Costs of Managing Wealth:

Transcription

1 An Overview of Fees in the Industry A CORDANT WHITEPAPER tel info@cordantwealth.com Learn more at cordantwealth.com

2 SUMMARY When it comes to managing your wealth, there are many different types of expenses you can incur. Some are easy to see, and some are more difficult to uncover. But all of them are important to consider and understand. We have classified the types of expenses you can pay into three main categories: Externally billed expenses Published investment expenses Non-published investment expenses Externally billed expenses are fees for advice that are typically tax deductible. Investment expenses, on the other hand, are related to buying, selling, or holding a product and are not deductible. Our goal with this paper is to help you better understand the different types of expenses that you pay when managing your wealth, and help you recognize what an expected range for each expense might be. Table 1 summarizes the different types of costs and outlines when you pay them, a typical expected range, a transparency ranking, and whether they are tax deductible. Additionally, the numbers in the first column correspond to the three main categories we outlined above: 1) external, 2) published, and 3) non-published. TABLE 1: TYPES OF COST AND KEY CHARACTERISTICS EXPENSE PAID IF YOU WORK WITH OR OWN TYPICAL RANGE TRANSPARENCY TAX - DEDUCTABLE (1) FINANCIAL PLANNING FINANCIAL PLANNER 0.90% 1.00% HIGH YES (1) ASSET MANAGEMENT ASSET MANAGER 0.75% 1.50% HIGH YES (1) COMPREHENSIVE FINANCIAL ADVISOR 0.75% 2.00% HIGH YES (2) EXPENSE RATIO MUTUAL FUND / ETF S 0.02% 4.00% MEDIUM NO (2) MUTUAL FUND LOADS MUTUAL FUND 3.00% 8.00% MEDIUM NO (2) EQUITY COMMISSIONS STOCKS 1.00% 2.00% MEDIUM NO (3) FIXED-INCOME COMMISSIONS BONDS 0.75% 1.73% LOW NO (3) TRADING COSTS MUTUAL FUNDS 0.50% LOW NO (3) CASH DRAG MUTUAL FUNDS 0.15% LOW NO (3) TAX DRAG MUTUAL FUNDS/ETF S 0.30% 0.75% LOW NO 2

3 In the balance of the paper we delve deeper into each of these three types of expenses in an effort to help you to understand more about the your costs of managing wealth. EXTERNALLY BILLED EXPENSES (FEES FOR ADVICE) Externally billed expenses are those that you pay for wealth management advice, and they fall into one of three categories: (1) financial planning, (2) asset management, and (3) comprehensive. These fees tend to be transparent and are typically tax deductible. Financial Planning Financial planning fees are charged for creating a financial plan, helping you set up a budget, and assistance in determining goals. They may also include advice in the areas of estate planning, insurance planning and charitable giving. Typical fee arrangements for financial planning include hourly billing, a flat fee on one-time engagements, an annual retainer for ongoing relationships, or a percentage of assets. According to the FPA s 2011 Financial Plan Development & Fees study 1, rates for fee-only Advisors (those that accept no compensation via commissions) range from: $150 $250 hourly $1,500 $3,500 for a one-time engagement $2,000 $6,000 for a retainer based fee 0.90% 1.00% reported for AUM fees Asset Management Asset management expenses are paid for investment management services only. These fees are usually paid directly to a manager that will set an allocation for your portfolio and execute their preferred strategy. Typically, these fees are charged as a percent of your assets. Standard fees for asset management range from 0.75% 1.50% of your assets, 2 although we have seen fees for asset management higher than 2%. 1 All fees are based on the 25 th and 75 th percentile based on 527 completed responses. 2 ICMA Research Quarterly, Q % of client with $1.5mm in assets and 80% of those with $5mm 2 ICMA Research Quarterly, Q % of client with $1.5mm in assets and 80% of those with $5mm in assets have a fees between 0.75% 1.00% and 94.4% and 81.4% respectively between 0.75% 2.00%. 3

4 Comprehensive A comprehensive fee model takes a holistic approach with the objective of providing advice on your entire financial situation. This comprehensive model combines financial planning, asset management and third-party coordination (e.g., CPA, Attorney, etc.) activities, with fees covering advice in the areas of goals and objective discovery, estate planning, insurance analysis, cash flow, tax planning, philanthropic giving, and portfolio construction and monitoring. The fees for comprehensive wealth management can range from 0.75% 2.00% of assets. 2 PUBLISHED INVESTMENT EXPENSES Published investment expenses are costs that you incur when buying, selling or holding an investment. These expenses are published, but may require a little digging to uncover. Fund Expense Ratio Every mutual fund or ETF (exchange traded fund) publishes the annual fee charged to the investors of the fund. This is the cost of running the fund, which consists of management fees, administrative fees, and operating costs. The amount you pay can vary widely, from 0.02% to over 4.0% annually 3 which translates to $20 to $4,000 per year on a $100,000 investment. If you re not clear as to why this is an important expense to consider, economist and Nobel laureate William Sharpe estimates that simply reducing the amount you pay in fund expenses can result in a 20% increase in your standard of living in retirement. 4 But what kind of control do you have over this expense? The fund expense ratio varies primarily based on the type of fund in question active or index based. For example, an actively managed mutual fund that is researching and selecting securities to purchase requires additional management, research, and operational staff therefore incurring greater expense than an index based fund. A person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in highcost investments. -William Sharpe 3 Source: Morningstar 4 William F. Sharpe The Arithmetic of Investment Expenses Financial Analyst Journal Volume 69, No pg. 34 4

5 Mutual Fund Loads There are multiple layers of expenses to consider when it comes to mutual funds. In addition to the fund expense ratio, many funds also have a sales load. So what is a sales load? Mutual funds come in two varieties: those with sales charges (i.e., loads) and those without. The sales charge is compensation to the salesperson or broker that helped you select a fund. To further complicate things, sales loads themselves come in two main varieties: front-end and back-end. The front-end load is charged up front upon purchase of the fund, and a back-end load is imposed later on when you sell the fund. A standard front-end load may be 5% and can range from 3% to 8.5%. A back-end load may by 5% in the first year and decrease by 1% for each year held. 5 On a $100,000 fund purchase with a 5% front-end load, only $95,000 of your funds would be invested and $5,000 would go into the pocket of the person selling you the fund. Of course, there are many no-load funds as well, and these can easily be purchased as an alternative to higher cost, loaded funds. Equity Commissions Equity commissions are paid when you buy or sell an ETF or stock position. While equity commissions can be quite low in some cases (many firms offer under $10 per trade), they can also add up to a significant amount of compensation for brokers. Why should you care about brokers compensation? Brokers are compensated based on the commissions they generate and therefore the number of transactions that customers like you complete with them. The financial incentive lies in getting you to buy and sell a product not in providing you with advice. A typical commission for a full service broker can range from % of the total dollar amount of the trade. 6 Assuming a 2% commission on both the purchase and sale of a position, your investment would need to increase in value by more than 4% before you break-even on the transaction. 5 For more on Mutual Fund loads see here: 6 Brokerage commission schedule for UBS can be found here: 5

6 NON-PUBLISHED INVESTMENT EXPENSES Non-published investment expenses are (like published investment expenses) costs incurred when buying, selling or holding an investment. They differ however, in that they are not transparent and typically must be estimated. CHART 1: COMMISSIONS Fixed Income Commissions Fixed income commissions are similar to equity commissions in that they are compensation to the selling broker, but they are less transparent. Typically, the expense is hidden in the bid/ask spread (i.e. the markup going to the broker). The bid/ask spread is the difference between what you pay for a bond and what you could sell that same bond for. The greater the discrepancy between these two prices, the more compensation that goes to the selling broker. These commissions can be especially high and opaque in municipal bonds. In 2013, according to the Wall Street Journal, the average spread in municipal bonds was 1.73% for the retail investor.7 See chart 1. Fund Trading Costs Fund trading costs are invisible costs that have been researched extensively in academia. These are the costs that your fund bears (which in turn reduce the returns you receive) when buying and selling shares due to bid ask spreads and commissions. In a 2014 article for the Financial Analyst Journal8, John Bogle estimated this cost is 0.50% annually for actively managed funds $500 per $100,000 investment. 7 The Wall Street Journal, Muni Bond Costs Hit Investors in Wallet by Matt Wirz. March 10, 2014 Bogel, John C. (2014). The Arithmetic of All-In Investment Expenses Financial Analyst Journal January / February 2014, Vol. 70, No. 1: pp Cordant Whitepaper 6

7 Fund Cash Drag A second invisible cost of investing in funds is known as cash drag. Because cash has a lower expected return than stocks or bonds, any funds held in cash act as a drag on returns over time. This is an opportunity cost (incurred when you forgo the chance for gain on a cash investment) but it is a very real cost, as it reduces your returns over time. John Bogle estimates that actively managed funds hold around 5% of the fund in cash while index funds typically are fully invested. 8 The estimated impact of this cash drag is 0.15% annually $150 on $100,000 investment. Fund Tax Drag Finally, the last invisible cost is known as tax drag. A fund generates a tax bill due to income, dividends and capital gains. Higher turnover funds (funds that trade more frequently) tend to generate a higher tax bill due to the difference in tax treatment of short-term vs. long-term gains, and from a quicker realization of gains. There are a few different ways to estimate the cost on taxable funds. Morningstar publishes a tax cost ratio for funds by looking at the difference in pre-tax and after-tax returns over trailing 3, 5, 10 and 15 year periods. This is a historical estimate and should give some insight into how well the fund controls the tax impact. Additionally, there have been several academic studies that attempt to estimate the tax impact. Bogle (2014) estimates the tax drag to be 0.75% annually on actively managed funds and 0.30% on index funds. Another study 9 published in 2000 by Rob Arnott et al. looked at equity mutual fund performance relative to the S&P 500 index. They found that over a twenty-year period starting in 1980 the average mutual fund underperformed the S&P 500 benchmark by 1.75% before taxes and by 2.58% after taxes implying a tax impact of 0.83% annually. A CASE STUDY Now that we have explored the different types of wealth management expenses and when you may pay them, a simple case study will help to sum up what this can mean for you. 9 Arnott, Robert D., Andrew Berkin, and Jia Ye. (2000). How Well Have Taxable Investors Been Served in the 1980s and 1990s? The Journal of Portfolio Management Summer 2000, Vol. 26, No. 4: pp

8 We will look at four scenarios for managing wealth: 10 A do-it-yourself (DIY) investor holding passive index funds A DIY investor holding actively managed funds An investor managing part of their wealth with a broker and part with an advisor An investor working solely with an independent advisory firm DIY Passive If you want to manage things on your own this is clearly a costeffective way to do so. Table 2 clearly shows how this scenario bears the lowest cost. Annual costs total 0.43% and fall into only two expense categories. For those we talk to with a relatively simple situation and a desire to self-manage their portfolio, this is often the approach we suggest. However, while inexpensive, this approach does have some gaps including: TABLE 2: TOTAL EXPENSE CASE STUDY EXPENSE FINANCIAL PLANNING ASSET MANAGEMENT DIY - PASSIVE DIY - ACTIVE BROKER ADVISOR 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.75% 0.00% COMPREHENSIVE 0.00% 0.00% 0.00% 1.50% EXPENSE RATIO 0.13% 0.81% 0.57% 0.50% MUTUAL FUND LOADS EQUITY COMMISSIONS FIXED-INCOME COMMISSIONS 0.00% 0.00% 0.33% 0.00% 0.00% 0.00% 0.15% 0.00% 0.00% 0.00% 0.35% 0.00% TRADING COSTS 0.00% 0.50% 0.35% 0.10% Comprehensive financial planning Coordination with advisors (CPA s, attorney s, etc.) TOTALS 0.43% 2.21% 3.13% 2.43% Financial advice when markets get rocky (e.g. think back to 2008) The added benefits of a robust investment framework 11 DIY Active CASH DRAG 0.00% 0.15% 0.11% 0.03% TAX IMPACT 0.30% 0.75% 0.53% 0.30% At 2.21% annual cost, the Active DIY approach is the second lowest of our scenarios although only 0.20% lower than the Advisor approach. This approach prioritizes active management by 10 For a full explanation of the data used and assumptions in each scenario please see the appendix. 11 For more on the benefits of a robust investment framework see our white paper titled, Managing Investment Assets in Retirement: A Proven 7-step Framework. 8

9 the investor in the hopes of higher returns. The trade-off for this chance for higher returns (which, according to the data show is a low chance) is higher expense ratios, and higher trading costs. Under this scenario there is no expense paid for advice, which means the DIY investor misses out on the planning, coordination, behavioral, and investment framework benefits that an advisor may provide. Broker The broker scenario assumes that 50% of the portfolio is managed via a brokerage arrangement and 50% under an advisory agreement. As can be seen in table 2, in addition to asset management and annual expense ratio costs, the client in this situation would have costs related to mutual fund sales loads, equity commissions and fixed income commissions. In addition to being higher cost, there are serious conflicts of interest that are introduced when one is compensated for selling a financial product. An incentive is introduced that shifts focus from providing the best and unbiased advice to clients towards a focus on products that generate one s income. Advisor Under the Advisor scenario the majority of expenses are shifted into the advice category. At Cordant, we feel that this provides the best alignment of interest between an advisor and the client. The 0.50% expense ratio is higher than under the DIY Passive scenario, as we are assuming some usage by advisors in alternative investments, which have benefits but also increases the expense ratio. In this scenario, the investor sees all the benefits of a holistic approach to wealth management, including: Comprehensive financial planning Coordination with advisors (CPA s, attorney s, etc.) Financial advice when markets get rocky (e.g. think back to 2008) The added benefits of a robust investment framework For more on the benefits of a robust investment framework see our white paper titled, Managing Investment Assets in Retirement: A Proven 7-step Framework. 9

10 CONCLUSION It can be confusing and difficult to determine the total cost of your investments. But getting clear on the full cost of your wealth management is a worthy endeavor, and understanding the landscape of expenses can help you make a more educated decision about your investments. At Cordant, helping our clients understand total investment costs is just one aspect of our holistic, intentional approach to wealth management. If you would like further assistance in determining your current costs, evaluating your investment strategy, and identifying opportunities to minimize your wealth management expenses, please call or visit cordantwealth.com. 10

11 HOW CORDANT CAN HELP Cordant primarily serves current and former employees of Intel, and our team has helped many people through their decision to retire. Specifically, we seek to deliver the following benefits: CLARITY - Help you quantify and prioritize your goals and objectives. PLAN - Develop a comprehensive financial plan, and meet regularly to assess whether you are on track to achieve your goals. RISK MANAGEMENT - Quantify and monitor the risks posed to your plan and retirement funding strategies. COMPREHENSIVE - Assist with every financial decision, from financing the purchase of a home, to managing investment assets, to estate planning. TRANSPARANCY - Offer aggregated reporting and online access for all of your financial assets, regardless of where they are held. ABOUT US Cordant specializes in wealth management for high-level corporate employees. We deliver an integrated approach to wealth management that empowers every financial decision with intention. With more than 10 years of experience helping Intel employees manage their wealth, the Cordant team has deep expertise in the retirement, benefit, and compensation plans of Intel. Our highly-skilled wealth planning and investment professionals deliver a broad array of investment, tax mitigation, income enhancing, and legacy planning services that align our clients direction with their vision for life. We utilize a historic wealth management model that requires our team to be fully aligned with our clients, and focused on managing their wealth holistically. Our unique systems and technology allow us to manage, integrate, and measure both company and non-company assets and benefits. Cordant s solutions are transparent and objective, so you have peace of mind that your wealth is well-managed. We ve adopted the highest fiduciary and legal standard of care, choosing to act as an unwavering fiduciary in the best and exclusive interest of our clients. In addition to being regulated by the SEC, we have built in additional transparency and safeguards for clients. For more information please call or visit cordantwealth.com. At Cordant, we empower every financial decision with intention. 11

12 The information provided herein is for informational purposes only and is not intended as tax advice or investment advice. Any investment or personalized financial planning advice provided by Cordant is client specific and based on each client s risk tolerance and investment objectives. Cordant, Inc. is not affiliated, associated or endorsed by Intel. APPENDIX: CASE STUDY ASSUMPTIONS DIY Passive Expense ratio (0.13%) The average expense ratio for index funds per the Investment Company Institute Trends in the Expenses and Fees of Mutual Funds, 2012 Tax Impact (0.30%) Per John Bogel (2014). The Arithmetic of All-In Investment Expenses Financial Analyst Journal January / February 2014 DIY Active Expense ratio (0.81%) Assumes a 60%/40% split between equity and fixed income funds. 0.92% and 0.65% are the average expense ratio for equity and bond funds per the Investment Company Institute Trends in the Expenses and Fees of Mutual Funds, 2012 Trading Costs, Cash Drag and Tax Impact (1.40%) Active fund costs per John Bogel (2014). The Arithmetic of All-In Investment Expenses Financial Analyst Journal January / February 2014 Broker Portfolio composition 20% Municipal bonds (broker), 10% Stocks (broker), 20% Load Funds (broker), 50% Actively managed funds (advisory). Asset Management (0.75%) Assumes 1.50% charge on 50% of the portfolio. Expense Ratio (0.57%) Assumes 0.81% expense ratio on 70% of the portfolio. Mutual Fund Loads (0.33%) Assumes 5% up-front load on 20% of the portfolio and a 3- year holding period. Equity Commissions (0.15%) Assumes 1.50% commissions on 10% of the portfolio Fixed Income Commissions (0.35%) Assumes municipal bond commissions of 1.73% on 20% of the portfolio. 12

13 Trading Costs, Cash Drag and Tax Impact (0.98%) 70% of the portfolio with active fund costs per John Bogel (2014). The Arithmetic of All-In Investment Expenses Financial Analyst Journal January / February Advisor Comprehensive (1.50%) Assumes 1.50% charge, roughly upper quartile fee from the ICMA Research Quarterly, Q Expense Ratio (0.50%) Portfolio of mostly index funds but including alternative and global investments. Trading Costs, Cash Drag and Tax Impact (0.43%) 20% of the portfolio with active fund costs per John Bogel (2014). The Arithmetic of All-In Investment Expenses Financial Analyst Journal January / February