This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

So what if the Management Expense Ratio that I pay on my mutual funds is 1% or 2% or 3%? If I’m planning to at least triple my money before I retire, why should such tiny percentages concern me?

The short answer is that the MER is collected on the same money year after year, which makes it really add up. The government may take one-third of your income every year, but at least they don’t tax the same money as income again. Imagine if instead of taking one-third of your income the government added up the value of everything you have and demanded one-third of that every year. “Let’s see ... your house plus the rest of your stuff is worth about $450,000. That makes your taxes $150,000 this year. Pay up.”

The MER is more like property taxes; you are taxed on what you have instead of what you make in a year. However, property tax rates are much lower than income tax rates. In my area, property taxes amount to between 1% and 2% of the value of a property each year. And at least the city takes my garbage away.

An Example

Suppose that your mutual funds charge a 2% MER. The rest of this will be easier to follow if you think of this as you getting to keep 98% of your money at the end of each year. After two years, you get to keep 98% of 98%. Pull out the calculator to multiply and you’ll find that you keep 96.04% of your money after two years. This is a form of compounding that works against you.

How bad does this get in 25 years? After paying 2% each year for 25 years, 40% of your money is gone. If you were expecting to have half a million dollars when you retire, $200,000 would be “missing”.

It might seem like the investment returns in the mutual fund should be a factor in all this, but these returns don’t affect the percentage of your money that is taken in the MER. Whether the investments do well or poorly determines whether the MER is a percentage of a big pot of money or a small pot, but the percentage stays the same.

The MER is definitely not the only thing to look at when investing in mutual funds, but it is too important to ignore.

This reminds me of talking to a friend about a cash-back mortgage, and he said "oh well, what's 2% over 25 years?" I didn't have a snappy answer for him at the time, but now I'd start with "25 years × 2% is 50%. That means you'll pay roughly half the price of your house for that cash back!".

ReplyDeleteOk, so that's not exactly right, but it makes the point. In reality, increasing a mortgage from 5% to 7% (which is what he was offered) would cost him about 37% of his house price.

Patrick: I hadn't thought about this in the context of a mortgage, but you're right that the same idea applies. Your friend's phrasing of "2% over 25 years" is interesting because it implies that the cost is 2% divided by 25, when in fact the cost is roughly 2% times 25.

ReplyDeletePatrick, MJ,

ReplyDeleteIn Patrick's friend's case (I'll call him SpongeBob), it seems the important difference is that 7% interest is 40% higher than 5%. SpongeBob's error was thinking 2% is a small number, and not relating it to the also small number of 5%.

Plenty of online mortgage calculators would give the difference in interest charged over a 25 year amortization, and it would be substantial.

Okay, I used RBC's mortgage calculator, and found that a $100,000 loan at 7% interest over 25 years with monthly payments will incur $110,122.61 in interest, while a 5% loan will cost $74,480.04 in interest.

ReplyDeleteThe difference is 47% more interest (35,642.57). Very close to Patrick's original estimate of 50%. I thought it would be lower, on account of the shrinking principal.