Earlier this week, the House approved a measure that would force mutual fund companies to disclose all of the fees they charge individual investors.  This is great news for all of us that have the majority of our retirement savings in mutual funds and currently have no idea how much we are spending each year on these services.

The legislation is part of an effort by the committee to improve disclosure of 401(k) fees and create more transparent marketing of retirement products…In addition, all fees taken from a plan participants’ 401(k) account would be disclosed in one dollar amount in their quarterly statement.

The reason this is such a big deal for investors is two-fold.

First, these hidden fees can sometimes be substantially more than the published management fees you think you are paying.  In a report done by Gregory W. Kasten of Unified Trust Company, which appeared in the Journal of Pension Benefits, he found that the average stock mutual fund cost over 3% a year when incorporating these fees, such as transaction fees.  Here is a great chart showing some funds, like Technology and Small Growth, that more than double their expense!

Second, and most important, investors are cheated out of the opportunity to compound these savings over time, significantly eating away at their nest egg.   In real terms, investors are losing $50K to $400K over their lifetimes to these fees.

So what can a smart investor do to combat high mutual fund fees?  Stick to a low-cost strategy appropriately weighted with Value and Growth, International, and Fixed Income Index funds.

Mutual funds are now a $100B a year business.  We have close to $10T of our hard-earned dollars invested in mutual funds.  But after 20 years of torrid growth is the industry on the precipice of a massive restructuring akin to what so many other mature businesses such as newspapers, music, and autos are experiencing?

I believe it is based on the acceleration of certain trends over the past few years and the long-lasting impact of the stock market’s performance over the past 18 months on the average individual investor.

The Innovator’s Dilemma is a theory and terrific book written by Harvard Business School professor Clay Christensen that states that established products are vulnerable when disruptive technologies offer lower-cost solutions that that will, over time, get better and become a serious threat- eventually destroying billions of dollars in enterprise value and creating new winners.

I believe we are seeing this paradigm in action with the rise of low-cost index funds and ETF’s.  Companies at the forefront of this low-cost strategy like Vanguard and Barclay’s iShares are posied to leapfrog the old stalwarts and capture much of the new value creation.

According to the Invesment Company, the mutual fund industry trade group, mutual funds experienced a net cash outflow of $226B, the first such annual outflow in long-term mutual funds since 1988.

It is interesting to note that the industry recognizes the threat of low-cost alternatives and investors are indeed paying less than we did a decade ago- management fees have decreased:

But look closer.  It appears that fund companies have simply transferred those management fees into hard-to-track “marketing fees” called 12(b)-1 fees that most investors never see:

While investors moved money away from actively managed mutual funds, 2008 saw index funds increase share.

And assets in ETF’s, while still small compared to mutual funds, continue to increase in size and number.

I am not suggesting that this change will happen overnight.  But as we are seeing with the demise of newspapers and the auto industry, the seeds for disruption were planted long ago and the innevitable evolution takes decades.  But when it eventually comes, it arrives quickly and the disruption is rapid.

And, in the case with mutual funds, individual investors will be better off having to pay less money for high-quality investments that give us more for our retirement nest egg.

Protecting your sensitive financial information and making you feel confident using our service is the most important thing we do at Cake Financial. As the VP of Engineering, I want to take this opportunity to give you an overview of our security polices at Cake and to tell you specifically how we keep your information safe and secure.

We want to make it as easy as possible for you to have access to your brokerage and retirement accounts and to help you with your retirement planning. Our technology must to do all of this while also safeguarding your information - such as the value of your investments or your salary - and ensuring that no one other than you has access to it.

The team here at Cake has extensive experience working at large financial services companies designing and building systems that have successfully protected you as you have paid your bills online, used your credit cards at large e-commerce sites, and traded stocks at your online brokerage firm. We have applied what we learned and practiced at these companies to create a service that is as safe and as secure as the bank you use - but more accessible and user-friendly.

Here are some of the most important policies that we employ to keep your information safe:

1) We do not share your brokerage and retirement account information with anyone else

We have built our own data import and account aggregation service to make sure that your data is never shared with any third party. Our aggregation platform is state of the art and one that we are very proud of.

2) We security classify every piece of personal information and treat it accordingly

The security classification is used both to determine what data we show to our users when and how we manage that data internally. What this means to you as a user is that you will for example never receive an email from us that contains the value of your investments and we restrict the amount of information you can see on our website without logging in.

3) We follow security best practices employed by the banking and brokerage firms you already use

Best practices are a big deal when it comes to security as the field is constantly evolving. We employ the same type of processes as other, much bigger, financial institutions do. Our security best practices include such things as encrypting sensitive data at rest and and help us building our infrastructure to be as secure as possible.

I appreciate your concerns around the security of your information. I take my responsibility in this area very seriously and I do everything I can to ensure that you are safe at Cake. If you have further questions about our security policies, or anything else for that matter, please feel free to send us an email at service@cakefinancial.com. You can also read more about our security work in a previous blog post that you can find here.

Sven Junkergård
VP, Engineering at Cake

The other day, I commented that many of the major mutual fund companies were increasing their fees to compensate for falling asset bases.   This despite delivering one of the worst performances to individual investors in the history of the stock market.  As I wrote:

After a year in which the industry as a whole produced one of its worst performances ever, that saw performance drops of more than 40% and the implosion of famous and non-famous mutual fund managers alike, individual investors are going to have to pay more, not less, for their funds this year.

It looks like one company, Charles Schwab(SCHW), the leading online brokerage firm with 7.5MM accounts and over $1T in client assets, sees this as an ideal opportunity to take business away from the competition.  Schwab announced this week that they will reduce the minimum amount invested to $100 and DECREASE fees on all 24 of their equity and fixed income funds.

Schwab is seeking to draw new customers after the worst year for the S&P 500 in seven decades eroded client assets.

All fees on six equity index funds will decline, effective immediately, to as low as 0.09 percent of assets. Overall, fees will fall an average of 54 percent, he said.

The good news for investors is that this is not some temporary promotion.

“We’re taking on what are some of the leaders of the pack,” said Randall Merk, a Schwab executive vice president. “This is not just a temporary promotion, this is a permanent reduction in fees.”

This is a measured strategy by Schwab to take on Vanguard, the leading provider of low-cost index and mutual funds.  While the majority of the industry seeks to preserve the status quo and their hefty management fees, innovators like Schwab and Vanguard continue to try and serve the interests of the individual investor by giving them more money to have when they retire.  As I have said before, saving a small amount on fees each year compounds over time and can result in an additional hundreds of thousands of dollars when people retire.

The other part of Schwab’s land grab is to develop and launch its own low-cost ETF’s.  As David Bogoslaw says in his BusinessWeek piece,

With about $60 billion of clients’ money already invested in other companies’ ETFs, which translates to roughly 10% of all ETFs volume, “we believe Schwab is already a major player in ETFs,” says Merk. “We would like to be a bigger player in ETFs.”

More than 20% of Schwab’s trading volume may now be coming from individual investors trading in ETFs, which is double what it was a year ago, says Snowling. One big draw of ETFs is the ease with which investors can move into and out of equity market sectors, which is more important amid heightened market volatility.

It is good to see at least one company acknowledging that mutual fund fees are critical to investor performance and that individuals are better off with lower cost alternatives.  It will be interesting to see how Schwab’s strategy pays off over the next few years.

In most industries, the worse someone performs at their job the less he/she is expected to be compensated.  Continue to underperform a commonly agreed upon and recognized standard over time, then that worker will likely be looking for a new job.  On the other hand, the implicit quid-pro-quo is that if an employee performs at a high-level and continuously and consistently surpasses expectations, then he/she will be financially enriched.

What I am really talking about here is capitalism- the lure of financial gains serve as an incentive for hard work.

But this is not the case with the mutual fund industry.

After a year in which the industry as a whole produced one of its worst performances ever, that saw performance drops of more than 40% and the implosion of famous and non-famous mutual fund managers alike, individual investors are going to have to pay more, not less, for their funds this year.

This is the finding of a new report written by Morningstar, Inc. (MORN).

“Given the tremendous drops in assets industry wide, it’s very likely expenses are rising and have already risen,” said Russel Kinnel, director of mutual fund research for Morningstar Inc.

What’s the cause of these increasing fees?

The reason is that many funds have built-in break points that allow them to raise their expense ratios automatically when total assets fall to certain levels.

That’s right.  Because their asset base has dwindled as a result of their performance, it is us that are getting penalized.

And don’t think for a minute the small 10 or 20 basis point fee increase won’t eat into people’s retirement funds.

What does that 1 percentage point difference amount to for you, the investor, over 25 years? It’s nearly $114,000.

That’s alot to pay for something that didn’t do what we paid it to do in the first place.

Morningstar does have some advice on how to deal with these rising mutual fund fees.

“Many studies have indicated expenses are the best predictor of future performance,” Kinnel said. He recommends looking for funds that rank in the bottom 20 percent for expenses in a given fund category.

You can read the report in its entirety here.

It is no secret that individual investors have lost a significant amount of trust (along with their retirement savings) in the large banks and brokerage firms that, seemingly, pursued policies that benefited a small number of executives’ short term interests to the detriment of the stability of millions of American’s long-term future.

While the financial ecosystem is certainly more complex than would allow for this simple correlation between the actions of big banks and the impact on people’s retirement, millions of investors are justifiably angry, and I believe, will demand better and more personalized services going forward.

So how do the large retail financial institutions attempt to win back some of that lost trust?

A simple viewing of the marketing campaigns and websites of the leading brokerage firms suggest that they are downplaying the ease and cheapness of trading and focusing more on retirement and the benefits of long-term planning.  As trading has become a commodity  (buying 500 shares of Apple, Inc. is the same whether you do it at Schwab, E*Trade or Fidelity) and less important to most investors (the average person makes under 5 trades per year), brokerage firms are finding that they need to evolve their offering to appeal to the needs of their customers.

In short, they are moving away from a transaction-focused model and more toward a service model that will help you get an individualized assessment, plan for retirement, monitor your investments to make sure you are on track, and made modifications to your plan as things change.

This is a great thing for investors.  But do not hold your breath for this to happen overnight.

Banks and brokerage firms are large and change comes slowly.  But you can see the direction they are headed, and if you squint a little bit, you can see the kinds of personalized services that will be available to all investors, regardless of the amount of assets they have, in a few short years.

E*Trade

E*Trade (ETFC), the brokerage firm that showed how easy it was to make trades that even babies and monkees(twice) could do it, is growing up.  They are now focused more on long-term planning, rather than on short-term trading opportunities and launched a nice retirement program called Retirement QuickPlan, to help investors get back on track.  I think it’s working; look at the happy Boomer couple.

Schwab

Schwab (SCHW) was the swiftest financial firm to respond to the market crisis with a calm, measured, and reassuring marketing campaign that suggested that investors had to do something about the financial future, rather than ignore the bad news.  Of any of the discount brokerage firms, Schwab has actively pursued a services-based model and a focus on planning, downplaying the act of trading.

And you can see that strategy play out today and it is reflected in their communications and marketing on the site.  Schwab recently launched a completely new website, with better retirement tools, that more tightly integrates planning and research tools with the account area.  It is a huge improvement to the old website, but it still has a long way to go to make it simple to manage for your retirement.

Fidelity

Of the three, Fidelity has the largest stake in the retirement business with over $700B in assets under management just for retirement.  With NetBenefits, the company manages the retirement plans for thousands of companies and millions of individual investors.  The company also has a large mutual fund business you may have heard of with $1.4 trillion in assets.

All of which makes it interesting to note that Fidelity seems to be doing the least, in terms of both marketing and product development, to increase the quality and amount of their retirement services.  Maybe the company does not feel the same sense of urgency as the other firms.  Maybe Fidelity, as the #1 player in retirement, wants to perserve the status quo.  Maybe because it is a privately held company it is investing in other areas.

Whatever the case, Fidelity appears vulnerable and it will be interesting to see how they respond to the changing circumstances and industry competition.

Check out their website and see the small blub on retirement- an article written by Motley Fool.  It’s not even football season and the message is far from empowering.

In our ongoing look at retirement, I wanted to take a look at just how many of us and how much money we have collectively put away into our 401K’s and Individual Retirement Accounts (IRA’s).

According to the Center for Retirement Research, social security will only have enough funds to cover approximately 30% of the average retiree’s annual financial needs.  That means that each of us will bear the responsibility for the balance.  In simple terms, if you make $100K/year and you want to maintain your current lifestyle, you will need to save enough to generate $70K/year for, say, 20 years.

As I mentioned in an earlier post, 50MM households have some sort of retirement plan and nearly 22MM participate in a 401K program, mostly through their employer.  Some Americans also have an IRA that they contribute to.  The data is a few years old but you can see just around 50% of us has an account with around $130K in it.

As you can see below, we have collectively saved $1.4 trillion in our 401K’s.  This sounds like a great accomplishment until you realize the $65,000 average barely covers a year or two of our retirement needs.

So what about our IRA’s?  That will hopefully make up the shortfall, right?

You can see that we have nearly 3x as much money sitting in our IRA’s than we do in our 401K’s, for a total of $4.75 trillion.

But only 10% of eligible Americans are contributing and the meager annual savings amounts arent enough to make a huge impact.  Here it is from 2000-2004.

While IRA assets have been growing consistently, especially since the last recession in 2002, this has occurred almost exclusively as a result of the fantastic run of equities over the past 2 decades.  In 1981, nearly 75% of our money was held in bank accounts.

Now, we have nearly 90% of our future wealth tied up in the stock market.

This is the reason the market meltdown is so devasting to everyday working Americans.

I have been thinking alot lately about the market decline and the repercussions on the ability for people to live comfortably as they enter their retirement years. The hard and sad reality is that millions of honest and hard-working Americans will not have enough to retire.  And I am not talking about retiring to a golf community in Florida or Arizona.  I am referring to the fact that many of our relatives, neighbors, and colleagues’ parents will not have enough money for health care, medicine, healthy food, a quality of life we would all want for ourselves.

So, I was glad to see that the situation got the 60 Minutes treatment this weekend.  It is a devasting look at what the future will look like for alot of aging people.

Formerly hopeful retirees will be forced to work longer at unfulfilling jobs to supplement the social security and pension benefits that are significantly below the levels promised years ago. And, of course, the projections for the shortfall in social security benefits were dire before the meltdown, so you can imagine the bleak outlook that many in their 50’s and 60’s now face as they enter what they hoped were to be their reward for working so hard for so long.

The reality is, as a society, we are living longer, saving less and our 401K’s were supposed to make up for a fissured safety net that cannot support the weight of aging Boomers. With 401K’s down 40%, millions of people are facing shattered expectations, are scared, and they do not know how they are going to make ends meet.

This is a devasting situation.

So how bad is it?

1) Confidence Is At All-Time Low: As the NYT reported this weekend, the number of people who “very confident” they will have enough for retirement have hit a new low.

This makes logical sense because…
2) Not Enough Saved for Retirement: The good news: 50MM Americans now contribute funds to a 401K.  The bad news: most of us do not have enough in our accounts upon which to retire.  Accordingto the Employee Benefit Research Institute,

Among RCS workers providing this type of information, 53 percent report that the total value of their household’s savings and investments, excluding the value of their primary home and any defined benefit plans, is less than $25,000. Twenty percent say they have less than $1,000 in savings.

3) Too Reliant on Mutual Funds:  We have been told over and over that if you want to save money then all you need to do is put it into a mutual fund and wait until you retire.  I put together this chart below showing the near linear relationship between the number of collective assets in our 401K’s and the total number of mutual funds.  As I have previously written (here, here, here) the historical performance of active mutual fund management does not justify the fees they charge us.

We are hard at work on new functionality that we hope will help address some of these issues.  We can’t wait to show them to you and get your reaction.

According to the latest numbers, today almost half of us in the United States, over 50 million households, own at least one mutual fund.  With over 10,000 funds from which now to choose and totaling $10 trillion in assets, we have made mutual funds our largest investment comprising nearly 70% of our collective nest egg.

With numbers like that, it is no wonder that mutual fund companies are amongst the world’s most profitable.  Think about it: on average we pay around 1% of our assets every year to these fund companies for payment for their services.  That is a total of $100 billion or $2,000 per household!  That’s like buying a brand-new HDTV every year.  In return, those funds are supposed to earn more for us than we could get by investing by ourselves.

But do you know what you are getting for that money?  And do you know the difference between the kinds of funds?  For $2,000 a year, you owe it to yourself to be as knowledgeable as possible.

In simple terms, mutual funds come in three flavors: actively managed, passive or index, and exchange traded funds.

Actively Managed Mutual Funds

The most prevalent kind of mutual fund, actively managed funds are those in which a manager picks stocks in an attempt to try and beat a benchmark, typically the S&P 500.  The biggest mutual fund “families” in this category are Fidelity, American Funds, Dodge and Cox, and Pimco.  There are numerous strategies that the manager employs to buy and sell stocks that he/she thinks will outperform the market.  As I have written here numerous times (here and here), nearly all of these actively managed mutual funds do not deliver for investors because these funds underperform their benchmarks when you factor in that 1% fee.

Passive or Index Funds

Of those of us that own mutual funds, 31 percent (15 million households) also own at least one index fund- a fund that simply seeks to track the performance of a broad basket of stocks such as the S&P 500.  Because these funds are not “active”, they tend to trade infrequently, and as a result, you pay less for them, around .25% or a quater of what you pay for actively managed funds.

As of 2007, such 373 different index funds managed total assets of nearly $860 billion, a small drop in the bucket compared to the overall dollars invested in mutual funds, but they are growing quickly.  Vanguard is the leading index fund provider.  As I have said before, you have to be careful that you are not paying more than you have to for these funds.  There are 150 mutual funds that just track the S&P with fees that range from a high of 1.50% to a low of .07%.  Don’t be the guy paying 1.50% for exactly the same product.
Exchange Traded Funds

Exchange traded funds (ETF) are a relatively new quiver in the individual investor arsenal.  And the small numbers of us that own them reflect the confusion around them.  Of households that own mutual funds, only an estimated 4 percent also own ETFs.  They have grown in popularity over the past few years and there are now close to 700 ETF’s with over $500 billion in assets.  Barclay’s iShares is the leading ETF company by far.

These funds are akin to index funds in that they allow you to track broad indexes as well as specific strategies, such as gold or China, relatively cheaply.  While they are similar to index mutual funds in many ways, there are a few key differences.  ETF’s trade on an exchange and can be bought and sold like a stock throughout the day, unlike mutual funds which get priced at the market close.  Most important, ETF’s track the performance of baskets of stocks so the biggest advantage is that you can get “actively managed” strategies for “passive” fees.

I have written at length about the relative performance and value of indexing versus active mutual funds.  Whatever your strategy, be an informed consumer and know how much and what you are paying for your mutual funds.  You might be surprised to learn that you are paying several thousands of dollars a year, which adds up to hundreds of thousands of dollars over the course of your investment life.

If you would like to see more data check out this great data and the 2008 Mutual Fund Fact Book from the Investment Company Institute, the national association of investment companies that includes mutual fund companies and ETF providers.

According to the latest data released by Standard & Poor’s, individual investors have over $1.5 Trillion in investable assets indexed to the S&P 500, the stock market index that tracks the performance of the 500 largest companies in the world.  With approximately $15 Trillion in total investable assets, we have most likely made replicating the returns of the S&P our single largest investment strategy for retirement.

For the most part, this is good news.

But did you know that there are close to 150 mutual funds that track the S&P?  And, more important, did you know that the fees for these funds vary widely, from a high of 1.50% to a low of .07%?  That’s insane.

To put this difference into everyday dollars, if you had $25,000 invested in either of these two funds, you would pay $375 for one vs $17.50 for the other, every year.  Over time, paying additional fees like that eat into your nest egg.

I decided to take a look at a sampling of the more expensive funds to see what investors get for that incremental fee.  The short answer: Nothing.

Can you see the difference between the performance of these 4 S&P Index funds?  You can if you look at their expenses.

The State Farm S&P 500 Index B (SNPBX) charges 1.48% of your assets, UBS S&P 500 Index (PWSPX) charges 1.45%, iShares S&P 500 ETF (IVV)has fees of .09%, and Fidelity Spartan 500 Index (FSMAX) is the cheapest of the bunch at just .07%.

How about when you look at different Index products within the same fund family?  Same thing.  Performance is nearly identical but fees vary dramatically.

Look at the 3 year performance of these funds, all from Morgan Stanley, and compared to the iShares S&P 500 ETF.

Morgan Stanley’s Equally Weighted S&P 500 (VADBX) has the worst return and charges the most at 1.37%.  The company also charges 4X more than the iShares ETF for its S&P Index Fund (SPIDX).

I realize that there are subtle differences between these 150 S&P Index funds.  But if you can’t see the differences in the performance, why waste your money on excessive fees.

Click here to see the entire list.

Do Not Pay A Lot For Your Index Fund!