Fees matter less in a high return environment, right? Wrong!

We have written regularly about the insidious impact of fees, how the seemingly tiny – but regular – nibbles off your retirement savings ultimately take a huge chunk out of your pension. In fact, one of the 10X mantras is that that for every 1% pa in fees you save you will have 30% more money at retirement, after 40 years of saving.

This (Fig 1) is the chart we typically show to make out point (which, incidentally, was adopted by National Treasury in its Discussion Paper “Charges in South African Retirement Funds” to make their point!).

Fig 1: Real value of saving R1 000 pm for 40 years, earning a 5% real return

We always quantify the impact of fees projecting real (after-inflation) returns. Only real returns grow your wealth; doing it this shows how much you stand to lose in terms of today’s money (ie mirroring current purchasing power).

A 5% pa real return (before fees) is a conservative estimate of the compound long-term real return you can expect on a balanced high equity portfolio. Historically, the number has been closer to 6,5% pa.

We have also warned that in a low return environment, the impact of fees will be more pronounced. If you are paying 2% pa in fees on a real return of 4% pa, you should be relatively worse off than if you were paying 2% pa in fees on a return of 6% pa. Intuitively, that makes sense, because you are now giving up 50% of your return, not “just” 33%.

Except that it’s not so. Assuming the same annual fee, the higher the return, the higher the % of your savings that fall by the wayside. John Bogle, the great index fund pioneer, talks about the tyranny of compounding costs. And by doing the maths, we realise that the higher the compounding rate, the more costs tyrannise investors.

To demonstrate, below we quantify the impact of fees using nominal returns. The historical inflation rate for the past 40 years has been around 10% pa. So in Fig 2 below, we show the impact of fees earning a nominal long term compound return of 15% pa.

Fig 2: Nominal value of saving R1000 pm for 40 years, earning a 15% return

The example in Fig 2 assumes a constant contribution over 40 years, as may well be the case if you invest in a retirement annuity fund (RA) without an escalating premium. Many people do this. Also assume that you pay 3% in fees, because that is the average cost of the traditional policy-based RA.

Note that instead of your RA being worth R1,5m after 40 years, before fees, it is now worth R21m. This completely dwarfs the accumulated contributions of R480 000. However, the R19,5m gain merely compensates you for inflation, so you would no wealthier than under the first example.

In fact, you would be poorer. Instead of losing 51% of your fund value to fees (at 3% pa), you have now lost 57%. That’s losing half your money (as before), and then another 12% of what’s left on top of that.

So why do you lose more when we factor in inflation? Simply because you are now also losing out on the inflationary return, and this too, compounds more aggressively over time, to worsen your outcome.

So next time someone tries to sell you a high cost product on the idea that fees don’t matter when returns are high, you’ll know they are either ignorant or deceitful. Either way, they are choosing to not put your interests ahead of their own.

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