No fee investing: Too good to be true

By Walter Updegrave, senior editor

(Money Magazine) -- Question: I recently retired with a balance of just under $500,000 in my company's retirement savings plan. The investment firm that manages that plan wants me to keep this money with them and claims it will charge me nothing to manage it. I'll pay only the usual mutual fund annual expenses.

I also have the option to move the money to another investment group that will charge me 1% a year to manage my portfolio. My question: Is it too good to be true that one company will manage my portfolio and charge no fees to do so? -- Ron H., DeLand, Florida

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Answer: Let's start with the premise that no investment firm -- or any company, for that matter -- is going to give you something for nothing. One way or another you pay for what you get. The only question is how, and what services you receive for whatever amount of money you shell out.

Given that, let's take a look at your choices when it comes to investing your near five hundred grand.

It sounds to me as if the company that manages your firm's retirement plan may be offering you some sort of account or mutual fund that spreads your money among different types of assets.

It could be a simple rollover service, in which case the company helps you transfer your money and then assists you in choosing a mix of stock and bond mutual funds deemed appropriate for your age and financial goals. If you're really paying nothing more than the annual fund fees, I wouldn't expect much in the way of ongoing oversight.

On the other hand, the company may also be suggesting you move your money to a target-date retirement fund. The premise behind this type of fund is simple: You choose a fund with a date that corresponds to the year you intend to retire -- in your case, 2010 -- and you get a mix of stocks and bonds that's appropriate for someone your age. As you get older, the fund automatically shifts to a more conservative mix -- that is, lightens up on stocks and moves more into bonds and cash.

A target-date fund can invest directly in stocks and bonds or more likely (and which appears to be the case with the fund you're considering), in stock and bond funds that are managed by that investment firm. When the target-date fund invests in funds, you pay a pro-rata portion of the annual expenses of each of the underlying funds.

So, to keep things simple, if the fund were to put, say, 35% of its assets in a domestic stock fund that charges 0.60%, 15% in a foreign stock fund that charges 0.70% and 50% in a bond fund that charges 0.60%, you would be on the hook for 0.62% a year ([.35 x .60] + [.15 x .70] + [.5 x .60]). Some target funds also add an advisory fee on top of the underlying asset charges (although based on what you say, that's not true in your case). So if the target date fund had the expenses above plus an advisory fee of, say, 0.20%, you would be paying a total of 0.82% of assets a year.

Whatever the arrangement, you can see exactly how much you'll be paying in annual fees (plus sales fees, if any) by checking out the fee table that appears in the front section of each fund's prospectus.

The other investment group, on the other hand, seems to be offering you an investment advisory account. In that arrangement, you would pay the investment group an annual fee -- in your case 1% -- to manage your assets.

What you don't say -- and perhaps never discussed with them -- is exactly how those assets will be invested. Although such an advisory service could invest your money directly in stocks or bonds, I think it's more likely that this group will be creating a portfolio of mutual funds and/or ETFs and managing it for you. If that's the case, then you'll not only be paying the firm's 1% advisory fee, but the underlying fund annual expenses as well.

So the total amount you pay will depend on what sort of funds the investment group puts you in. If the adviser sticks to low-cost index funds or ETFs, you could end up paying a relative pittance in ongoing investment expenses -- say, 0.20% a year -- and your total annual costs might run 1.2% a year. It's possible you could pay even less.

On the other hand, if the adviser chooses actively managed funds, you could easily end up paying 1% or more a year in fund costs alone. Add in the 1% annual advisory fee and you could be looking at an annual nut of 2% of assets, possibly more.

But fees are only one side of the equation. You also want to look at what you're getting for what you pay.

If the investment firm that oversees your company plan is essentially helping you do a rollover and create a portfolio -- and is charging no ongoing fee other than the mutual fund expenses -- I doubt you're going to get very much in actual management of your overall portfolio. To the extent you get help, it will likely consist of a rep answering your questions and perhaps helping you tweak your fund mix or choose new funds (although they'll likely be limited to fund in the company's stable).

In the case of a target-date fund, you're essentially getting a mix of funds that automatically changes over time. Whether your money is being "managed," depends on what you mean by the term.

Yes, there's a manager choosing the securities in the underlying mutual funds (although if the target fund includes an index fund, the manager is just tracking the relevant benchmark). The fund also adheres to an asset allocation policy, assuring that you'll get a mix of stocks and bonds that follows a "glide path" over time that assures the fund's equity stake declines over time. You could call that management as well, I suppose, although it's pretty much laid out in advance with perhaps some occasional minor adjustments along the way.

On the face of it at least, the investment group's approach might seem like a more personal form of management. You'll probably talk to an adviser, discuss investment options, maybe fill out a questionnaire to determine your level of risk.

But when it comes to managing your money, the adviser will probably put you in one of a pre-set menu of portfolios that goes from aggressive (nearly all stocks) to very low risk (mostly cash and bonds, very little stock). Since you're retired, you'll likely end up in one of the portfolios at the conservative end of the spectrum. The point, though, is that I don't think you should expect personalized management in the sense that the portfolio manager is going to be calling you up and asking, "Hey, Ron, how do you feel about throwing some energy stocks in the old portfolio?"

So which option is better?

Before you can make that decision, you need to know more about what each firm is offering. What exactly do they mean by "managing" your money? How will they help you arrive at a portfolio? Will they review its performance with you? How often? How frequently might the portfolio change? What could trigger a change? Does the firm offer investment services only -- or will it help you with issues such as determining how much you can spend from your savings each year without running out of money?

You'll also want to know exactly how much you're paying in fees -- that is, all fees combined. If you stick with the company that runs your former employer's plan, just how much will those mutual funds charge? (And are you sure you'll incur no other costs?) As for the investment group, the key question is how much will you pay in addition to its 1% annual advisory fee?

Remember too that this isn't an either-or situation. You're not limited to these two firms. You've got plenty of other options, ranging from large well-known investment firms like Vanguard, Fidelity and Schwab that offer advisory services to independent financial planners who can help you create a portfolio and provide other financial advice. And, of course, there are a variety of target-date funds (including the two that made our MONEY 70 list of recommended funds).

Ultimately, you need to decide what's the right blend of price and services for you. But to make that decision properly, you'll want to understand not only what these two firms are offering, but what's available from their competitors as well. To top of page

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