Today I want to write about why cost of investments matters. Why you should be aware of cost of investments and when you should pay for cost and when you should not be paying for such cost.
It has become almost like a norm that to retire, it is important to increase your wealth by making your money work hard for you. Unfortunately most people will be met with large number of obstacles. For today’s article, I will mention one obstacle which is cost.
Most people invest in Investment-linked policies for their retirement. These can be regular premium or single premium but recurring. The ILP invests in unit trusts. During the first 3 years or so, a large amount of money is given out in commissions. For regular premium ILP, the commission can be typically be 50%, 25% and 10% for the respective first three years. Some ILP have a commission structure of 100% for the first 18 months. For this article, I’ll use the former type of commission structure as analysis. After all commissions are paid, there is typically no sales charge because the insurer gives ‘105%’ allocation to offset the bid-offer spread. Nevertheless there is still a management fee charged by the fund manager. I will use 1.5% per annum as an assumption. However, I will not take into account of mortality and morbidity charges because these are insurance charges and have nothing to do with investment.
Those who use Unit Trusts will encounter a different kind of charges. Unit Trusts have sales charge. Typically it is from 1% to 3% depending on who you buy from. If you buy from a licensed financial adviser, there might be a wrap fee of about 1% per annum. For this analysis, I will assume a sales charge of 1% and no wrap fee. For management fee, I will assume 1.5% per annum just like an ILP.
In the last scenario, I will use index funds. Index funds are typically low in management fee ranging from 0.5% to 0.75% per annum. If using Exchange Traded Funds (ETFs), there will be a brokerage fee. For this analysis, I’ll assume a management fee of 0.75% per annum and brokerage fee of 0.3%. If you are not familiar with ETFs, you can read my article: Are The ETFs We Have In Singapore Good Investment Options Relative To Unit Trusts?
Other assumptions I will use are:
Regular investment of $12000 yearly.
Return on investment before cost is 7% per annum.
Time horizon is 30 years
Therefore, 30x12000 = $360,000 is the cumulative investment.
The investment value would have accumulated after 30 years to:
For ILP, $867,584
For UT, $907,863
For index funds, $1,050,312
As it can be seen that the ILP and UT is lower than the index counterpart by $182,728 and $142,449 respectively. In terms of percentage of the cumulative investment, the ILP and UT takes up 50.76% and 39.57% respectively!
Can you imagine having up to half of your capital eaten up in fees? This is the reason why it is important to have a low cost of investments. If you do not control the cost, you could end up delaying your retirement indefinitely.
Financial advisers would argue that the high cost in fees is to pay for good investment return. Say if the annual management fee is 1.5% but if the fund manager can outperform the index by 2% every year, you win by 0.5% per annum. Sounds good on theory but it is known that nearly 2/3 of the active managed funds underperform the index.
Even if you would to look for funds that are “leaders” among its global peers, you could still end up disappointed. For instance, the “List A” of the CPFIS approve funds are supposed to be among the top 25 percentile of its global peers. But if you look at some funds, you will be in for a shock. As an example, the GreatLink Global Intersection Fund is part of the “List A” for ILP but had a dismay past returns as compared to its benchmark. The 3 and 5 years underperformance is -6.42% and -5.58% annually respectively. I copied and paste its factsheet dated 31 July 2010 so that you can seen visually what I mean:
Some financial advisers would attempt to confuse their clients that the poor performance has to do with the poor performance of the stock market. These financial advisers do their clients a disservice by misrepresenting. When analyzing a fund, it is important to remove the market return because it is the skill of the fund manager that we want to know. For instance in the above example, the 3 years annualized return of the market as represented by the benchmark is -11.75%. But the fund performed -18.17%. Therefore the fund underperformed by 18.17-11.75 = 6.42% per annum.
In the light of this, it is better to invest with an index fund that mirrors the benchmark. For example, LionGlobal’s Infinity Global Index tracks the same index as the above Greatlink fund. The tracking error is about 1% due to fees. Unfortunately, Infinity Global Stock Index is not in the “List A” and will delisted from CPF investment come January 2011 if nothing is changed.
Since it is important to keep cost low, why can’t financial adviser simply recommend index funds? There are endless list of obstacles to do that but the most important is that index funds do not pay trailer fees and do not pay commissions. For instance, buying an Exchange Trade Funds (ETFs) do not allow the financial advisers to earn any sales charge and trailer fees since the purchase is done via the stock exchange.
So what can the man-in-the-street do? There are two choices, either you can do it yourself to make your own investment decisions or engage a financial adviser. For the former, you will have to decide on your own in terms of suitability. If engaging a financial adviser, paying consultation fee for advice is the solution to overcome the lack of commissions. It is better to pay say $5000 in consultation fee than to pay more than $100,000 cost. Remember, the ILP and UT example given showed that it can cost by $182,728 and $142,449 respectively. However, only engage professional financial planners that are qualified and authorized to charge fees. There are just too many salesman already claiming to be “consultants”.
To download the calculation in Excel sheet, you can click HERE
This article appears on CPF Board's IMSavvy: http://www.cpf.gov.sg/imsavvy/blog_post.asp?postid=461584228-154-1786920428
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