When it comes to investing, it’s essential to understand how fees can compound over time and potentially affect your long-term financial goals. The sphere of investing is marked by an array of both explicit and implicit charges, irrespective of whether one chooses the avenue of direct investment in a unit trust or fund or, alternatively, the indirect path through the involvement of a Financial Adviser and a Linked Investment Services Provider (LISP). In this article, we’ll explore some real-life examples that illustrate the compound effect of some of the main fees involved in investing.
- Underlying Unit Trust and Fund Fees:
The unit trust or fund will typically display its fees either in the form of the Total expense ratio (TER) or in the form of the Total investment Charge (TIC) in their marketing material or minimum disclosure document (MDD and/or fund factsheet). Displaying this is required by legislation, and the performance is generally expressed net of these costs on a factsheet. But what do these charges include?
TER covers fees such as management, trustee, legal, and audit– no, it doesn’t include fees for your friendly Financial Advisor or the platform. TIC? Well, that’s the TER plus the costs of buying and selling assets within the portfolio. Transaction costs are also part of the reason why actively managed funds are usually more expensive than passively managed funds and ETFs. The TER and TIC are shown as a percentage of the portfolio’s Net asset value and, as such, are constantly changing as the portfolio or fund either grows or declines in value. These percentages can change like a chameleon, so keep your eyes peeled.
- Platform and LISP Fees:
Different platforms use different fee structures, each tailored to their specific services. Platform fees are levied to pay for administration aspects of the investment and, similar to other fees, are commonly expressed as a percentage of the total investment’s value. Typically, local platforms initiate their fee structures at around 0.50% (exclusive of VAT) and often employ a tiered approach, wherein fees decrease proportionally as your investment’s value escalates. Furthermore, it is worth noting that certain investment platforms (such as Ninety One) may offer family rate incentives. These incentives entail consolidating assets belonging to immediate family members who have chosen to invest through the same platform.
- Financial Advisor Fees
Financial advisors are more than just product pickers; they play a critical role in assisting investors to make the right decisions for their circumstances and, importantly, help you avoid the pitfalls of investing on your own.
In the usual course of financial advisory services, it is customary for financial advisors to levy an initial or establishment fee, which typically falls within the range of 0.50% to 3.00%. This fee encompasses the efforts to formulate and execute the advisory recommendations and usually depends on the initial amount invested. Additionally, an ongoing management fee, typically within the range of 0.25% to 1.00%, is assessed for the continuous oversight and counsel pertaining to the investment. Both of these fees are commonly represented as a percentage of the total investment’s value.
Aggregate Costs
The Effective Annual Cost (EAC) encompasses the above aggregate costs, including the Total Expense Ratio (TER) or Total Investment Charge (TIC), financial advisor fees, and platform fees. Carefully assessing the EAC enables a comprehensive understanding of the actual costs of your investment.
Fee Effects:
Over time, these fees can add up and significantly impact your overall investment returns. To illustrate this, you may want to consider scenarios where you calculate the total fees paid over several years and compare them to your investment gains. This exercise can help you evaluate the actual cost of your investments. Let’s have a look at a few examples to illustrate the compounded effect they can have.
Example 1: The Power of Small Percentage Fees
Let us consider an individual who allocates $100,000 to an investment vehicle with an Effective Annual Cost (EAC) of 1%. Presuming that fees are assessed annually at year-end and considering an average annual return of 7%, a 20-year investment horizon unfolds as follows:
Without any of the fees, the initial investment would have burgeoned to approximately $386,968. However, in the presence of the 1% fee, the investor would have disbursed roughly $70,000 in fees over this time frame. Consequently, the net investment value would stand at $316,504.
Example 2: The Effect of Higher Fees
Now, let’s compare the previous scenario to a situation where the EAC is a higher fee of 2%, charged annually at the end of the year. Using the same initial investment and average annual return, after 20 years, the investment would have grown to approximately $258,343. The difference between a 1% and 2% fee can considerably reduce the final investment value, as illustrated below:
Example 3: The Impact of Fees on Retirement Savings
Consider an individual who contributes R5,000 annually to their retirement account over a 30-year period. Assuming an average annual return of 6% and an EAC of 1%, the total fees paid over that period would be around R81,000. This is equivalent to more than 1.5 years of contributions.
Other Considerations:
- Capital Gains Tax (CGT)
Depending on your investment structure and product, you may trigger a CGT event when you sell and/or rebalance your portfolio. Consequently, you would be obliged to compute and settle tax obligations associated with your realized capital gains unless it is taxed within the structure itself (such as an endowment). The CGT inclusion rate is 40% of the gain. However, the effective rate of CGT is contingent upon many variables, encompassing your tax bracket and the nature of the asset being divested. Proper record-keeping and tax planning are essential to minimize your CGT liability, and there is an R40,000 annual exclusion of gain or capital loss granted to individuals.
- Tax on Distribution
Distributions from your investment, such as dividends and interest income, can incur taxable events. In RSA, local dividends are subject to a 20% dividend withholding tax paid by all resident and non-resident companies regarding shares listed on a South African exchange. Dividends are tax-exempt if the beneficial owner of the dividend is an SA-resident company, SA retirement fund, or other prescribed exempt person.
Interest income is subject to income tax based on the individual’s applicable tax rate. However, it is noteworthy that interest income derived from a South African source, earned by individuals under the age of 65, is exempt from income tax up to an annual limit of R23,800. For individuals aged 65 and older, this exemption threshold is increased to R34,500 annually.
Investment platforms typically furnish investors with IT3(b) and other tax certificates, which are used for reporting taxable income on your tax return. These certificates should be available through your chosen investment platform, and you may request them as required for tax compliance purposes.
Investors should also be aware of additional tax considerations, such as the tax treatment of different types of investments (e.g., tax-free savings accounts or retirement annuities). It is also advisable to consult with a qualified tax professional for personalized guidance on managing your taxes.
- Performance-Based Fees
Some asset managers charge performance-based fees. You may be subject to additional fees if the fund’s performance exceeds a predefined hurdle or benchmark. This fee structure is typical in alternative investments like private equity funds but can also apply to other investment products.
Conclusion:
In 2019, findings from studies conducted by both the Vanguard Group and Morningstar revealed a compelling narrative – the studies indicated that portfolios guided by astute financial advisors consistently delivered annual returns that outperformed their non-advised counterparts by a net 3% and 1.82%, respectively (Horan, 2023). This substantiates the value that can be derived from appointing a good and qualified financial advisor, even when considering the associated costs. Of course, this may not always be the case. Still, as illustrated previously, small margins of return can make a substantial difference, and a net outperformance of 1.82% – 3.00% over a 20-30-year period will significantly impact your life savings.
The fact is no one enjoys paying high fees, and understanding the compound effect of the fees associated with your investment is crucial. At Paragon Wealth Managers, we remain acutely attuned to the profound influence that cumulative fees can exert on your assets. As an independent firm, we are committed to offering a range of solutions designed to complement efficiency and cost-effectiveness, ensuring that we navigate the complex landscape of fees with a discerning eye.
