The Importance of Understanding Investment Fees

Individuals investing for retirement most often encounter fees in IRAs and 401(k)-type defined contribution plans through mutual funds. Fees for mutual funds are levied in several different ways, all of which should be reviewed and understood by a potential investor. External investment management fees include those associated with individual transactions, such as an initial investment, and ongoing operating expenses of an investment manager. The former are referred to as “shareholder fees” and the latter are called “annual fund operating expenses” and can be found (per the U.S. Securities and Exchange Commission’s requirement) in the table located at the beginning of a fund’s prospectus. More information on fees is available on the SEC’s Web site.

The Employee Benefits Security Administration within the U.S. Department of Labor provides an example of the impact of fees on a retirement investment portfolio as follows. Assume that an employee with 35 years until retirement and a current 401(k) account balance of $25,000 could average investment returns of 7 percent. Fees and expenses would then reduce those average returns by 0.5 percent, leaving the employee with an account balance equal to $227,000 even with no further contributions to the account. However, if the fees and expenses were 1.5 percent, the account balance would only grow to $163,000 by retirement. The 1 percent difference in fees and expenses in these two examples would reduce the employee’s account balance at retirement by 28 percent.

Of PERA’s more than $40 billion in investable assets, approximately $30 billion is allocated to publicly traded stocks and bonds. PERA manages a significant portion of these assets in-house with savings upwards of 75 percent of costs that would have been incurred if outsourced. To illustrate the point, assume PERA could invest $400 million in either an externally managed fund that pools the assets of multiple investors (like a mutual fund) or a fund internally managed by PERA’s investment team. Assuming the $400 million was allocated to 70 percent stocks and 30 percent bonds, the average external management fee would be 0.53 percent or $2.1 million. Using PERA’s internal investment management, costs would be 0.14 percent of assets, or $548,000. Expanding this methodology to the entire PERA portfolio, internal management saves PERA more than $25 million every year compared to the cost of external management.

Owing to the cost savings and the competitive performance of PERA’s investment staff, more than 55 percent, or greater than $23 billion of the total investment portfolio, is managed internally. However, PERA’s Board of Trustees also recognize that there are circumstances where an external manager is warranted due to unique elements of the investment. External managers are hired for numerous reasons; they may have deeper resources in smaller, niche markets such as international emerging markets, or they may have particular strategies that complement PERA’s internal portfolios. PERA measures external manager results after taking into account management fees. External and internal managers are held to similar performance standards. The goal is to deliver optimal returns while accounting for risks and manager fees.

PERA’s total cost to manage the $40 billion in member assets has averaged 0.40 percent of assets over time. The advantage PERA has as a large institutional investor benefits PERA members, their employers, as well as taxpayers, while providing secure retirements for the public employees who enhance Colorado’s quality of life.