What are the implications of costs for you as investor and pensioner?

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4 February 2022
People talk a lot about investment costs these days when they refer to unit trusts, endowment policies, retirement annuity funds and retirement funds.  

Financial services professionals’  talk about costs and often tell you: “Pay peanuts and you get monkeys.” “Look at everything else first” they say, “and worry about costs last.”

"Since a small increase in the rate of return will make a huge difference to the growth of your investment over the long term, it is important to minimise investment charges because they can substantially reduce your overall return in later years.  Let’s not forget inflation."  Fred Schwed's Where are the Customers' Yachts?: A modern-day interpretation of an investment classic by Leo Gough published in August 2010

So, who is right?  I think you must be the judge.  The investments are your money.  So, let’s look at costs in investing to accumulate funds.

The arithmetic is not difficult, and it is just arithmetic.  Costs must be related to inflation as inflation is a major component of investment returns.  Take for instance, the illustrative example of an investment portfolio which is aimed at a return of 12 percent gross per annum.  Annual costs might be the following:

 

{These costs are percentages of your capital per annum}

 

Advice                                                 1.15 percent including VAT

Administration                                  0.35 percent including VAT

Investment management fee           1.50 percent including VAT

That’s a total fee of                           3.00 percent of your capital per annum

 

Let’s say your return is 12.00 percent per year. If we take costs off 3.00 percent, 9.00 percent net of costs will be left.

 

Real return is the amount by which your net earnings are greater than inflation:

 

Net return                                            9.00 percent

If we deduct assumed inflation         7.00 percent

Net real return is                                 2.00 percent.

 

That’s the amount by which your money actually grows above inflation.  The official inflation figures often are a lot less than people’s actual experience of inflation, so I think using them isn’t always helpful.

But back to costs... If you invested R100 000 in an investment that yielded a consistent 12 percent per annum return and had two distinct levels of cost, the results would look like this:

 

After years

Rand value @ 1 % cost

Rand value @ 3 % cost

Additional amount of higher costs

Growth loss

5

R168 506

R153 862

R14 644

8.87 %

10

R283 942

R236 736

R47 206

16.63 %

20

R806 231

R560 441

R245 790

30.49 %

 

Costs are inescapable but they can be controlled.  The average investor, through the above-mentioned financial instruments, seems to have no idea of how much costs actually are.  We are accustomed to getting discounts on cars, of somewhere between 3 or 4 percent, so we are unimpressed when informed that costs on policies are, for example, 2.50 or 3.00 percent of the capital.  But cost like that is every year for as long as the contract lasts.

You can shrug your shoulders and say that’s the way it is, but you should at the very least find out how much you are paying and what return you are getting on your investment, because the earnings are quite a lot less over time. For a high-cost plan to beat a low-cost plan, it has to out earn the lower cost one - something that is not easy.

Let’s look at the costs of investing in a living annuity... When it comes to living annuities, this is how the process goes: you invest your capital in a living annuity by making a selection of the investment portfolios available to you.  There are many available and most people use the services of a financial advisor to make these choices.  But you as the client sign them off, so the choice is certainly yours.

You then withdraw a pension which is expressed as a percentage of the capital that is invested in the living annuity.  The range is anywhere from 2.5 to 17.5 percent.  You can change this once a year to suit your needs.  You pay the following costs as percentages of capital:

 

  • Advice fees if you use an advisor;
  • Administration fees;
  • Asset management fees (this is what you pay the portfolio manager or managers).

 

Every month you are sent a statement which shows the advice fee (or commission) paid to your advisor, and your administration fee.  The investment manager’s fee is not shown on your statement, it is calculated into what is called the unit price.  You can find that percentage by looking up what is called ‘the fund fact sheet’.

The idea of the living annuity is to allow you the pensioner to benefit from investment success.  How it works is, you draw a pension every month and you manage the entire investment to replace what you withdrew every year and grow the capital each year to deal with the inflation risk.  And in an instance where the last survivor of a pensioner couple dies, any money that is left can be bequeathed to nominated beneficiaries who, for most people, will be their children.  That’s of course if there is anything left.

What is not often made clear is the fact that costs are also withdrawn from the fund, so they must also be topped up.  Therefore, if you draw a pension of 5 percent per year it must be replaced, and the 3 percent costs and provision needs have to be made for inflation.

That means that in the above illustrative situation, you need to earn 5 percent plus 3 percent in order to replace what was taken out.  And if you want to keep pushing the pension percentage up, you must cater for inflation as well.  In fact, with costs of 3 percent and a pension draw of 5 percent with inflation of 5 percent, you will need to earn a total return of at least 13 percent per annum. 

As your costs and inflation rates rise, you need to earn better returns, and this means that higher investment risks may be necessary. If you can't get the returns, you may run through your capital a little faster than you want to and may not be able to leave a legacy for your heirs.  In fact, if you live a very long time, you may battle with making your capital last.  Therefore, the real skill is in balancing these elements. 

 

 

 

 

D.L. Crawford CFP®

OUTvest is an authorised FSP. All investments are exposed to risk, not guaranteed and dependent on the performance of the underlying assets. Results are provided for illustrative purposes only and are amount and time horizon dependent as well as the performance of the underlying assets. Ts and Cs apply.

 

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