The Tyranny of Compounding Fees: Are Mutual Funds Bleeding Retirement Accounts Dry?

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The investments in a 401(k) plan or any retirement plan are meant to save for the long term. The most appropriate strategy is a risk adjusted globally diversified portfolio. Evidence proves that trying to find the next active manager will hurt your returns.

Executive Summary

  • Investments in retirement accounts are plagued by poor returns. An important factor is that, in aggregate, returns of actively managed equity mutual funds trail those of broad market indices.
  • This paper partitions the real total return of the S&P 500 into: (1) return to mutual fund investors and (2) return to the financial services industry. The author calculates these shares for all 10-, 20-, 30-, 40-, and 50-year investment periods using data from January 1871 to June 2011.
  • The financial services industry share of market returns increases with the length of investment period. For annual performance lags of 250 basis points (bps), the industry share over 10 years is about 46 percent on average; over 50 years it increases to 74 percent.
  • Smaller degrees of underperformance increase investor shares substantially: 50-bp lags result in an average investor share of 90 percent for 10-year investment periods and 77 percent after 50 years.
  • The shares of market returns to investors and the financial services industry are highly variable for shorter investment periods, but this variability declines as the investment period increases.
  • A 100-bp annual lag in performance over 50 years would reduce retirement assets currently held in equities by about $28 trillion (inflation adjusted), an amount almost twice that of the entire U.S. national debt as it currently stands, assuming average market returns.
  • The author recommends that pension plan fiduciaries be required to select default investments with a management expense ratio (MER) as low as possible, ideally no greater than 10 bps. Also, financial advisers should direct client funds to similarly low-cost investment vehicles.

Stewart Neufeld, Ph.D., is an assistant professor at the Institute of Gerontology at Wayne State University in Detroit, Michigan

This article illustrates how Wall Street makes most if not all of their income. It is not through savvy investing but rather by actively traded mutual funds.

Please comment or call to discuss how this affects you and your investment goals.

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