Yes, investment costs eat away at returns. But these costs amount to a double whammy, impacting both the accumulation of wealth and the withdrawal of income.
To demonstrate this, John Ameriks, who heads Vanguard’s Investment Counseling & Research Group, looked at the impact of investment costs on a hypothetical investor who retires at age 60 with a $100,000 portfolio. After retiring, she plans to spend 4% of her portfolio balance at the beginning of each year.
Ameriks supposes this investor can choose one of three identical portfolios (A, B, or C) to generate a 5% before-cost total investment return, and these hypothetical portfolios differ only by cost (0.25%, 1.00%, and 2.00% respectively). He also assumes all dividends and distributions are reinvested and there are no taxes on the returns.
On the surface, it seems simple. It’s obvious the cheapest portfolio will result in the greatest returns. But there’s more to it.
Impact on withdrawals
Let’s look at the impact of costs on withdrawals on income over time. The year’s withdrawal amount is determined at the beginning of each year, so all three portfolios start with the same $4,000 withdrawal (4% of $100,000). But after five years, differences start to mount.
Compare high- and low-cost portfolios
| AGE | |||
|---|---|---|---|
| Portfolio | 70 | 80 | 90 |
| A – 0.25% | $105,624 | $111,564 | $117,838 |
| B – 1.00% | $98,037 | $96,113 | $94,227 |
| C – 2.00% | $88,839 | $78,924 | $70,115 |
Source: Author’s calculations. See notes to chart under “Over time, effects of costs are more pronounced” chart.
As the charts on this page show (see “Compare high- and low-cost portfolios” below, and “Over time, effects of costs are more pronounced”), at age 65, the high-expense portfolio (C) generates a withdrawal amount that’s 8.3% lower than the amount for the low-expense portfolio (A).
After 15 years, the gap grows to over 20%. The result: a decline in spending power over time, which stands in contrast to the single-digit-percentage point differences in expense ratios.
Also, the low-expense ratio portfolio (A) enables the retiree to keep her withdrawals (plus investment expenses) below the total gross return on the portfolio. That means the balance could keep growing over time, giving her a chance to offset potential increases in future cost-of-living expenses.
The only way to achieve a similar result in the higher-expense portfolios is to lower the withdrawal amount. In other words, her chance to keep up with cost-of-living increases diminishes.
Here’s another way to look at it. If she’s relying on portfolio withdrawals of 4% and paying investment providers 1% every year, she’s handing over an amount equal to a quarter of the total annual amount she’s spending. All of a sudden, paying 1% doesn’t look like such a great deal.
Impact on income
The impact on income is only one whammy. The other is what’s happening to the balance over the same period.
The percentage differentials in balances across the three identical portfolios are the same as the percentage differences in withdrawals above. But when looking at the dollar difference in balance totals, the amounts may surprise you.
By age 70, there could be more than a $16,000 difference in the size of portfolios A and C, in favour of the lower-cost option. By age 90, the difference could jump to more than $45,000.
This is a simplified example. Portfolio returns don’t straight-line at 5% like they do in this hypothetical example.
Also, retirees need to smooth out their spending more than their wealth over time, rather than simply taking last year’s withdrawal balance and multiplying it by a fixed number.
Regardless, investment costs have double the impact than you may at first suspect. This is particularly important for advisors because the more you can rein in costs, the more investment return you can pass to clients.
Over time, effects of costs are
more pronounced
Source: Author’s calculations. Initial withdrawal is 4% of $100,000. Initial opening balance is $100,000. Withdrawal each year thereafter is 4% of prior year’s closing balance = (Opening balance minus this year’s withdrawal) x (1+5%) / (1+ expense %). For example: Age 61 withdrawal in Scenario A is $4,022, which is 0.4 x $100,548.63 = ($100,000 – $4,000) x (1.05) / (1.0025).