Investment Fees are a Big Deal

Over a lifetime, investment costs take a huge bite out of people’s savings, but many investors don’t understand how they work.  It’s not that they’re complicated, it’s that the final answer seems unbelievable.  How could it be that these fees nearly cut my retirement nest egg in half?

Let’s go through some of the misunderstandings.

I don’t pay investment fees

Some people think that because they never swiped a credit card or wrote a cheque to pay investment fees, they didn’t have to pay them.  This isn’t true.  If you own mutual funds or exchange traded-funds (ETFs), then fees are quietly deducted from your savings.  The total of these fees for the year is called the Management Expense Ratio (MER).

The investment returns you see on your statements are net of fees in most cases.  An exception is that some group RRSPs report before-fee returns.  The fact that you see net returns is good in the sense that you see represent what you actually got.  On the other hand, it further serves to hide the existence of fees.  

Current rules require investment companies to partially disclose fees on customer statements.  New rules require fuller disclosure of these fees starting in early 2027.  This fee disclosure may be buried late in a very long and confusing statement, but it will be there somewhere.

My bank says I only pay fees on my returns, not my principal

This isn’t true.  You pay fees whether your funds make money or lose money.  The way the MER is calculated is to add up all the fees you paid and divide by your total assets in the fund.  So, by definition, the MER is paid on all your savings every year and not just on your returns.

My fees are only like 2%, no big deal

It’s common for Canadians to pay MERs of 2% to 2.5%.  This sounds small enough to be unimportant.  After all, you tip more than this, and even your real estate agent charges more than this.  However, your real estate agent doesn’t show up every year demanding to get paid again.  With MERs, you pay every year.

Let’s say you had around $100,000 in a mutual fund last year.  With a 2% MER, you paid about $2000 in fees.  Let’s say this year it’s up to $105,000.  Now you’ll pay about $2100 in fees.  You’re not just paying fees on the extra $5000; you’re paying fees on the original $100,000 again.  So, now you’ve paid about $4000 in fees on the original $100,000, and that’s just 2 years.  After many years, you’ll pay hefty amounts in fees.

I like to think of fees over 25 years.  I call this the MERQ (Management Expense Ratio over a Quarter century).  There’s some compounding math with this, but here are a few percentages to show how annual fees grow over 25 years:

MER, MERQ
0.2%, 4.9%
0.5%, 12%
1.0%, 22%
1.2%, 26%
1.5%, 31%
2.0%, 39%
2.5%, 46%

That seemingly insignificant 2% MER really costs you 39% of your money after 25 years.  So, if a one-time investment would have grown to a million dollars without fees, a 2% MER reduces this to $610,000.  Of course, it’s not possible to invest without fees, so a fairer comparison would be to a DIY index ETF MER like 0.2% where you’d have $951,000 after 25 years.  If you have an advisor charging 1% plus the index ETF MER for a total of 1.2%, you’d have $740,000 after 25 years.  It’s clear that these small MER percentages are very important over the long term.

In our example, the 1% additional advisor fee reduced your final portfolio value by $211,000.  This is true if everything else is equal.  Advisors would argue that if they do their jobs well, everything else won’t be equal.  If they can stop you from making dumb investments that will lose money or provide other valuable advice, then you benefit compared to just investing on your own.  It’s up to you to decide if the benefits you get are worth a 6-figure sum over an investment lifetime.

The previous examples were based on a one-time investment that sits untouched for 25 years.  In reality, most people add money or even make withdrawals over time.  What matters is the average number of years each dollar sits invested.  A lifetime of investing could last from age 30 to 80.  Over 50 years of investing, the average dollar invested could easily be in the account for 25 years or longer.  So, the 25-year MERQ gives a realistic estimate of the compounding effects of fees.

I’ll just pick the advisor who promises the highest returns

Advisors have little control over returns.  Markets drive returns.  Advisors can steer you to higher or lower risk, but higher expected returns always come with the risk of larger losses.  The best advisors won’t promise a specific return minimum.  A quick way to get a poor advisor is to choose the one who promises the highest return.

Many advisors are stuck in a compensation model that pushes them to sell expensive mutual funds.  When the investor is paying 2% or 2.5% MERs, the advisor often doesn’t get much of this money.  Much of the money flows to a fund manager.  Once your portfolio is large enough, you’re in a better position to find an advisor arrangement with lower annual fees.  Some advisors even work by the hour.  The hourly rate may seem high, but this arrangement is often cheaper over the long run.

I’m in great funds whose returns make up for the MER

This is very unlikely to be true over the long run.  Stock and bond markets are dominated by professional investors who have a hard time outdoing each other.  On average, mutual funds and ETFs earn roughly the market average before fees, but less after subtracting the fees.

Some professional money managers beat the market over short periods, but it’s rare for any to win over the long run.  Your advisor might put you in funds that performed well over the past 5 years, but they are unlikely to repeat their outperformance.  I don’t know how to pick funds that will outperform in the future, and I don’t know how to pick an advisor who can pick a fund that will outperform.

Over an investment lifetime, your mutual funds and ETFs are likely to earn average returns before fees.  The size of the fees then determine how much lower your returns will be.  As Jack Bogle says, “In investing, you get what you don’t pay for.”