extremely high expenses charged by these share classes. It is incumbent upon you to ask your employer if the plan can move to lower cost shares or even a different provider. The R3 shares are a bit of an improvement but still quite pricey for a retirement plan in my opinion.

To be clear, I’m generally a fan of the American Funds. Overall however, their funds tend to offer a large number of share classes between their retirement, non-retirement and 529 plan shares. While the overall portfolios are generally the same, it’s critical for investors and retirement plan sponsors to understand the differing expense structures and the impact they have on potential returns.

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Filed Under: 401(k) Tagged With: 401(k), American Funds, Investment, Mutual fund, Mutual fund fees and expenses, Pension

6 Investment Expenses You Need to Understand

October 1, 2018 by Roger Wohlner 5 Comments

Investment expenses reduce your investment returns. While nobody should expect investment managers, financial advisors or other service providers to offer their services for free, investors should understand all costs and fees involved and work to reduce their investment expenses to the greatest extent possible.

Here are 6 investment expenses you need to understand in order to maximize your returns.

Mutual fund and ETF expense ratios

All mutual fund and ETFs have expense ratios. These fees cover such things as trading costs, compensation for fund managers and support staff and the fund firm’s profit. Expense ratios matter and investors shouldn’t pay more than they need to.

Vanguard’s site, as you might expect, deals with this topic at length. In one example, it shows the impact of differing levels of fees on a hypothetical $100,000 initial account balance over 30 years with a yearly return of 6%. After 30 years the balance in the account would be:

$574,349 with no investment cost

$532,899 with an investment cost of 25 basis points

$438,976 with an investment cost of 90 basis points

These numbers clearly illustrate the impact of fund fees on an investor’s returns and their ability to accumulate assets for financial goals like retirement and funding their children’s college educations.

Mutual fund expense ratios are an example of where paying more doesn’t get you more. Case in point, Vanguard Value Index Adm (VVIAX) has an expense ratio of 0.05%. The Morningstar category average for the large cap value asset class is 1.03%. For the three years ending September 30, 2018 the fund ranked in the top 10% of all funds in the category; for the trailing five years it placed in the top 6% and for the trailing ten years it placed in the top 24% in terms of investment performance.

Sales loads and 12b-1 fees

Front-end sales loads are an upfront payment to a financial advisor or registered rep. Front-end sales loads reduce the amount of your initial investment that actually goes to work for you. For example, if a rep suggests investing in a mutual fund like the American Funds EuroPacific Growth A (AEPGX) for every $10,000 the investor wants to invest, $575 or 5.75% will be deducted from their initial investment balance to cover the sales load. Over time this will reduce the investor’s return versus another version of the same fund with a similar expense ratio that doesn’t charge a sales load.

Some will argue that this load is a one-time payment to the advisor and their firm for their advice. This strikes me as dubious at best, but investors need to decide for themselves whether the advice received in exchange for paying a sales load warrants this drain on their initial and subsequent investments. This share class has an expense ratio of 0.82% which includes a 12b-1 fee of 0.24% (see more on 12b-1 fees below).

Level loads are associated with C shares. The American Funds EuroPacific Growth C (AEPCX) fund has a level load of 1% in the form of a 12b-1 fee and an overall expense ratio of 1.60%. Brokers and registered reps love these as the level load stays in place for ten years until the funds convert to a no-load share class of the fund. There is a 1% surrender charge if the fund is redeemed within the first year of ownership.

12b-1 fees are a part of the mutual fund’s expense ratio and were originally designated to be marketing costs. They are now used as trialing compensation for financial advisors and reps who earn compensation from selling investment products. They can also be used to provide revenue-sharing in a 401(k) plan. While 12b-1 fees don’t increase expenses as they are part of the fund’s expense ratio, typically funds with a 12b-1 fee will have a higher expense ratio than those that don’t in my experience.

401(k) expenses

For many of us our 401(k) plan is our primary retirement savings vehicle. Beyond the expense ratios of the mutual funds or other investments offered, there are costs for an outside investment advisor (or perhaps a registered rep or broker who sold the plan) plus recordkeeping and administration among other things. If your employer has these costs paid by the plan they are coming out of your account and reducing the return on your investment.

Be sure to review the annual fee disclosures provided by your employer for your company’s plan for information on the plan’s expenses.

Financial advice fees

Fees for financial advice will vary depending upon the type of financial advisor you work with.

Fee-only financial advisors will charge fees for their advice only and not tied to any financial products they recommend. Fees might be charged on an hourly basis, on a project basis for a specific task like a financial plan, based on assets under management or a flat retainer fee. The latter two options would generally pertain to an ongoing relationship with the financial advisor.

Fee-based or fee and commission financial advisors will typically charge a fee for and initial financial plan and then sell you financial products from which they earn some sort of commission if you choose to implement their recommendations. Another version of this model might have the advisor charging a fee for investment management services, perhaps via a brokerage wrap account, and receiving commissions for selling any insurance or annuity products. They also would likely receive any trailing 12b-1 fees from the mutual funds used in the wrap account or from the sale of loaded mutual funds.

Commissions arise from the sale of financial and insurance products including mutual funds, annuities, life insurance policies and others. The financial advisor is compensated from the sale of the product and in one way or another you pay for this in the form of higher expenses and/or a lower net return on your investment.

Investors need to understand these fees and what they are getting in return. In fact, a great question to ask any prospective financial advisor is to have them disclose all sources of compensation that they will receive from their relationship with you.

Surrender charges

Surrender charges are common with annuities and some mutual funds. There will be a period of time where if the investor tries to sell the contract or the fund they will be hit with a surrender charge. I’ve seen surrender periods on some annuities that range out to ten years or more. If you decide the annuity is not for you or you find a better annuity, the penalty to leave is onerous and costly.

Taxes

Taxes are a fact of life and come into play with your investments. Investments held in taxable accounts will be taxed as either long or short-term when capital gains are realized. You may also be subject to taxes from distributions from mutual funds and ETFs for dividends and capital gains as well.

Investments held in a tax-deferred account such as a 401(k) or an IRA will not be taxed while held in the account but will be subject to taxes when distributions are taken.

Tax planning to minimize the impact of taxes on your investment returns can help, but investment decisions should not be made solely for tax reasons.

Fees and expenses can take a big bite out of your investment returns.

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The Bottom Line

Fees and expenses can take a big bite out of your investment returns and your ability to accumulate an amount sufficient to achieve your financial goals. Investors need to understand all costs and expenses associated with their investments and take steps to minimize these costs.

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Filed Under: Investing Tagged With: 401(k), Annuity, ETF, Financial Advisor, Investing, Mutual fund, Mutual fund fees and expenses

Reverse Churning Are You a Victim?

June 4, 2017 by Roger Wohlner 7 Comments

One of the best things about being a freelance financial writer and blogger is that I often learn new things in the course of my writing. A reader left a comment on a post here on the blog and mentioned reverse churning. Until that time, I had never heard this term, but after a bit of research I found that its’s one more thing that clients of stock brokers and registered reps need to be aware of.

The issue of reverse churning is one that will come to the forefront as the initial implementation of the DOL fiduciary rules commences next week. Here’s what you need to know about reverse churning to protect yourself and to make a good decision if your broker proposes a fee-based account.

What is churning?

Investopedia defines churning as “Excessive trading by a broker in a client’s account largely to generate commissions. Churning is an illegal and unethical practice that violates SEC rules and securities laws.”

Churning conjures images such as the boiler room in the movie Glengarry Glen Ross (actually they sold real estate) or the iconic 2002 ad by Charles Schwab (SCHW) in which a brokerage house manager is depicted as telling the brokers, “Let’s put some lipstick on this pig” in reference to a sub-par stock he wants them to pitch to clients.

What is reverse churning?

A 2014 piece by Daisy Maxey in The Wall Street Journal describes reverse churning as follows:

“The Securities and Exchange Commission says the practice of so-called “reverse churning”–putting investors in accounts that pay a fixed fee but generate little or no activity to justify that fee–is on its radar. Regulators will be watching for signs of double-dipping by advisers who generate significant commissions within a client’s brokerage account, then move that client into an advisory account and collect additional fees.”

This occurs in brokerage accounts that at one point generated significant commissions for the broker from the purchase and sale of individual stocks or other commission generating transactions. If the activity in the account tails off the broker makes little or nothing from this client.

As a way to generate ongoing fees from this type of client, the broker may suggest moving to a fee-based advisory account, often called a wrap account.

Under this arrangement there is an ongoing fee based upon the assets in the account plus often trailing commissions in the form of 12b-1 fees from the mutual funds usually offered in this type of account. These generally include proprietary mutual funds offered by the brokerage firm, or at the very least costly actively managed funds from other fund families in share classes geared to offering broker compensation.

Fee-based is not fee-only

Fee-based is often confused with fee-only. I suspect the brokerage industry likes it this way.

Fee-only compensation means that the financial advisor earns no compensation from the sale of financial products including trailing fees and commissions. Their fees come from their clients. These can be hourly, a flat-fee or as a percentage of the assets under management.

Fee-based compensation, also called fee and commission, is a mix of the two forms of advisor compensation. A common form of the fee-based model entails the client paying the advisor to do a financial plan and then if the client chooses to have the financial advisor implement their recommendations this will often be via the sale of commission-based products.

The version with fee-based advisory accounts associated with reverse churning by brokers and registered reps arose out of a 2007 rule that prohibits the charging of fees in brokerage accounts. Many broker-dealers have a registered investment advisor (RIA) arm which runs these accounts.

The fiduciary rule

The new fiduciary rules make fee-based accounts more desirable for brokers and other fee-based advisors. These types of accounts will become even more prevalent with the disclosures required for retirement accounts under the new rules.

There has been a movement towards fee-based accounts in the brokerage world for several years now, likely in anticipation of the eventual issuance of these rules. This movement should accelerate in IRAs. In some cases, this will be a good thing as clients will fully know what they are paying in terms of fees.

In other cases, clients will find themselves paying 100 basis points or more in wrap fees for accounts where they were formerly trading infrequently on a commissioned basis. Whether the fee-based account will be a better deal will vary.

If all they are getting is an expensive managed account filled with bad to mediocre mutual funds that charge high fees on top of the wrap fee, this is not a good deal. If the advisor does little more than collect a fee, this sounds like the definition of reverse churning based on my understanding of the term. Much will depend upon the level and types of advice clients receive for the fees they will now be paying.

Buyer beware

If you are working with a stock broker or registered rep and they propose moving to a fee-based or wrap account, you should take a hard look at what you are being offered. What is the wrap fee? What types of investments are used in the account? Are they expensive actively managed mutual funds that throw off 12b-1 fees in addition to wrap fees? What is the track record of the manager of the account that the advisor is proposing? What types of advice and service will you receive for the fees you will paying?

If your broker proposes a wrap account make sure this arrangement is in your best interest.

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The Bottom Line

I can’t recall hearing about a case of churning in recent years. Reverse churning is a new term to me, but from the perspective of a broker or registered rep, fee-based advisory accounts make a ton of sense. They provide ongoing fee income and frankly require little attention from them. If your broker proposes a wrap account, make sure you understand how this arrangement benefits you the client.

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Filed Under: Investing Tagged With: Active management, fee-only, Financial Advisor, Investing, Mutual fund, Mutual fund fees and expenses

5 Reasons 401(k) Lawsuits Matter to You

November 20, 2015 by Roger Wohlner 9 Comments

Several 401(k) lawsuits against major employers have been in the news this year. These suits are about high fees, conflicts of interest and plan sponsors failing to live up to their fiduciary obligations.

Ameriprise Financial settled a suit that alleged that the firm offered a number of its own proprietary mutual funds in the company’s 401(k) plan and collected revenue sharing payments on these funds from an Ameriprise subsidiary.

The U.S. Supreme Court ruled in Tibble vs. Edison International that the large utility company had a duty to monitor the investments offered in the plan no matter how long along they were initially added to the plan. One of the issues here surrounds the fact that lower cost share classes of these funds became available but the plan stayed with the higher cost retail share class.

Most recently Boeing settled a lawsuit that was first filed in 2006 for $57 million. The suit alleged that the company had breached its fiduciary duty to its employees by using high cost and risky investment options in the plan and by allowing the plan’s record keeper to charge employees and retirees excessive fees.

While all of this may be interesting, you may be asking what does any of this have to do with me? Here are 5 reasons 401(k) lawsuits matter to you.

Plan Sponsors have a fiduciary obligation

These and a growing number of 401(k) related lawsuits have reaffirmed that retirement plan sponsors have a fiduciary obligation to act in the best interests of the plan participants. This includes:

The selection and monitoring of the mutual funds (or other investment vehicles) offered in the plan.

The selection and monitoring of the service providers selected for the plan.

All costs and fees associated with the plan.

Moreover plan sponsors should have a process in place to manage all aspects of the plan.

401(k) plan sponsors have a fiduciary obligation to their employees.

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Mutual Fund share classes

Several of the lawsuits centered on plan sponsors offering expensive retail share classes of funds when lower cost share classes were available. These higher cost share classes might throw off more revenue sharing and other fees to the plan but they are more expensive for the plan participants. It behooves plan sponsors more now than ever to offer the lowest cost share classes of a given fund available to them.

Numerous studies have shown the connection between lower investment costs and investment return. Well-run 401(k) plans strive to keep investment costs down and one way to do this is to ensure that the plan offers the lowest mutual fund share classes available.

There is a direct relationship between low investment costs and return.

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Duty to monitor

As shown in the Tibble versus Edison ruling the Supreme Court said plan sponsors have a duty to continue to monitor the investments offered in the plan long after they may have been initially offered. This dovetails into an ongoing duty of plan sponsors to monitor the investments offered to you to ensure the costs are reasonable and that they meet a set of criteria.

Typically a 401(k) that is well-monitored and managed via a consistent investment process will tend to offer a better investment line-up to their participants.

Manage plan expenses

Boeing recently settled the second largest 401(k) suit in history at $57 million. In part the allegations included that Boeing allowed its outside record keeper to charge employees and retirees excessive fees.

This and other suits underscore the responsibility of plan sponsors to manage 401(k) plan costs and the activities of plan providers such as an outside record keeper. To the extent that administrative expenses are paid out of plan assets plan sponsors who strive to keep these expenses low are doing the right thing for their employees.

Plan Sponsors are getting it

While this is not a blanket statement as there are still plenty of lousy 401(k) plans out there, there is evidence that plan sponsors are getting the message that they have a responsibility to the plan’s participants.

As an example mutual fund expenses in 401(k) plans have been declining for the past 15 years. Fewer companies are mandating the use of company stock in their 401(k) plans and a 2014 Supreme Court ruling will certainly help keep this trend going.

The Bottom Line

Retirement plan sponsors have a fiduciary obligation to act in the best interests of the plan’s participants. A number of 401(k) lawsuits in recent years have served to reinforce this duty and this is a good thing for those participating in 401(k) plans. As a plan participant become knowledgeable about the investments offered in your plan and how much the plan is costing you. If you have concerns raise them in a constructive fashion to your employer.

FINANCIAL WRITING. Check out my freelance financial writing services including my ghostwriting services for financial advisors.

Filed Under: 401(k) Tagged With: 401(k), Investing, Mutual fund fees and expenses, retirement, Supreme Court of the United States

Are Brokerage Wrap Accounts a Good Idea?

January 4, 2015 by Roger Wohlner 4 Comments

A reader recently emailed a question regarding a brokerage wrap account he had inherited from a relative. He mentioned that he was being charged a one percent management or wrap fee and also suspected that he was incurring a front-end load on the A share mutual funds used in the account.

Upon further review we determined that the mutual funds were not charging him a front-end load. Almost all of the funds being used, however, had expense ratios in excess of one percent plus most assessed 12b-1 fees paid to the brokerage firm as part of their expense ratios.

Are brokerage wrap accounts a good idea for you? Let’s take a look at some questions you should be asking.

What are you getting for the wrap fee?

This is the ultimate question that any investor should ask not only about wrap accounts but any financial advice you are paying for.

In the case of this reader’s account it sounds like the registered rep is little more than a sales person who put the reader’s uncle into this managed option. From what the reader indicated to me there is little or no financial advice provided. For this he is paying the brokerage firm the one percent wrap fee plus they are collecting the 12b-1 fees in the 0.25 percent to 0.35 percent on most of the funds used in the account.

Before engaging the services of a financial advisor you would be wise to understand what services you should expect to receive and how the adviser and their firm will be compensated. Demand to know ALL aspects of how the financial advisor will be compensated. This not only lets you know how much the relationship is costing you but will also shed light on any potential conflicts of interest the advisor may have in providing you with advice.

What’s special about the wrap account?

While the reader did not provide me with any performance data on the account, from looking at the underlying mutual funds it would be hard to believe that the overall performance is any better than average and likely is worse than that.

Whether a brokerage wrap account or an advisory firm’s model portfolio you should ask the financial advisor why this portfolio is appropriate for you. Has the performance of the portfolio matched or exceeded a blended benchmark of market indexes based on the portfolio’s target asset allocation? Does the portfolio reduce risk? Are the fees reasonable?

What are the underlying investments?

In looking at the mutual funds used in the reader’s wrap account there were a few with excellent returns but most tended to be around the mid-point of their asset class. Their expenses also tended to fall at or above the mid-point of their respective asset classes as well.

Looking at one example, the Prudential Global Real Estate Fund Class A (PURAX) was one of the mutual funds used. A comparison of this actively managed fund to the Vanguard REIT Index Fund Investor shares (VGSIX) reveals the following:

Expense ratios:

	PURAX	VGSIX
Expense Ratio	1.26%	0.24%
12b-1 fee	0.30%	0.00%

Trailing returns as of 12/31/14:

	1 year	3 years	5 years	10 years
PURAX	14.03%	14.47%	11.12%	6.66%
VGSIX	30.13%	16.09%	16.84%	8.41%

While the portfolio manager of the wrap account could argue the comparison is invalid because the Prudential fund is a Global Real Estate fund versus the domestic focus of the Vanguard fund I would argue what benefit has global aspect added over time in the real estate asset class? Perhaps the attraction with this fund is the 30 basis points the brokerage firm receives in the form of a 12b-1 fee?

Looking at another example the portfolio includes a couple of Large Value funds Active Portfolios Multi-Manager A (CDEIX) and CornerCap Large/Mid Cap Value (CMCRX). Comparing these two funds to an active Large Value Fund American Beacon Large Value Institutional (AADEX) and the Vanguard Value Index (VIVAX) reveals the following:

Expense ratios:

	CDEIX	CMCRX	AADEX	VIVAX
Expense Ratio	1.26%	1.20%	0.58%	0.24%
12b-1 fee	0.25%	0.00%	0.00%	0.00%

Trailing returns as of 12/31/14:

	1 year	3 years	5 years	10 years
CDEIX	10.01%	NA	NA	NA
CMCRX	13.11%	19.30%	12.98%	5.78%
AADEX	10.56%	21.11%	14.73%	7.57%
VIVAX	13.05%	19.98%	14.80%	7.17%

Again one has to ask why the brokerage firm chose these two Large Value funds versus the less expensive institutionally managed active option from American Beacon or the Vanguard Index option. I’m guessing compensation to the brokerage firm was a factor.

Certainly the returns of the overall wrap account portfolio are what matters here, but you have to wonder if a wrap account uses funds like this how well the account does overall for investors.

The lesson for investors is to look under the hood of any brokerage wrap account you are pitched to be sure you understand how your money will be managed. I’m not so sure that my reader is being well served and after our email exchange on the topic I hope he has some tools to make an educated evaluation for himself.

The Bottom Line

Brokerage wrap accounts are an attempt by these firms to offer a fee-based investing option to clients. As with anything investors really need to take a hard look at these accounts. Far too many charge substantial management fees and utilize expensive mutual fund options as their underlying investments. It is incumbent upon you to understand what you are getting in exchange for the fees paid. Is this investment management style unique and better? Will you be getting any actual financial advice?

The same cautions hold for advisory firm model portfolios, the offerings of ETF strategists and managed portfolios offered in 401(k) plans. You need to determine if any of these options are right for you.

FINANCIAL WRITING. Check out my freelance financial writing services including my ghostwriting services for financial advisors.

Filed Under: Investing Tagged With: AADEX, Active management, Asset allocation, CDEIX, CNCRX, EMGAX, Index fund, Investing, Mutual fund, Mutual fund fees and expenses, Personal finance, VGSIX, VIVAX

Your 401(k) is not Free

March 16, 2014 by Roger Wohlner 2 Comments

Several studies in recent years have highlighted the fact that a significant percentage of 401(k) plan participants don’t realize that their company retirement plan is not free. Further they were not aware that they often pay all or a portion of these expenses out of their plan accounts.

A 2011 study by AARP showed that 71% of the 401(k) participants that were surveyed were unaware there were expenses associated with their retirement plan. The survey also showed a high level of misunderstanding of plan fees even by those who were aware of them. More recent studies have also shown significant levels of both participants who are unaware of the fees and a high level of misunderstanding, even with the advent of required 401(k) fee disclosures in 2012.

Typical 401(k) plan fees and expenses

There has been an emphasis on the negative impact that high cost 401(k) plans have on the ability of participants to save for retirement via media. The 2013 PBS Frontline program The Retirement Gamble, for example did a nice job of highlighting the negative impact of high fees on retirement savers. Some of the expenses that are typical of a 401(k) plan include:

Investment expenses. Here I am primarily referring to the expense ratios of the mutual funds, collective trusts, annuity sub-accounts, or ETFs offered as investment choices by the plan. Using mutual funds as an example, all mutual funds have an expense ratio whether you invest within a 401(k) plan or outside the plan. The key is whether the expense ratios of the choices offered by your plan are reasonable.
Administration and record keeping. This includes keeping track of plan assets, participant assets, ensuring that salary deferrals and matching contributions are invested in line with the participant’s elections, generating quarterly statements, as well as various testing and external reporting functions.
Custody of plan assets. This is where the money invested and the mutual funds (or other investment vehicles) are housed. Examples of custodians might be Fidelity, Vanguard, Schwab, Wells Fargo, etc.
Investment advisor. The fees here are for an outside investment advisor who provides advice to the plan sponsor in areas like investment selection and monitoring and the development of an Investment Policy Statement for the plan. However, sometimes these charges are simply the compensation for a registered rep who sells the plan to company and may offer little or no actual investment advice.

Other than mutual fund expense ratios (investor returns are always net of expenses) these expenses may be paid from plan assets (your money), by the company or organization sponsoring the plan, or a combination of both. For example the plan sponsors who engage my services as advisor to their plan pay my fees from company assets so the plan participants bear none of the cost.

Additionally the delivery of these various functions can be fully bundled, partially bundled, or totally unbundled. Generally (and hopefully) the outside investment advisor is independent of the other service providers.

Providers like Fidelity, Vanguard, or Principal are example of bundled providers. They provide the investment platform, custody the assets, and do all of the administration and record keeping. In an unbundled arrangement, the custodian, record keeper, and the investment advisory functions are all separate and provided by separate entities.

Neither arrangement is inherently good or bad, it is incumbent upon the organization sponsoring the plan to monitor the costs and quality of the services as part of their Fiduciary duty to you the plan participant. Plan sponsors should insist on transparency regarding all provider expenses.

BrightScope

BrightScope is a service that independently rates 401(k) plans on a number of criteria. Check to see if your company’s plan is ranked by them at their site.

Mutual Fund expenses

The required fee disclosures that I mentioned above focus on the plan’s investment options and their expenses. You should start seeing them in the near future.

While they may not look particularly informative and don’t delve into the plan’s total costs, the investment expenses can be telling none the less.

If your plan is via a large employer, you may see institutional share class mutual funds with very low expense ratios. As an example my wife works for a division of a Fortune 150 company and some of the index funds available to her have expense ratios less than 0.05% which is very low.

In fact looking at the fund share classes offered by your plan is also revealing.

The American Funds offer six share classes for retirement plans ranging from R1 to R6. Using the popular American Funds EuroPacific Growth fund as an example you can see the differences in the expenses and the impact on return below.

	Ticker	Expense Ratio	12b-1	5 Year return
R1	RERAX	1.61%	1.00%	15.35%
R2	RERBX	1.60%	0.74%	15.35%
R3	RERCX	1.14%	0.50%	15.90%
R4	REREX	0.85%	0.25%	16.24%
R5	RERFX	0.55%	0.00%	16.58%
R6	RERGX	0.50%	0.00%	16.62%

Source: Morningstar as of 3/14/14

Looking at this another way, $10,000 invested in the R1 and R6 share classes would have grown to the following amounts by February 28, 2014:

R1 $20,915

R6 $23,022

I think you will agree that this is a rather significant difference.

The 12b-1 fees are included in the fund’s expense ratio and generally go to compensate the plan provider, the registered rep or broker who sold the plan or other service providers. In the case of the American Funds you generally see the R1, R2, and R3 shares in higher cost, broker sold plans.

Similar share class comparisons can be made with other mutual funds in many other families including Fidelity, T. Rowe Price, and even low-cost Vanguard.

According to Morningstar data as of 12/31/13 here are the median expense ratios for the following investment styles:

Large Blend	1.07%
Large Growth	1.15%
Large Value	1.07%
Mid Cap Blend	1.16%
Mid Cap Growth	1.24%
Mid Cap Value	1.24%
Small Cap Blend	1.23%
Small Cap Growth	1.36%
Small Cap Value	1.31%
Foreign Large Blend	1.23%
Intermediate Bond	0.79%

While these are median expense levels I would say that for the most part if the funds in your plan are at these levels they are too expensive. Index funds across these categories should be 0.25% or less.

Several studies have concluded that the biggest determinant in retirement success is the amount saved. None the less having access to a solid, low cost 401(k) plan as vehicle for retirement investing is a big plus.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.

Photo credit: Flickr

Filed Under: 401(k) Tagged With: 401(k), American Funds, Mutual fund fees and expenses, retirement

1% a Small Number with Big Implications

November 16, 2013 by Roger Wohlner 4 Comments

The inspiration for this post comes from fellow finance blogger and financial advisor Jim Blankenship and his November is “Add 1% to Your Savings Month” movement.

It’s amazing how a small number like 1% can have such a big impact on your investments and the amount you’ll be able to accumulate for goals like retirement. Here is a look at the impact of saving 1% on your investment expenses.

Mutual fund expenses matter

Using two share classes of the American Funds EuroPacific Growth fund as an example, the chart below illustrates the impact of 1% in expenses on the growth of your investment. I was able to find two share classes of this fund whose expense ratios were exactly 1% different. The B shares (ticker AEGBX) carry an expense ratio of 1.59% and the F-2 shares (ticker AEPFX) which carry and expense ratio of 0.59%. Using Morningstar’s Advisor Workstation I compared the growth of a hypothetical $10,000 investment in each fund held over three time periods.

5 years ending 10/31/13

	Value of $10,000 investment
B Shares	$17,710
F-2 Shares	$18,606

As you can see varying nothing more than the expense ratio in these otherwise identical mutual funds, investing in the fund with a 1% lower expense ratio resulted in the accumulation of an additional $896 a 5.1% increase over an investment in the B share class.

10 years ending 10/31/13

	Value of $10,000 investment
B Shares	$22,677
F-2 Shares	$24,734

Again varying nothing more than the expense ratio in these otherwise identical mutual funds, investing in the fund with a 1% lower expense ratio resulted in the accumulation of an additional $2,057 a 9.1% increase over an investment in the B share class.

From 4/30/84 through 10/31/13

	Value of $10,000 investment
B Shares	$205,652
F-2 Shares	$260,042

Once again varying nothing more than the expense ratio in these otherwise identical mutual funds, investing in the fund with a 1% lower expense ratio resulted in the accumulation of an additional $54,390 a 26.4% increase over an investment in the B share class.

A couple of things about the above comparison: The assumption is that an investor put $10,000 into each of the funds and held them for the full time period, including the reinvestment of all fund distributions. Any potential taxes or the expenses of engaging an investment advisor were not considered. Further B shares are no longer available to new investors and even when they were they would generally convert to the less expensive A shares after a period of time. None the less this comparison illustrates the impact saving 1% on your investment expenses can have on your returns and the amount you can potentially accumulate over time.

How to reduce investing expenses

While you may not always be able to save a full 1%, reducing your investment expenses by even a fraction of 1% can have a significant positive impact. Here are some ideas that may help:

Utilize low cost index mutual funds and ETFs where possible and where they fit your investment strategy. In many asset classes index funds outperform the majority of actively managed products. Combine this with low expenses and index funds have a major leg up on most of their competitors.
In all cases make sure that you invest in the lowest cost share class of a given mutual fund that is available to you.
Avoid sales loads whenever possible.
Understand the expenses associated with the investment choices in your company’s 401(k) plan and the plan’s overall expenses. If they are excessive consider asking your company’s plan administrator to look at some lower cost alternatives. You might also consider limiting your contributions to the amount needed to receive the maximum company match (if one is offered) and invest the remainder of your retirement savings elsewhere.
If you work with a financial advisor you must fully understand all of the ways in which your advisor makes money from your relationship. This might include fees (hourly, flat-fee, or a percentage of assets). In some cases the advisor makes money from the investment and insurance products they sell to you. This can include up-front sales commissions (loads), deferred loads (B shares which are mostly obsolete), and level loads (C shares). Additionally the advisor may make money from trialing commissions (12b-1 fees) or surrender charges incurred if your sell out of some mutual funds or annuity products too early. If you are a regular reader of this blog you know that I am horribly biased in favor of using fee-only advisors (of which and I am one), avoiding the inherent conflict of interest that can arise when an advisor earns money from the sale of financial products.

Saving 1% might seem like a trivial endeavor, but as you can see it can have big ramifications for investors.

Please contact me at 847-506-9827 for a complimentary 30-minute consultation to discuss all of your financial planning and investing questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.

Photo credit: Flickr

Filed Under: Uncategorized Tagged With: Expense ratio, Index fund, Investing, Investment, Mutual fund, Mutual fund fees and expenses

The Ameriprise 401(k) Lawsuit – What Does it Mean to You?

February 13, 2013 by Roger Wohlner 8 Comments

Update: In March of 2015 Ameriprise settled this suit for $27.5 million before the case was to go to trial. Kudos to St. Louis attorney Jerome Schlichter for his work on behalf of these 24,000 current and former plan participants.

A lawsuit brought by a group of current and former employees of financial services firm Ameriprise has been allowed to proceed. The suit alleges that Ameriprise violated their fiduciary obligations as the sponsor of the 401(k) plan it offers to employees. The main issue is that Ameriprise offered a number of its proprietary mutual funds as options in the plan; these funds were allegedly expensive compared to other non-proprietary options that could have been utilized. Further it is alleged that these funds paid revenue sharing and other fees to Ameriprise and several of its subsidiaries.

What does this mean to you as a 401(k) participant?

The implications of this suit are pretty clear. If Ameriprise is found to be guilty of breaching its Fiduciary duty by stocking their 401(k) plan with sub-par, expensive proprietary funds this moves us further along the path of accountability by retirement plan sponsors for the retirement plans offered to their employees in my opinion.

During 2012 your company (generally via its retirement plan provider) provided several disclosures regarding your 401(k) plan. While some of these disclosures were not all that revealing (and others may have been downright cryptic) these disclosures began to “open the curtain” a bit. In anticipation of these disclosures I am aware of several providers who improved their plan offerings as well as activity on the part of a number of plan sponsors who started to look at other platforms and providers for their organization’s 40(k) plan.

The temptation among many employees is to ignore information received about your 401(k). Hard to blame them, much of this information is poorly written and hard to understand. However, you would be wise to review the disclosures received and any future disclosure materials. Do your best to become an informed plan participant. Review the mutual funds (or other investments) offered. Are they typically at least in the top half of their category in terms of investment performance? Are the expenses low relative to other funds in the same fund peer group? Could less expensive share classes of the funds offered that be considered? This last point includes even low cost index funds that may be offered. For example, low cost Vanguard has several share classes that are lower in cost than their basic Investor share class.

I’m not necessarily advocating that you sue your employer for offering lousy investments or for sponsoring a plan that is sub-par, but there is nothing wrong with joining together with other co-workers and presenting your concerns about the plan to your employer. By definition a 401(k) plan and other defined contribution plans put the onus on you to save and invest for your own retirement.

What does this mean to organizations that sponsor 401(k) plans?

To say that companies who offer 401(k) plans, consultants and advisors (like yours truly), and ERISA attorneys are watching this suit with a great deal of interest is an understatement. Essentially this suit could say to employers that if you offer a crappy, high cost 401(k) plan with lousy investment choices it could cost you. And you know what, with the number of lousy 401(k) plans that I’ve seen offered over the course of my career this advisor would have no sympathy for Ameriprise and those involved with their plan should they lose the suit. Offering your own funds and receiving revenue sharing from them to boot, really? What’s OK about that? I wonder how much of their own money senior Ameriprise executives have in these proprietary funds.

My hope is that this suit will help motivate employers who don’t already focus on offering the best 401(k) plan possible to look at ways to improve their plan. I am fortunate to have a group of 401(k) sponsor clients whose main concern is doing the best that they can for their employees. Don’t get me wrong, these companies are concerned with meeting their Fiduciary obligations and managing their Fiduciary liability as a plan sponsor. I view these goals as being very consistent with offering a top-notch plan for their employees. From my experience a sound process to choose and monitor investments based upon an Investment Policy Statement generally results in a better result for the plan participants. Add to this a regular review of the plan providers (record keeper, custodian, etc.) and you have the ingredients of a solidly run plan.

I wonder what Tommy Lee Jones would say to the employees if he was used as a spokesperson to “sell” the 401(k) plan internally?

Photo credit: Wikipedia

Filed Under: 401(k) Tagged With: 401(k), Fiduciary, Mutual fund, Mutual fund fees and expenses, retirement

Mutual Fund Expenses – Where Real Holiday Savings Can be Found

November 26, 2012 by Roger Wohlner 4 Comments

As I write this its Cyber Monday, the biggest online shopping day of the year. Where to save a few dollars on this item or that has been the focus of many news stories and discussion. While we all like to save money on the things we buy, these savings are “chump change” compared with the savings opportunities available by reducing your expenses on the mutual fund and ETFs in which you invest. Here are 5 tips for reducing your investing costs for mutual funds and ETFs to help grow your investments for retirement, college savings, and other goals.

Index Funds are Not Created Equal

As an example the Dreyfus Mid Cap Index Fund (ticker PESPX) has an expense ratio of 0.50% which is pricey for a core index fund of this type. The Investor Share Class of the Vanguard Mid Cap Index Fund (VIMSX) carries an expense ratio of 0.24% and the SPDR S&P Midcap 400 ETF (MDY) has an expense ratio of 0.25%. An investment of $10,000 in each of these funds made on May 31, 1998 and held until October 31, 2012 would have grown to:

Dreyfus Mid Cap Index	$30,743
SPDR Midcap	$31,643
Vanguard Mid Cap Index	$31,770

The above information is via Morningstar and is based upon the earliest common inception date of the three funds and also assumes reinvestment of dividends and distributions. Note that an investment in one of the lower cost share classes of the Vanguard fund would yield even better results.

ETF Price Wars are a Good Thing

There is a price war happening among several providers initiated by Schwab to offer the lowest cost ETF. Vanguard has jumped on the bandwagon by changing the index provider on many of its funds and ETFs; Blackrock’s ishares unit has also joined in. While I likely would not suggest switching from an already low cost index ETF product because it is not the absolute lowest in cost, I would suggest taking a look at the offerings of the “warring” factions. You should also take any transaction fees into account as well. Schwab and Vanguard allow transaction free trading of their own ETFs, TD and Fidelity offer a menu of transaction free ETFs as well.

Your Financial Advisor May be able to Save You Money

In many cases I am able to invest my client’s money in less expensive share classes of a given mutual fund than they might be able to purchase on their own. As an example PIMco Commodity Real Return as a number of share classes as do most of the PIMco Funds. I am able to invest client dollars in the Institutional Share Class (PCRIX) with its 0.74% expense ratio and typical $1 million minimum. This compares to the no-load D shares (PCRDX) with an expense ratio of 1.19% and a $1,000 minimum initial investment. Often the savings in expense ratios that I can provide to my clients can go a long way in covering a portion of my professional fees.

Ensure that Your Stock Broker or Registered Rep isn’t costing you Money

The flip side of the last point is to make sure that you are not paying more in mutual fund fees just so that your broker or registered rep can make additional fees and commissions. Case in point is if your money is invested in a proprietary mutual fund offered by the rep’s employer. While some of these proprietary funds can be decent, all too often they are under performers that are laden with fees and charges to generate revenue for the broker and their firm.

Read your 401(k) Plan Fee Disclosures

Some plans sold by commissioned reps and producing TPAs (Third-Party Administrators) may contain funds that are not very low cost. Case in point might be a plan with an American Funds fund in the R1, R2, or R3 share classes. This might also be the case with some Fidelity shares classes (typically the Advisor share class), as well as with some T. Rowe Price funds (the Advisor or the R share classes). These shares exist typically to compensate a producer. If you see these or similar share classes for other fund families in your plan it would behoove you to ask the person who administers your plan if it might be possible to move the plan into lower cost funds or fund share classes.

We all like to find a bargain when doing our holiday shopping. If a fraction of the time and effort that people spend on this activity went into analyzing their investment portfolios, the potential cost savings alone would dwarf anything that you might realize from finding a couple of deals this holiday season. These savings are not just one-time in nature, but they “keep on giving.”

Check out Morningstar to review the expenses for all of your mutual funds and ETFs and to get a free trial for their premium services.

Please feel free to contact me with questions about your investments.

Photo credit: Flickr

Filed Under: Investing Tagged With: American Funds, Exchange-traded fund, fee-only, Financial Advisor, Index fund, Mutual fund, Mutual fund fees and expenses, Vanguard

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Watch out for high and/or hidden fees

Who’s really guaranteeing your annuity?

Should you buy an annuity?

American Funds EuroPacific Growth

Growth of $10,000 invested

Share classes matter

Mutual fund and ETF expense ratios

Sales loads and 12b-1 fees

401(k) expenses

Financial advice fees

Surrender charges

Taxes

The Bottom Line

What is churning?

What is reverse churning?

Fee-based is not fee-only

The fiduciary rule

Buyer beware

The Bottom Line

Plan Sponsors have a fiduciary obligation

Mutual Fund share classes

Duty to monitor

Manage plan expenses

Plan Sponsors are getting it

The Bottom Line

What are you getting for the wrap fee?

What’s special about the wrap account?

What are the underlying investments?

The Bottom Line

Typical 401(k) plan fees and expenses

BrightScope

Mutual Fund expenses

Mutual fund expenses matter

How to reduce investing expenses

What does this mean to you as a 401(k) participant?

What does this mean to organizations that sponsor 401(k) plans?

Index Funds are Not Created Equal

ETF Price Wars are a Good Thing

Your Financial Advisor May be able to Save You Money

Ensure that Your Stock Broker or Registered Rep isn’t costing you Money

Read your 401(k) Plan Fee Disclosures

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