Monday, October 29, 2007

MERs seem low - why worry?

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 made by 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 is part 2 of 2 parts. Back to part 1.

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