What A 0.75% Expense Ratio Costs Over 30 Years

I found out what my 401k was charging me on a Sunday afternoon, in a PDF that took four clicks to reach, and the number was 0.71%.

Zero point seven one percent sounds like nothing. That is not an accident, that is the design. Nobody prints the number as a dollar amount, because the dollar amount is where it gets uncomfortable.

So let us print it.

What an expense ratio is

An expense ratio is the slice a fund takes every year for running itself, quoted as a percentage of your balance. It pays the managers, the compliance people, the accountants and, in an actively managed fund, the person deciding what to buy.

It is deducted from the fund's assets daily. You will never see it on a statement as a charge, you will never approve it, and it is taken whether the fund goes up or down.

0.71% on a $40,000 balance is $284 a year. The mechanism is that the share price is very slightly lower than it would otherwise have been, every single day, forever.

Invisible by construction.

The arithmetic, one line at a time

Start with $100,000, add nothing to it, assume the underlying investments return 7% a year, and run it for thirty years. Two funds, identical holdings, different wrappers.

The cheap fund charges 0.04%, so your net return is 6.96%. The expensive one charges 0.75%, so your net return is 6.25%.

Line one. $100,000 times 1.0696, raised to the power of 30. That is $752,700.

Line two. $100,000 times 1.0625, raised to the power of 30. That is $616,400.

Line three. $752,700 minus $616,400 is $136,300.

Three lines. You can check every one of them on a phone calculator in about forty seconds, and I would rather you did than took my word for it.

Why the damage is six times what you would guess

The obvious way to estimate this is to take the fee as a dollar amount and multiply. 0.71 percentage points of $100,000 is $710 a year. Thirty years of $710 is $21,300.

The real answer is $136,300, which is more than six times that.

The gap exists because the fee does not only take the money. It takes every year of growth that money would have produced, and then the growth on that growth. The $710 taken in the first year would have grown to more than $5,000 by year thirty at 7%, and the fee took $710 in year one and a larger amount in every year after, because it is charged on a balance that keeps rising.

The fee compounds against you on exactly the same schedule your money compounds for you. That is the whole mechanism, and it is why the chart above is boring for a decade and then is not.

Expressed as a share of the outcome: $136,300 of $752,700 is 18.1%. Roughly a fifth of what you would have had.

Now add contributions, because you will be contributing

The $100,000 example holds the balance still, which makes the arithmetic checkable but understates the real case. If you are also putting $7,200 a year in, the balance is larger in every year, so the percentage takes more each year.

I am not going to run that one line by line, because the formula stops fitting in a sentence and a number you cannot check is a number you should not trust. The direction is the point. Every dollar you add makes the fee difference bigger in absolute terms and leaves the percentage unchanged.

When the fee is worth paying

Sometimes it is, and pretending otherwise is the kind of thing that makes fee writing untrustworthy.

If your plan's only international option charges 0.55%, then 0.55% is what international exposure costs inside your plan. Pay it, or decide you do not need international exposure in that account. Those are the two honest choices.

If a fund is doing something a rule cannot do, holding illiquid assets, running a strategy that requires judgment, covering a corner of the market nobody indexes cheaply, a higher fee is a price for a service. You can argue about whether the service is worth it. That is a real argument.

What I object to is 0.71% for an index fund. An index fund follows a published rule about which companies to own and in what proportion. Running a rule does not cost 0.71%, and the funds charging 0.03% to 0.05% for the same rule prove it.

The fee you pay twice

A fund that holds other funds charges its own expense ratio and then passes through the expense ratios of everything underneath. Target date funds are the common case: the wrapper charges something for doing the allocation, and the underlying funds charge something for being funds.

The fund fact sheet sometimes shows only the wrapper fee, with the rest appearing further down as acquired fund fees and expenses. The number you care about is the total, and on a $50,000 balance the difference between a target date fund built from index funds at around 0.08% and one built from the family's own active funds at around 0.65% is $40 a year against $325.

Same product category, same glide path, eight times the cost.

The costs that are not in the ratio at all

Two of them, and neither appears in the number you are quoted.

Trading costs

When a fund buys and sells, it pays spreads and commissions, and those come out of returns without appearing in the expense ratio. A fund that turns over most of its portfolio every year is paying these constantly. An index fund tracking a stable list barely trades at all, which is part of why it is cheap.

Advisory fees

If an adviser manages the account, a common arrangement charges a percentage of assets annually, often around 1%. On a $500,000 balance that is $5,000 a year, and it stacks on top of every fund fee inside the account. Whether that is worth paying is a real question with a real answer for some people, and it is a separate question from what the funds cost.

Where to find yours

• The fund fact sheet, a one or two page PDF linked from the fund name on your plan's website. The expense ratio is usually in a box on the first page, labelled gross and net.
• The participant fee disclosure, the annual document your plan mails or emails you, which lists every fund and its expense ratio in one table. This is the fastest way to see the whole menu at once.
• The prospectus, in a section called fees and expenses, which shows the breakdown between management fee, distribution fee and other expenses.
• The fund's page on your recordkeeper's site, where it is often shown as an annual dollar cost per $1,000 invested. Multiply by your balance in thousands.
• The plan administration fee, which is separate from all of the above and pays the recordkeeper. It might be a flat $45 a year, or another 0.15% on top of the fund fee.

That last one catches people. 0.15% on a $40,000 balance is $60 a year, charged as $15 a quarter, which is small enough to scroll past on a statement and large enough to matter across thirty years.

Watch for gross and net expense ratio being different. Net is what you pay today, because the fund company is waiving part of the fee. Waivers expire. Gross is what you pay when it does.

The ninety second comparison

When two funds on the same menu look interchangeable, four checks settle it and none of them require a spreadsheet.

1. 01Do they own the same thing? Compare the top ten holdings on each fact sheet. If eight of the ten match, you are looking at two wrappers around one idea and the cheaper wrapper wins.
2. 02What is the net expense ratio, and is there a waiver that expires? Gross and net being different means somebody is discounting the fee temporarily.
3. 03Is there a load? Some share classes charge a percentage on the way in or the way out. A 5.75% front load on $10,000 means $9,425 gets invested, and you start the race behind.
4. 04What is the turnover? High turnover means trading costs you never see quoted, and in a taxable account it also means taxable gains distributed to you in years you did not sell anything.

Then convert the fee gap into dollars on your actual balance before you decide anything, because 0.45 percentage points is an abstraction and $270 a year on $60,000 is a number you can react to.

One number, four clicks

Go find the expense ratio on your largest holding. Just the one, the biggest position, the fund most of your balance is sitting in.

If it starts with a zero point zero, you are fine and you can stop. If it starts with a zero point seven, you now know what that decision is worth over thirty years, and you know it to three significant figures instead of as a vague feeling that fees are bad.

The next thing worth knowing is what the rest of the menu charges, because the cheap option is almost always already on it, sitting four rows down with a name so boring nobody reads it.