How I Potentially Saved a Friend Over $880,000

by Kevin on October 20, 2008

I recently had a discussion with a friend about what he should do with some of his investments. I get questions like this a lot from people I know — what to do with the 401k, what is going on in the markets,etc.

He’s a couple of years older than I am, but pretty much in the same situation that I’m in. Owns a home, is married, all the good stuff. He has been faithfully putting away a small amount of money every month into a mutual fund. My friend is also a big believer in dollar cost averaging. (Phew, we won’t have to fight that battle!) He asked me if he was on the right track with the mutual fund, and if not, what to do with it. The goal for the money is a future child’s college fund, or a “whatever” fund.

He also has an old 401k from a previous employer and wanted to know what to do with that.

Different Issues, One Problem

With all of the above questions and listed issues at hand, it all boils down to one major problem: lack of an investment plan. Or possibly, lack of the investment portion of an overall financial plan.

Planning is key, folks. Let me repeat that: planning is key! Everything you do with your money should come from a plan. Plans tells your money what to do rather than your money telling you what to do. That’s why I’m writing my No Debt Plan.

Here are the questions I asked my friend to help get clarity on the issues at hand:

  • What mutual fund is he investing in, and why?
  • What is the purpose of the money?
  • What is the 401k invested in?

Costly Mutual Fund Company Choices

I was disheartened to hear the mutual fund he was investing in was Franklin Templeton’s Developing Markets (A class shares – TEDMX). We’ll talk about different share classes tomorrow.

Taking a quick look at the various Franklin Templeton offerings I can say one thing: this is not the company to be using if wealth accumulation is your goal. (That is, of course, unless wealth accumulation for your “financial adviser” and Franklin Templeton is your goal.)

This is absolutely ridiculous folks. The fund he is investing in:

  • is primarily investing in developing markets — not where you want a core portfolio sitting
  • has a 5.75% front sales load
  • has an expense ratio of 1.83%
  • has performed below average (per Morningstar) over the last 5, 10, and since inception period

Fees are Killing Your Retirement

Not only is there a front sales load (fee) of 5.75%, the expense ratio is ridiculous high, too! What does all this mean?

A “front load” is really a “front sales load”. It’s a fee that helps pay the broker who sold you the ridiculously overpriced fund in the first place. So for every $100 you put into the fund, you lose $5.75 to the company. You should never… absolutely never… pay a front or deferred load. (A deferred load charges you when you withdraw the money instead of when you first put it in.)

You’d think that 5.75% charge would be enough and might result in a lower expense ratio for the fund, right? Think again. 1.83% is also way above the already high “acceptable limit” for expense ratios of 1% of assets. In fact, its 83% higher than what is found acceptable. In reality, you can get funds for a lot cheaper than 1% — so the pain is just piling on here.

For every $100 put into this fund, not only do you lose $5.75 right off the top, you also pay $1.83 for every $100 in the fund… every year. That really starts to kill your returns over time.

You’re Overreacting — Fees Can’t Be THAT Bad, Can They?

I wish I was wrong, but let’s run some math using my Roth IRA Calculator. I’ll use myself as an example.

Inputs: Age: 24; Annual Investment Return: 7%; Annual Contribution: $10,000; Beginning Balance: $0.

I added another column for “Expense Ratio”, and a new input at the top left of the sheet for it as well. We’ll use Vanguard’s Target Retirement 2050 (VFIFX) as our example with an expense ratio of only 0.21%. (Again, that means for every $100 invested you only pay 21 cents in expenses rather than $1.83 with the other fund.)

You will find that when you retire at the end of age 65 the portfolio is worth $2,315,927. Not too shabby, eh?

Now change the expense ratio from 0.21% to 1.83% and prepare to hold down your lunch. The portfolio is only worth $1,436,019.

The difference? $879,908 or 37.9% of what your portfolio should have been.

If that doesn’t shock you, I don’t know what will.

And I didn’t even account for the 5.75% front sales load charge which would reduce your principle even further.

The True Cost is Higher than $879,908

The title of this post says I saved him over $880,000. Am I counting rounding error on that $92 difference?

No. The cost is actually much higher. Unless you were to completely cash out all of your retirement savings at 65, you’re still going to be in the market. If you’re in this Franklin Templeton fund, you’re still paying 1.83% on your invested money… which means that is more growth that is stunted by the expense ratio. So the costs keep piling up.

Granted, I don’t think he is currently funding two Roth IRAs ($5,000 each) with this fund. He is slowly putting money away. But at the end of the day you’re still looking at a significant difference in portfolio value.

Again, Fees Will Kill Your Retirement

Franklin Templeton is more than happy to take your money, underperform the market, and encourage you to save more. They’re going to earn a ton of money off of you either way. Remember, there is only one real thing you have a say in with your retirement investing: costs. The lower the costs the better your portfolio will perform in the long run.

That 1.62% difference between the two funds I talked about doesn’t sound like much to most people. When you show them the math, jaws usually hit the floor.

Advice for My Friend

This is what I told this person to do:

  1. Goals determine direction. Come up with an investment plan including an asset allocation. (Raise your hand if you think any portfolio should be 100% emerging markets. That’s what I thought. Whoever sold this crap to him should be ashamed of themselves.) Goals matter. Plans matter. It doesn’t matter what I tell you to do if you don’t know where you are going. The same is true with just about everything in personal finance.
  2. Give the money a name. What is this money going to be used for? If you need it in the next five years you shouldn’t even be in the stock market.
  3. Sell the Franklin Templeton crap and buy an index or Target Retirement fund. I’m a big proponent of Vanguard, but I’m not saying everyone has to invest there. He is looking for a one stop investment that he won’t have to monitor, so a Target Retirement Fund makes sense. And with the low fees at Vanguard you simply can’t beat that.
  4. Roll the 401k into an IRA. We didn’t get into a lot of details on this, but my recommendation is to get all of the money from various jobs and 401ks into one main account. It makes it easy to manage and determine asset allocation.

At the end of the day my friend has to make his own independent choices. This is what I would do. What about you? What’s your advice?


Ray October 20, 2008 at 6:38 pm

That’s a great advice you gave your friend.

It took me years to realize that, simply because I never did the time value of money calculation–I didn’t care enough back then (Yeah, what is 1% more? What is 5% front sales load? Come on man, it’s nothing.)

Luckily I recovered from that stupidity pretty fast once I had realized what I had been doing :-S Phew!

Looking forward to your different share classes post tomorrow! Thanks!

Amanda October 21, 2008 at 7:38 am

This is great advice. I am currently dealing with an IRA situation. My husband just changed jobs and I had his 403(b) rolled over into an IRA at Etrade. It is not much money, but I don’t want to put it into anything stupid. I have picked a few mutual funds that I have been watching. I am looking for advice if anyone has any to offer.

ChristianPF October 24, 2008 at 10:25 am

I agree – good advice. Getting the money into and IRA is great because you have so many more options than the few that your 401k will offer…

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