The last couple of posts have emphasized the importance of investing and maximizing the time that your money can compound exponentially. Last week, I compared using a full-service advisor or robo-advisor as a convenient way to get started. The most cost-effective way to start was to learn DIY investing basics and use an asset allocation ETF. Eventually, you must learn about investing (even if you use an advisor) because only you can truly lead your financial team. It does take some up front time, but the savings from lower investment management fees could more than pay for other time-saving services. Regardless, the differences in the first five years of investing are relatively minor getting appropriately invested is better than doing nothing. However, if you do start with a high-fee model there is a long-term danger.
You may not recognize the impact of the advisor and investment management fees until later. Percentage fees grow over time along with your portfolio. Exponential growth makes the largest cost show up later. At that point, you may also find it harder to make changes. Switching to the optimal advisor and brokerage model for your situation as soon as you can is vital, and the ultimate cost of complacency is high. I will use the fee-drag simulator that I described previously to put some numbers to that today.
Our Model Investor
This section lays out the input parameters used for the simulations in this post.
Accumulation & Decumulation
The baseline model investor that I will use invests $50K/yr from age 30 to 55. They then retire and draw $100K from their portfolio each year. They keep the same asset allocation throughout, and the index for that investment mix returns 7%/yr. Inflation is 2%/yr to give a 5%/yr inflation-adjusted return. That is roughly equivalent to the historical performance of a North American all-equity portfolio. Doing that keeps the numbers in “today’s dollars” so that it is easier to relate to. I assume that funds will match the index minus their fees.
Some Limitations
The simulation ignores taxes. That is pretty reasonable if investing via an RRSP and TFSA. Growth will be tax-free, but there will be taxes on the RRSP withdrawals down the road. By investing $50K/yr, our model investor would have to put at least $10K/yr into a tax-exposed account. Still, that does not change the message. This is not meant to be a detailed financial planning simulator, but more to illustrate the impact of investment management fees and value over a long period of time.
This simple simulation also uses linear returns. In real life, different sequences of returns would change the numbers. The practical implication of that is a range of outcomes. However, on the whole, the risk of running out of money is much higher when you have less net growth. Fees drag on growth in both good and bad market years. In bad years, fees will be lower, attenuating the impact – but you still have less.
Behavioral Gap
I will assume a behavioral gap of 0.4%/yr for all strategies as the baseline. That is roughly equivalent to the behavioral gap for an asset allocation fund. In real life, there will always be some gap unless all money is invested on the first day of each year and exposed to growth for the full time-period. Most people get money and invest it over the course of a year.
There could also be significant variation in practice depending on how simple to execute and stick to your process. Buying regularly and using an all-in-one ETF may have a low behavioral gap. Making sector bets, stock picking, or attempts at market timing will likely have a behavioral gap larger than any fee savings by DIY investing. Assuming the advisor comparator isn’t also doing this.
Advisor Value
On the other side of the equation is advisor value. This is highly variable and depends on both the client and advisor. There are some studies that have tried to quantify this, but some of the numbers are suspect. I will give my thoughts in the Canadian context.
An investor who takes the time to select an appropriate asset allocation, is disciplined, and ignores expensive self-talk may not get as much benefit from someone else handling their investments. Of course, that also depends on the advisor not doing a better job of that net of their fees.
Some who are scared to invest, leading them to avoid compensated investment risk or procrastinate, may benefit greatly. Each year missing the market is a 6-10% opportunity cost on average. Also, being comfortable investing in only 60:40 stocks and bonds on your own – but comfortable with 80:20 invested through a trusted advisor could hypothetically bump returns by 0.9%/yr based on historical model portfolios.
Much is said about advisors providing tax optimization. It is actually very complicated, and many advisors don’t do it or don’t even realize that they may not be doing it well. The impact in Canada is also generally small and variable. The possible exception is an incorporated business owner. They may gain efficiency through optimal compensation strategies. That is an area that my collaborators at PWL Capital and I have spent a lot of time on. However, it is just being realized by the broader advisor community.
For the scenarios in this post, I will assume our model investor takes the time to learn about and become comfortable with investing. They are disciplined enough not to procrastinate and have better things to do with their time than chase hot investment tips. They don’t watch business TV or listen to chatter, thinking they are getting actionable market insights. Be honest about how you and your advisor mesh in the diagram below. I have added an advisor value input to the simulator that you can adjust if you want to.
Investment Fees & Costs Compound Too
In the preceding post, I showed how our model investors faired over the first five years of their investing journey. The investor using a “free” bank advisor and their mutual funds with 2%/yr MER under the wrapper had $320K of buying power. That is way better than the $300K that they’d have if they just matched inflation using cash equivalents. However, it was $14K less than what they’d have had using an all-in-one asset allocation ETF with an MER of 0.2%/yr. That would require the time to learn how to DIY invest, but still pays more per hour than anything I do as a physician. The truth is that even if you use an advisor, you will have to learn the basics of investing or you will pay the price at some point.
Getting invested instead of doing nothing is more important than getting it perfect. Paying for convenience may help, but being complacent using a high-fee model is also very expensive. Extending our simple model over a lifetime shows that the low-fee investor has enough money to retire and maintain their wealth. The higher-fee investor runs out of money at age 80. That little symbol on the chart is a can of cat food. Just to highlight the potential impact.
Why does this happen? As investments compound and grow, the investment management fees when charged as a percentage, do too. Why does it surprise us? We tend to underestimate the impact of compounding. Our brains project linearly, and compounding is exponential. So, the gap widens later in life. Sorry, the sports car is not being driven by you. You got Fancy Feast instead. That said, not all of the decrease in your portfolio went to the managers. Some of the difference is simply opportunity cost from money paid in fees not being invested to grow in the future. Either way, it is money you don’t have.
Shifting From High-Fee Funds
If you are using high-fee mutual funds, and don’t like Fancy Feast – fear not, you can make the switch to DIY ETF investing. If it is early on, that is actually relatively easy and can have a major long-term impact. Below is what would happen if our model investor started in high-fee funds, but then switched after five years over to a low-cost strategy.
Importantly, in this simple model switching just means adding new money to the ETF strategy. The original high-fee mutual funds are kept, and that money grows more slowly due to the fees. Those mutual funds were spent down in the first five years of retirement. However, the impact of that early high-fee investing is outsized when you look over the long run. There was a little less at retirement, but it was enough that the nest egg shrank rather than grew when withdrawals were made. Their estate was cut in half, but at least their taste buds were spared.
A Clean Escape to DIY Investing
In the above switch, the investor didn’t purge themselves of their mutual funds. That could have the potential advantage of still keeping their “free” advisor. While the quality of advice is highly variable, it could be worth something. However, let’s say that they were not getting much added value. How big of a difference would selling those mutual funds and starting fresh using only an asset allocation ETF make? A clean escape from high investment management fees. My simple online calculator won’t do that, but I have run the numbers below.
As you can see, ripping off the bandage and starting fresh makes a big difference. Left to fester, those high mutual fund fees resulted in a significant drag for the 25 years that they were held onto in the previous example. Free of that anchor, our model investor has only slightly less at retirement. They have enough that their portfolio growth is able to keep pace with inflation and their spending. Maintaining their buying power throughout the simulation.
Better Late Than Never
Making a clean escape from a high-fee advisor and fund structure after five years, our model investor was able to salvage the situation. Unfortunately, many people don’t realize how much investment management fees have dragged on their portfolio until it is getting around retirement time. Things get real at that point. Both because you are looking at how much you can safely spend in retirement and because your portfolio is at or near its peak value. A percentage of a large portfolio is a meaningful amount of money.
The cost of fees also continues if you stay. While the exact percentage safe withdrawal rate (SWR) varies and is debated, it is based on historical market returns. That also means that it is pre-tax and pre-fee. Still, having a 1%/yr higher fee does not linearly reduce your SWR from 4% to 3%. That is because if you do get an unlucky sequence of returns, the fees paid struggle along with your portfolio. So, the SWR drops to more like 3.6%/yr.
Another way to look at it is how much of the money you can safely remove from your portfolio for a given SWR goes to you vs fees. I will use a 4% withdrawal rate below to fund $100K/yr spending. That requires a $2.5MM portfolio. Below is a table showing how much of that $100K/yr year taken out of the portfolio comes to you vs the fees.
Of note, planning retirement drawdown and giving you the confidence to spend in retirement are two areas where a good advisor can potentially add significant value. So, I have included %AUM advisor using low-cost funds and hiring a fee-only planner every year as options.
Making a Clean Escape At Retirement
After seeing the above table, some people are probably thinking that they’d rather have $70-90K/yr of their $100K/yr going to them rather than fees. Fortunately, switching to a better advisor and investment management fee structure can still make a difference. Even late in the game.
Our model investor invested in 2% MER mutual fund portfolio, would have $1.825MM at age 55. If using a 1%/yr fee-based advisor and 0.50% fund fee advisor, they would have $1.95MM. Either way, they have substantially less money than some of their friends who invested using an All-in-One ETF all those years. Those friends also understand exactly how they are invested and how much money they have because they learned about investing. They don’t mind talking about their $2.35MM portfolio. They also help their friends to learn and switch to ETF investing using the help of a “fee-only” advisor.
For the chart below, I will just show the investor who used a 1%AUM advisor that uses the “discount” series of high-fee (0.5%/yr) funds. They were likely courted by one once they had over $500K to $1MM invested. I will compare continuing with that fee drag vs a clean escape to an ETF plus $5K/yr for “fee-only” advisor support. As you can see, it was not too late for them to avoid the Fancy Feast by decreasing costs. Your full investment horizon is actually your lifespan and not just your retirement date.
Of course, the best time to switch to a lower cost structure is as soon as possible. Someone starting out may balk at a few thousand dollars when they are just trying to save that. However, if it gets you started with good advice and support on a better path, that will compound. It may be particularly useful for people facing complex situations (like incorporation) or who expect to invest large amounts quickly.
What about capital gains taxes?
This modeling was done ignoring taxes. That is reasonable for someone investing within their tax-sheltered registered accounts (eg. RRSP & TFSA). However, many must also invest using taxable accounts to squirrel away enough for retirement. In that case, there could be capital gains taxes triggered while escaping to a lower fee structure. That may occur if you have to sell proprietary mutual funds rather than being able to transfer assets “in kind”. Usually, large savings from lower investment management fees will counteract the loss of tax deferral by paying capital gains taxes earlier than you planned to. I will explore that further in the next post. There are also ways to attenuate the impact.
Since sales within an RRSP and TFSA do not trigger taxes, they are ideal places to shift to DIY investing. Both due to lack of taxes, but also to gain experience and confidence. Some may even opt to manage that and keep their advisor to manage their taxable accounts by using multiple brokerages. Or gradually selling and transferring taxable assets.
DIY Investing is Not for Everyone
In the modeling used in this post, there were important assumptions. Basically, I assumed that the model investor is really “the model investor”. Most of us fall somewhere short of that. While an advisor can potentially add value, that is also variable and dependent on the specific advisor.
Good, but Not-So-Model Investor
It is no secret that I am a strong advocate for DIY investing. Perhaps coupled with support from a fee-only advisor – especially at important milestones like considering incorporation or approaching retirement. However, that is definitely not for everyone. How would our scenario look if our model investor was not-so-perfect? They use an asset allocation ETF, but sometimes they forget to invest large chunks of cash or get talked into waiting a few months until after the next election or whatever other narrative the story-tellers are selling. Their behavioral gap is 0.8%/yr rather than 0.4%/yr.
The Valuable Advisor
Advisors whose value proposition is picking better investments are unlikely to outperform net of fees. There are tonnes of data to show that at this point because markets are efficient enough. However, an advisor whose value proposition is based on improving your comfort, convenience, and behavior may add financial and psychological value. Some improved tax planning may help save money too.
Our Not-So-Model investor was a model student and is incorporated as a high-income professional. Their advisor listens to The Money Scope Podcast. So, they are on the cutting edge of investment and tax planning. This adds 0.5%/yr from tax savings over a lifetime of long-range planning. This isn’t free. They charge what works out to 1%/yr AUM. They also use low-cost funds for the portfolio (0.1%/yr). Our investor not only feels more comfortable with their advisor, but they are comfortable with a slightly higher equity allocation. Their advisor doesn’t excessively fiddle with the portfolio weightings. That higher risk and return is 0.5%/yr.
The Perfect Couple
In this scenario with a DIY investor who is a bit more timid and not perfectly disciplined – they are better off using an advisor. Of course, that also hinges on finding a valuable advisor and avoiding advisors who do not provide value for their situation. The perfect couple. Unfortunately, like in real life, the perfect couple can be hard to find. This is also not an excuse for complacency and marrying the first advisor you meet. Recognizing and choosing a good advisor requires you to become educated about what to look for and to look beneath the surface.
A Cheaper Date
Not all cheap dates are bad. Part of laying my own financial foundation was finding a partner with similar spending habits and compatible values around money. We were both cheap dates. In regards to financial advisors, a good fee-only advisor could provide many of the supports that a valuable %AUM can provide. You still must pull the levers of buying and selling. However, a valuable “fee-only” advisor can help with behavioral coaching, asset allocation, and tax planning. For a flat fee instead of a % of AUM. In both cases, you must have some good education to spot them. Unfortunately, they are also rare in Canada at present.
A fee-only advisor may cost $5K. That would not be cost-effective with a smaller portfolio. However, a small portfolio doesn’t require much in the way of tax planning etc. So, for the simulation, I will use DIY investing. There is still a 0.8%/yr behavioral gap due to some procrastination. However, they are able to benefit from appropriately aggressive asset allocation and tax planning. They pay $5K/yr when their portfolio is over $500K. As you can see, they are even better off by a wide margin. The chart had to increase the portfolio value axis to accommodate it.
Avoid Complacency. Take Action.
Complacency can be very costly. By complacency, I mean not educating yourself enough to be able to spot how much your advisor and investment fee model is costing you. The discussion does not end there. You must also be able to recognize when an advisor may add value or not. That depends on your ability to DIY invest and whether the advisor complements your weaknesses. The largest benefits are probably in behavioral coaching and long-term planning.
Action 1: Learn About Investing
The emphasis in the first scenario was on the benefits of a low-cost DIY strategy. That assumed an easy-to-implement and stick-to strategy. Using an all-in-one asset allocation ETF has largely solved that problem. It is feasible to be a model investor using that coupled with the education, support, and entertainment provided here. You must learn the basics to do that. However, you must get that basic education to spot a valuable advisor regardless. This is why DIY investing is my default optimal strategy. You have already put in the effort.
The appeal of DIY ETF investing is reinforced by the fact that fees (as a %) are relatively high for those using an advisor and little money invested. It leaves a lot of wiggle room to make some mistakes while learning and still have them cost less than a high-fee structure.
Action 2: Reflect & Choose Deliberately
DIY investing & DIY financial planning are not optimal for everyone. Being honest with yourself after you have taken the action of educating yourself is vital. You may be able to do the simple mechanical tasks of investing well, but benefit from some extra coaching and planning. A fee-only advisor could optimally fill that gap when your portfolio is large enough that it is cost-effective or at key milestones when it matters the most. If you are likely to procrastinate, panic, or be too timid pulling the levers, then higher a %AUM advisor is best.
Do not be complacent by falling into and sticking with a model that is not suitable for you. Learn, reflect, and choose deliberately. Continue to do this over your investing career as your situation changes.
Action 3: Do Not Give Up
Do not just roll over and go back to sleep if you discover that the investing and advisor combination that you have is sub-optimal for your situation. The net costs will continue to drag on your performance going forward. Unfortunately, they do not become most readily apparent until later in the game. Even then, a switch could have you driving a Corvette to a restaurant rather than sitting at home with a less palatable menu. The potential cost of complacency. Fortunately, it is almost never too late. Making a change can alter your course. Recall that your investment horizon is your lifetime.
I have no disagreement with your analysis. A very important consideration you don’t touch on is an individual’s capacity to be a DIY investor in later life. Studies show that elderly investors (like elderly drivers) subjectively rank their abilities as excellent when in fact objectively their skills are declining. Reflecting and choosing deliberately earlier in one’s investing life should include planning for this. Having settled three family estates recently and sharing experiences with friends at my age doing the same I know that previously competent DIY investors can blow things up badly in latter years.
Thanks for pointing that out Michael. I definitely agree with that. I’ve alluded to it a few times previously and I was going to put a scenario about that in this post, but it was already way longer than I wanted it to be. I just left it at a vague re-evaluate when your circumstances change. You are right in that people don’t always recognize that. Awareness and planning in advance (like a shift to a stronger advisor support model) is important. Both to do it before there is a problem, but also to allow time to vet and build trust with an advisor so that it will be constructive and you’ll listen to them.
Mark