How much would you pay each year for a financial advisor to manage your investments? Most of you probably had a dollar amount pop in your head when you read the question. Maybe $1,000, $5,000, or $10,000. I need you to switch your thinking now. Instead of thinking of the answer in dollars, think of it in terms of a percentage of your assets that they are managing. What percentage would you be willing to pay that advisor each year to manage your assets? Write down that number. (Hopefully it is more than zero and less than five).
Now, let’s assume you just inherited $1,000,000 that you would like to invest.
Have you ever seen the movie Office Space? It’s a great comedy about a guy named Peter who hates his job and just stops caring about work. Towards the end of the movie, he teams up with his two friends/coworkers in a scheme to steal money from his employer. The plan is to create a program that takes less than a penny from each transaction and deposits it into a bank account that they own. Peter argues that the company won’t notice because they are fractions of a penny, but over time it will add up to a lot of money.
Paying high fees in your investment accounts can have the same impact! Before I go any further, I am not saying that investment advisor fees are the same as the fraud committed in Office Space. I am trying to help you understand that seemingly small amounts can add up quickly.
So what investment fees should you be concerned about? There are three main fees that people should focus on when they are choosing an advisor. These are account management fees, investment fund fees, and transaction fees. Account management fees are the fees that you are paying the financial advisor. The industry average is around 1.0%. Investment Fund fees are paid from each of the investments that you own. The average fee for mutual funds is around 1.25%. Finally, transaction fees are paid every time an investment is bought or sold. These fees are usually between $5 and $10 per transaction. In total, these three fees add up to around 2.25-2.5% per year.
So what?!?! 2.5% doesn’t seem like that much. It may even be less than the amount you said you were willing to pay for investment management. Let’s run the numbers. 2.5% means that your $1 Million inheritance is now paying $25,000 in fees each year. That isn’t the end of the world because hopefully the investments will earn an average of 6-7% which means you are still a net positive. However, that is no small fee to pay each year. What if you could find an advisor who charges a lower fee and uses investment funds that charge 0.25% or less? You could lower your total fee percentage to be around 1.0% in total. That would mean you are paying around $10,000 on your $1 Million investment.
Now let’s look at these fees for the average investor saving for retirement. Let’s say you were to start with $10,000 in an IRA and contribute the maximum of $5,500 each year. If you do this for 40 years (at a 7% rate of return) and pay 2.5% in fees each year, you would end up with about $650,000. Not too shabby! If you did the same exact things, but only paid 1.0% in fees, you would wind up with about $950,000. That difference of 1.5% results in a $300,000 difference in your retirement account. That could be the difference in retiring and working another few years for your eight bosses.
As you start doing research on financial advisors to invest your $1 Million, or any amount you have, make sure to discuss fees. Ask them how much they get paid by you. Talk to them about how much they expect the investment fund fees to be. Also, ask if they make money from commissions or other programs. One of the best things to do is ask if the are a Fiduciary. These advisors usually have the most transparent fee pricing and don’t make anything from commissions.
Just like in Office Space, small amounts over a long period of time can make a big difference. Grab your red stapler and put on your 17 pieces of flair. Go talk to your financial advisor about this. If you don’t feel comfortable with their answers, find an advisor that you are comfortable with. Your investments are too important to work with someone you don’t feel is putting your interests above everything else.
Mike Zeiter, CPA/PFS