The real cost of a 2% fee over a lifetime

Last week I said the single biggest reason most active funds fall behind a simple index is cost, and that I owed you the real numbers. This is that post.

Most Canadians have no idea what their investments cost them. The fee is buried in a document nobody reads, taken out a little bit at a time, and the statement still shows a number that went up this year, so it feels free. It is one of the most expensive things you will ever not notice.

I want to show you the math that pulled me into financial planning in the first place, because once you see it, you can't unsee it.

Where this started for me

For years I watched my parents get the kind of "free" advice a bank gives you. Someone friendly sits you down, puts you in a few mutual funds, and never sends you a bill. What I didn't understand at the time was that the bill was always there, it just came out of the returns before anyone saw it. They were paying well over 2% a year, every year, for products with no real evidence of beating a simple index.

The thing that really changed how I saw it was an episode of Freakonomics Radio called "The Stupidest Thing You Can Do With Your Money." Anyone who knows me knows I'm a numbers guy, I love thinking about numbers, and when I worked out what a 2% fee does over an investing lifetime, I couldn't get it out of my head. Then I started thinking about how many Canadians are paying fees like that, since Canada has some of the highest mutual fund fees in the world, and how a 2% fee can balloon into a huge portion of someone's wealth over the years, the way the example below shows. It bothered me, and it made me want to do something about it.

What 2% does to your money

A 2% fee sounds small, but over a lifetime it takes a big slice of your final outcome, because it compounds against you for as long as you stay invested.

Say you invest $100,000 and leave it alone for 30 years, and your investments earn 8% a year before fees. That 8% is just an assumption to show the mechanics, not a promise, but it's a reasonable long-term number to think with.

If you pay a 0.2% fee, which is roughly what a low-cost index ETF charges, your money grows at 7.8% a year and turns into about $952,000.

If you pay a 2% fee, which is normal for a lot of Canadian mutual funds, your money grows at 6% a year and turns into about $574,000.

It's the same starting amount, the same investments underneath, and the same 30 years. The only difference is the fee, and it cost you about $377,000. That's not a typo. The high-fee version handed back 40% of what you could have had, and you never saw it leave.

Here is the calculator I use to show people this. It starts on the example above, and you can put in your own balance, your own time frame, and the fee you're actually paying.

Try moving the years from 30 to 40 and watch what happens. The gap between those two lines starts almost invisibly and then accelerates. After the first year the two portfolios are only about $1,800 apart, which is nothing you would notice on a statement. By year ten it's about $33,000, by year twenty about $128,000, and by year thirty it's the $377,000 above. Stretch it to 40 years and the fee has taken about $989,000, which is 49% of what you could have had. In that fortieth year alone the gap widens by roughly $88,000, close to fifty times the damage done in the entire first year.

Time is what turns a small fee into a large number, so this matters most if you are young and have decades of compounding still ahead of you. But it is not only a young person's problem. If you are 60 with a $1,000,000 portfolio, a 2% fee is $20,000 leaving your account this year, against about $2,000 for a low-cost index fund. That is an $18,000 difference in a single year, on money you have already finished saving. The percentage looks the same at every age, and the dollars behind it get bigger as your portfolio does.

It works the same way if you're contributing as you go. Put in $500 a month for 30 years at that same 8%, and the low-fee version lands near $655,000 while the 2% version lands near $474,000, a difference of about $181,000 for nothing you can see or feel along the way.

Why a 2% fee is bigger than it sounds

A 2% fee on an 8% return isn't really a 2% fee, it's closer to a 25% fee on your returns. The fee comes off the whole 8%, but what you keep is what's left after it, so giving up 2 points out of every 8 means you're handing over about a quarter of your gains every year. Nobody would knowingly agree to give away a quarter of their returns for a product that doesn't beat a simple index.

The compounding is what does the real damage. 2% of a $100,000 account is $2,000 this year, which doesn't feel alarming. But that's $2,000 that's no longer growing for you, and you pay it again next year on a balance that should have been bigger, and again the year after that.

Last week's post covered the other half of this, which is that the higher price usually buys you a worse expected result, and that the handful of funds beating the index are nearly impossible to pick ahead of time. So the cost is certain and the benefit is a coin flip.

None of this means anyone holding high-fee funds was foolish. Most people were never shown the alternative, and the products were sold to them by someone they had every reason to trust. That was true for my parents, and it's why I think the fix here is information, not blame.

What to do with this

You don't need to do anything dramatic today, you just need to know your number. Find the MER, the management expense ratio, on the funds you own. It's the yearly percentage the fund takes off the top, it comes out before the returns you see reported, and it's on the fund's page and on your statements once you know to look for it. Trading costs sit on top of it as a separate line, so the MER is the floor of what you pay, not the whole of it.

Once you have that number, put it into the calculator above with your own balance and the number of years you have left to invest. If your MER starts with a 2, the result is worth seeing, and it's worth asking whether a simple low-cost option would do the same job for a fraction of the price.

That one number, the fee, is the part of investing you have the most control over, and the part that matters most. You can't control the market, but you can control what you pay to be in it.

What's next

Knowing you want a low-cost index fund is one thing, and picking one is another. Next up we'll look at one-ticket ETFs, the single funds that hold a whole diversified portfolio for you so there's nothing to rebalance.

This is general financial education, not individual advice. The example uses an assumed rate of return to show how fees compound, and your own situation will differ. For advice specific to you, talk to a qualified professional.