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The expense ratio: It’s a fancy term for a critical concept. This investing cost can rob your nest egg of as much as hundreds of thousands of dollars over time if you aren’t paying close attention.
It’s easy to understand that keeping investing costs low is critical to retiring comfortably. But it can be difficult to understand just how much investing fees amount to — and whether those fees are low or high.
Average expense ratios can serve as a comparison starting point. If you know the average expense ratios for the types of investments you have, you can compare those ratios with the industry averages to get a general sense of whether you’re paying too much.
Why mutual funds and expense ratios are important
A mutual fund is a pool of investments such as stocks, bonds or both — and therein lies one of its advantages. As Money Talks News founder Stacy Johnson explains in “Ask Stacy — How Do I Invest in a Mutual Fund?“:
“The chief advantage of a mutual fund is that it allows an investor to own a small slice of a big portfolio. Diversifying with a bunch of stocks or bonds is much safer than putting all your money into one or two stocks or bonds.”
There are two main types of mutual funds: actively managed mutual funds and passively managed mutual funds, commonly called index funds.
Active mutual funds are run by a professional who aims to beat the market. Passive funds aim to mirror the performance of a market index — such as the Standard & Poor’s 500 stock market index — and require little management. In fact, they can be run by a computer. Due to these differences, active funds tend to come with heftier fees, and index funds tend to have much lower expenses.
The operating costs for mutual funds are generally passed on to investors as what’s known as an expense ratio. It’s expressed as a percentage of the money you invest in a mutual fund. So if a mutual fund has an expense ratio of 1 percent, you will pay $1 in fees for every $100 you invest in the fund.
How high expense ratios can damage your retirement
Expense ratios can sound negligible because they are expressed as a percentage. In reality, they can amount to thousands of dollars — even hundreds of thousands of dollars — by the time you retire.
Consider this example from our story “Of All the Fees You Pay, This One Is the Worst by Far”:
Say you have a 401(k) with a current balance of $25,000. Over the next 35 years, you earn an average return of 7 percent on that balance. Even if you didn’t contribute another penny to your account during those 35 years, here’s how much money you’d have if your account fees were 0.5 percent, compared with how much money you’d have if your fees were 1.5 percent:
|Beginning balance||Annual return||Fees||Balance in 35 years|
So the higher fee cost you an additional $64,000 over 35 years — even though the fee was only 1 percent higher. That’s $64,000 less to live on in your golden years.
And that’s if your 401(k) had only $25,000 in it. Imagine how much money you would stand to lose in fees if you were more diligent about saving for retirement.
How to judge expense ratios
Knowing average expense ratios gives you a starting point for judging the expense ratios you are currently being charged.
We learned from a Morningstar study released in May that average expense ratios last year included the following:
- All mutual funds: 0.57 percent average asset-weighted expense ratio
- Actively managed mutual funds: 0.75 percent
- Passively managed mutual funds, aka index funds: 0.17 percent
Now new data from NerdWallet gives average expense ratios for more types of mutual funds, including the following:
- Equity mutual funds: 0.63 percent average asset-weighted expense ratio
- Bond mutual funds: 0.51 percent
- Hybrid mutual funds: 0.74 percent
- Target-date funds: 0.51 percent
- Money market funds: 0.18 percent
- Equity index funds: 0.09 percent
If you’re unsure what expense ratios you are being charged on your mutual funds, consult the literature that came with the investments.
A document known as a “prospectus” — which you should have received upon buying a mutual fund — is the definitive mutual fund source to consult. Typically, you also can find this information online at the fund’s webpage.
For investments in 401(k) accounts, we discuss other such documents to consult in “Of All the Fees You Pay, This One Is the Worst by Far.”
Prospectus documents tend to be lengthy and can be intimidating to the average person, though. When I want to cut right to the chase, I use FINRA’s Fund Analyzer. It’s no substitute for reading a prospectus, but it’s a free tool that enables you to evaluate mutual fund expenses and compare expenses of one fund with another.
What are your thoughts on expense ratios? Let us know below or on Facebook.