The Single Best Strategy
Keeping costs down gives you more bang for the bucks you save
(MONEY Magazine) – If I told you there was a risk-free way to boost your retirement savings by 20% or more, would you be interested? How about if I added that the strategy could also significantly increase the odds that your savings would last through 30 years of retirement? Would that get your attention?
Of course, you might think there's a catch—that you'd have to live the life of an ascetic, or make like the Amazing Kreskin and identify in advance the top-performing investments each year.
But there's no catch. In fact, what I'm suggesting is the soul of simplicity: Rein in your investment costs. By favoring low-cost funds over high-cost alternatives, you can dramatically increase your chances of having a secure retirement.
Of course, MONEY has long extolled the virtues of low-cost investing. But the power of this simple idea never quite hits home until you examine the numbers. Say you're 30 years old, make $40,000 a year and have a 401(k) that lets you sock away 6% of your salary, with a 50¢-on-the-dollar match. Further suppose that over the next 35 years, your salary increases 3% a year on average and that your investments earn 8% a year before expenses. How much will you have by age 65? That depends.
Let's say you opt for a lineup of stock and bond funds that puts your portfolio's overall expenses at 1.5% a year—on the expensive side, though hardly extravagant given the lofty fees some funds charge. In this case, you'd end up with $663,600 at gold-watch time.
That's not bad. But as the table at right shows, you could have done much, much better by holding the line on costs. With ultra-low-cost funds—say, index funds with expenses of 0.25% a year, you'd end up with $188,200 more.
As compelling as these figures are, however, they tell only half the story. The other half is the effect of low expenses after you retire. So I enlisted the people who run T. Rowe Price's Retirement Income Manager program—a service that helps retirees manage withdrawals—to figure out how expenses affect the odds of your assets supporting you in retirement.
Specifically, we wanted to determine the probability that a 65-year-old's savings will last at least until age 95. To gauge that, we assumed a withdrawal equal to 4% of savings in the first year of retirement and increased the withdrawal by 3% each year. We also assumed a lower expected return before expenses—7% vs. 8%—figuring that retirees invest more conservatively.
The odds of a retirement portfolio lasting 30 years rise dramatically as costs fall. With expensive funds, there's a 31% chance the hypothetical portfolio won't last. Investing in ultra-low-expense funds cuts the probability to 13%.
I'm not saying that everyone can duplicate these results. For one thing, getting overall costs down to an ultralow 0.25% is a challenge. But there's no doubt you can dramatically improve your retirement prospects by studiously avoiding high-cost funds. One way to do that is to opt for 401(k) choices like institutional funds (whose expenses are often half those of retail funds) and low-cost index funds, which are now available in nearly two-thirds of 401(k)s.
I certainly don't want to underplay the importance of saving regularly and diversifying. But when it comes to getting the biggest bang for each buck you do save, I believe keeping costs down is the single most effective strategy. And you don't need the mental powers of the Amazing Kreskin to pull it off.