Q: I am an active Army officer. All my investment accounts are with a single asset management firm. The mutual funds in my Roth IRA have expense ratios of 1 percent or higher. But when you look at their Morningstar returns, the portfolio of loaded, actively managed funds outperforms my Vanguard account, with less market risk. I also pay a wrap fee of 1.15 percent. It is only $500 a year for my $50,000 account, but over the next 40 years that will be $20,000. That makes me wonder what the lost gains on that $20,000 might be. Is the fee worth the potentially higher returns of the managed account?
A: We all have a time perspective problem when it comes to investing. Since the value of stocks and bonds can shift by 1 or 2 percentage points in a single day, it doesn’t seem unreasonable to pay 1.15 percent a year to manage a portfolio of mutual funds. In fact, the longer you invest, the more danger such fees pose to your long-term return.
One way to see this is to examine the performance of a category of mutual funds over different time periods. Morningstar’s “world allocation” category, which includes funds that are allowed to diversify with international stocks and bonds, is probably quite similar in makeup to the holdings of your portfolio of individual funds.
During 2013, a return of 16.09 percent put a world allocation fund in the top 25 percent. A return of 4.33 percent pushed it into the bottom 25 percent. With a return difference of 11.76 percent between the top and bottom 25 percent, it would seem that a good wrap manager could earn his keep.
But things change as the investment period increases. At five years, the difference between the top and the bottom 25 percent shrinks to 2.62 percent; at 10 years the difference shrinks to only 1.64 percent. (These performance spreads change from year to year and from portfolio type to portfolio type. But the common event is this: The longer you invest, the smaller the performance gap between the top 25 percent and the bottom 25 percent.)
So think about the odds. You are spending 1.15 percent, certain, in the hope of higher performance, uncertain, through astute management. But in this example the cost of management, all by itself, will take your performance down by 35 percentile. What are the odds the managers will be able to overcome the burden of their own expense over the long term?
These figures, by the way, don’t include another burden. Your asset managers have chosen to put your money into managed funds with fees of at least 1 percent. Yet multiple research studies have shown that 70 percent of all managed funds can’t beat their appointed index. As a consequence, your portfolio manager is building your portfolio with funds that, by themselves, have only a 30 percent chance of sustained superior performance — and that’s before the percentile-dropping cost of the wrap fee.
This isn’t about this particular firm. Lots of other organizations have the temerity to charge still more. The problem here is fundamental. Money management is a low value-added business. It should charge accordingly.
Q: I began receiving Social Security benefits at age 66 last December. I am still working. Should my employer be withholding FICA and Medicare taxes from my check? I’m not sure whether they should or shouldn’t because I don’t know how that would benefit me. Will Social Security at some point re-evaluate my earnings and possibly raise my monthly benefit?
A: If you still work for wages or salary, you will continue to pay the employment taxes for Social Security and Medicare. The other side of the coin is that each year of additional earnings will be entered in your record. Since the basis for your benefit is the highest 35 years of adjusted wages, it is entirely possible that your continued work will either add a year of wages to your record or displace a year in which your wages were lower.
Either way, your record will be increased and so will your basic benefit. The increase, however, is likely to be small.
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