Saving for your retirement is important, and it is likely you have either a 401(k) or Individual Retirement Account (IRA) set up for that purpose. However, funds have fees that decrease the total amount available at retirement. One fee that can decrease a total balance is an expense ratio, which is a fee that exists on all retirement funds and is one of the most important fees to understand.
Expense ratio is a term that seems more complicated than it is. We are going to break down what is an expense ratio, the expense ratio formula for how your fees are calculated, what is a good expense ratio that won't cost you unnecessary money and how to evaluate fees compared to returns.
What is an expense ratio?
Expense ratios are a consistent fee that is applied every year. The fee is the cost that investment companies charge to cover fund operating expenses.
Operating expenses can include a few different aspects of running a mutual fund. However, the largest portion of an investment expense ratio is the management fee paid to an investment manager, the individual who selects different stocks, bonds and assets that participate in the mutual fund. Actively managed funds that frequently change to get higher profits tend to have a higher expense ratio due to the management fee.
However, not all funds are actively managed. Index funds are designed to mimic the market in general. An example is an index fund that follows the S&P 500 Index. The fund will reflect different companies as they exist in the index and is designed to either rise or fall with the S&P 500. This is considered a passively managed mutual fund, and the management fee portion is lower because no advisor is changing the fund structure for higher returns.
Other costs that are included in an expense ratio are record-keeping, custodial services, taxes, legal expenses and auditing fees. In general, these costs are for compliance with regulations designed to protect investors from fraud, as well as reporting to the IRS. However, some funds can charge for advertising and promotion expense, though this cost cannot exceed 1 percent of the expense ratio. For example, a fund with an investment balance of $10,000 and an expense ratio of 1 percent, resulting in a yearly fee of $100, cannot charge more than $1 per year for advertising and promotion.
Keep in mind, an expense ratio does not include all fees associated with retirement accounts, such as transactional fees like sales charges or commission that are applied when you withdraw or move your money. Expense ratios are only the fees associated with each specific fund you are investing in.
How is an expense ratio calculated?
The fees assigned to fund operating expenses can change. However, the expense ratio itself does not vary. Instead, an average expense ratio is applied to every account in a set percentage. The expense ratio formula is calculated by dividing all operating costs by the fund assets, meaning the dollar amount of all investments within the fund.
For example, if the entire balance equals $10 million and the operating costs are $100,000 per year, the expense ratio assigned to every investor account will be 1 percent ($100,000/$10 million = 0.01).
What this means for your retirement is expense ratio fees can change by fund depending on how much money is invested, as well as how much the operating expenses are in total. Funds with different objectives will have varying levels of expense ratios, also. An index fund designed to mimic the market, in general, will be on the lower end, while funds with fewer assets and more aggressive objectives will be on the higher end.
Index equity funds, which are tied to an equity index like the S&P 500 rather than bonds, are at the lowest end with an average expense ratio of 0.09 percent per year, or $9 a year on a $10,000 investment balance. Hybrid mutual funds cost the most with an average expense ratio of 0.7 percent per year, or $70 on a $10,000 investment balance.
What is a good operating expense ratio?
While there is no clear answer to what is a good expense ratio, there are some standards that can apply. A good expense ratio is between 0.5 and 0.75 percent for an actively managed portfolio. A fund that is greater than 1.5 percent is considered too high.
The different costs can impact how much you have at retirement. For example, let's say you have an initial investment of $100,000 and can contribute $10,000 per year for 30 years. We will assume you are earning a 6 percent return on this amount. If your expense ratio is between 0.5 percent and 1 percent, you will potentially have $126,167 less in your account at the end of 30 years as that amount goes to fees. Keep in mind these are not just the fees. The amount would include potential lost earnings on the fees if the money were in the account.
However, let's say you have the same amount invested for the same period. In this account, you are paying between 0.25 percent and 0.5 percent expense ratio. At the end of 30 years, you will have paid potentially $68,966 in fees. That is a difference of $57,201 in your retirement potential between the first example and the second example.
A simple way to see how much you are paying in expense ratios is to use our fee calculator. This is a great tool to see how much your 401(k) or IRA is costing you versus an IRA that we offer. Even if you don't care what we offer, the calculator will show you what your fund is costing you in retirement savings. Knowing how much your retirement fund is costing you is vital in helping you adjust your retirement to save the most money, as well as help you evaluate whether to roll over a 401(k) you might have left behind at a previous job.
Evaluating if fees are worth the cost
Of course, there is more involved when considering the fees applied to your retirement. In some cases, higher fees are worth the cost because of a higher return. The fees in the following examples are just to help you understand how higher returns with higher fees could benefit you, as expense ratios are never this high. In the first example, a fund gives you 5 percent in annual return, but the fees cost you 2.5 percent a year. If you earn $10,000 in a year in returns, the fees are costing you $5,000. The result is you only add $5,000 to your account.
Now, let's take a second investment that gives you 9 percent per year, but the expense ratio is 3 percent. Instead of only receiving half your money, you are now receiving 67 percent. If you earn $10,000 in a year, the fees are costing you $3,000. You add $7,000 to your balance. In this situation, paying a higher cost in fees might be worth it because you are earning more money.
However, returns can go up and down year over year, and higher returns can be the result of higher risk. The second example might be worth it in year one, but if the return drops to 2 percent the following year, the high expense ratio might cost you more in investment balance than an index fund with a low fee.
It is important to know when and how to evaluate if a higher ratio will benefit you, but ultimately lower fees mean more retirement. Understanding all the fees associated with your retirement, including investment expense ratios, will help you make smart decisions.