Dump that high-fee fund
A financial adviser is promising high returns on a fund that charges a 6.5% sales fee. But do the math and it doesn't add up, says Walter Updegrave.
NEW YORK (Money) -- Question: An adviser helped us set up an IRA account and on his recommendation we began investing in a target-date retirement fund that charges a 6.5 percent sales fee. We've asked him to switch us to another target-date fund that has no sales fee and invests in low-cost index funds, but he says the fund we're in now has a shot at better returns because it's actively managed. Do you think we should stay with the fund our adviser recommended? - Dinh Ho
Answer: The short answer: No, you shouldn't stick with the fund your adviser recommended. I think you ought to switch to the no-load (i.e., no sales fee) target-date fund that invests in index funds immediately, if not sooner.
But I want to explain why I come to this conclusion, so that you understand I'm not just reacting out of some reflexive anti-sales fee or anti-adviser bias. I have no problem with investors like yourself paying an adviser for competent advice.
In this case, you needed help setting up your IRA and figuring out how to invest the money you contribute to that IRA. The 6.5 percent sales fee is how you compensated the adviser for his time and expertise. Fair enough. But now the circumstances have changed.
You've got the IRA going and you've become more familiar with some of the investment options out there. And it seems to me the question you've now got to ask yourself is this: Will the advice you get from the adviser from this point on be worth paying 6.5 percent of what you invest year after year after year?
I suppose the answer could be yes if you think your adviser will provide ongoing insight that will significantly enhance the value of your IRA. But is that likely in your case?
I mean, the adviser has put you into a target-retirement fund, a type of fund that gives you a pre-set mix of stocks and bonds that automatically shifts more toward bonds as you age. I'm a big fan of these funds because you get a fund and an investment strategy rolled into one.
But the point is that, once you're in a target fund, the adviser doesn't really have much to do. These funds are pretty much designed to run on autopilot. So it's not as if the adviser is carefully putting together a portfolio of funds and monitoring it to assure that the stocks-bonds mix remains appropriate as you age. The fund does that. So I don't see the adviser adding much, if any, value there.
As for whether or not the fund will outperform an index-based target fund, well, that's certainly possible. But hardly a given or, for that matter, even particularly likely, considering index funds tend to outpace actively managed funds over long periods of time.
Indeed, given the upfront sales commission you're paying and the fact that the actively managed fund charges higher annual fees, your actively managed target-date fund would have to outperform the index-based target fund by a considerable margin to come out ahead.
How considerable? Here's a quick example. Let's assume you contribute $5,000 a year to your IRA for the next 20 years. (This year's IRA contribution limit is actually $4,000, which rises to $5,000 next year. Anyone 50 or older can also throw in an extra $1,000. But for simplicity's sake, let's just go with $5,000 a year.) Let's further assume that, in addition to the 6.5 percent sales load, your actively managed fund levies annual expenses of 0.75 percent a year (in fact, many actively managed target funds charge more).
And let's also assume that the target-date fund that invests in index funds charges 0.25 percent in annual expenses (in fact, you can find index-based target funds that are cheaper, such as those offered by Vanguard). And let's say that both funds deliver an annual return of 8 percent a year before expenses.
Okay, so of the $5,000 a year you have to invest in the load fund, only $4,675 makes it into the fund after you pay $325 in sales commissions. That $4,675 investment then earns 7.25 percent a year after deducting 0.75 percent in annual expenses from the 8 percent annual gross return. So after 20 years, your IRA balance would be roughly $211,200.
With the no-sales-fee index target-fund, every cent of your $5,000 goes into the fund. And since the index-based target fund charges just 0.25 percent a year, your after-expense annual return is 7.75 percent. After 20 years, your $5,000 annual investment in your IRA would grow to about $239,800.
In short, if you stick to your current fund, you would be giving up $28,600 based on this scenario. To overcome that difference, the actively managed fund would have to earn about 8.3 percent a year after expenses, or more than half a percentage point a year more than the index fund. I don't think that's very likely, unless it takes a lot more risk.
One more thing. Since we're talking about an IRA here, you can move to the cheaper fund without having to worry about triggering taxes on any gains you may have in your current fund. Of course, your adviser may not be too happy about this switch. If you move to a no-sales-fee fund, he won't receive a commission on your future IRA contributions.
So to make this change, you'll probably have to open up an IRA account yourself with a company that offers a no-load index target-fund, and then roll over the balance in your old IRA account to the new one. That shouldn't be a problem. The fund company you're moving to can easily help you do that. Just be sure you do a trustee-to-trustee transfer (aka, a direct rollover). Otherwise, 20 percent of your account balance will go toward withholding taxes. You'll get that money back after filing your taxes.
But in the meantime you'll have to come up with the missing 20 percent to complete the rollover. Fail to do that, and you'll owe taxes and, if you're under age 59 1/2, a 10 percent penalty on that 20 percent. By doing a trustee-to-trustee transfer, you'll avoid this hassle.
Bottom line: I don't see any compelling reason for you to continue to shell out 6.5 percent of your future IRA contributions to stay in this fund. So if I were you, I'd thank the adviser for his help and then I'd tell him that, as far as this IRA is concerned at least, it's time for you to move on.