FAIR Canada ? The Tyranny of Compounding Fees: Are Mutual ...

Stewart Neufeld, PhD, assistant professor at the Institute of Gerontology at Wayne State University in Detroit, has written an article in the Journal of Financial Planning, which tackles the issue of low returns on savings in retirement savings accounts. A key factor to the low returns is the poor performance relative to broad market indices delivered by mutual funds. One-half of the retirement savings in the United States are invested in mutual funds. There is a large body of research, states the author, that has shown that a typical mutual fund underperforms its relevant benchmark index by approximately the amount of its fees levied and expenses incurred. The difference between the market return (for example, the S&P 500) and that of the typical mutual fund may appear small but over time it results in significant gaps between market returns and what people can accumulate in their retirement accounts. ?The author examines the performance lag between the S&P 500 and mutual funds over various time frames. He presents findings on what portion of real returns have gone to mutual fund investors versus have gone to the financial services industry (?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.

His findings include:

• Industry?s 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.
• Small degrees of underperformance increase investor share substantially: 50 bp lags result in an average investor share of 90 percent for 10 year investment periods and 77 percent after 50 years.
• Investors could triple their returns simply by investing in mutual funds that lag the S&P 500 by 50 bps rather than 250 bps; for an initial investment of $10,000, this means a gain of $134,000 rather than $45,000.
• Concludes that typical mutual fund fees can be extremely destructive to investors? portfolios and even relatively low-cost mutual funds can reduce investors? returns significantly over time.

The author recommends that pension plan fiduciaries be required to select default investments that track broad market indices and that have total fees as low as possible, ideally not more than 10 bps. These types of investments should be made available in all tax-deferred retirement plans. Investment advisers should also direct clients to low-cost index funds unless this approach contravenes the client?s expressly stated investment objectives. He states ?To do otherwise is to act against the best interests of the client. Among the general public, financial education is weak and financial literacy is low, and therefore it is easy for advisers to recommend investments that primarily benefit themselves and not their clients.?

FAIR Canada notes that, according to Morningstar?s Global Fund Investor Experience 2011, mutual fund fees in Canada are higher, on average, than in the United States. Studies in Canada have also indicated that Canadian mutual funds (both equity and fixed income) underperform their benchmark indices* (see note below).?FAIR Canada therefore believes that policy reform is also urgently needed in Canada, including a best interests standard, and replacing trailing commissions with fees for service paid directly by the client to the advisor.

*For example, see Keith Ambachtsheer and Rob Bauer ?Losing Ground: Do Canadian mutual funds produce fair value for their customers??, Spring 2007, Canadian Investment Review; and Rob Bauer and Luc Kicken, ?The Pension Fund Advantage: Are Canadians Overpaying their Mutual Funds?, Vol. 1, Issue 1, Fall 2008, Rotman International Journal of Pension Management.

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