Retirement Income and the Impact of Fees
As more Canadians are seeking guidance on the best way to save for retirement, one common piece of advice involves the cost of investment fees and the potential impact high fees can have on the size of your retirement nest egg.
Over the past few years many new direct-to-consumer digital investment platforms, or robo-advisors, have entered the Canadian market place with the mandate to provide access to professional investment advice at a cost well below what traditional investment firms and financial advisors charge.
To highlight the potential cost of investment fees, many case studies have been published by digital investment firms claiming the average investor could save hundreds of thousands over an investment lifetime.
Most case studies simply focus on how much less an investment will be worth 10, 20 or 30 years from now due to lower net returns. But to understand the true cost of investments fees, you must look past the accumulation stage and include the decumulation stage in retirement.
When planning for retirement, the focus is on how much after-tax income will be needed. For this reason, how much after-tax income an investor can expect, should be used to measure the true cost of investments fees.
In this study, we started by creating a baseline analysis, assuming a return on investment with no related management or trading fees. This allowed us to establish a target after-tax retirement income.
Next, we analysed three common investment platforms and the impact different fee structures could have on projected capital at retirement vs. the capital required to generate the target after-tax income. The three investment platforms include:
- Digital investment firm or robo-advisor.
- Traditional brick and mortar investment firm.
- Professional advice via financial planning engagement.
To eliminate any impact on after-tax income due to the tax savings related to income splitting, our case study assumed that both spouses earn equal income and have equal assets and savings. This ensured that any difference in results would be directly related to the investment platform used.
Financial Planning Software:
All analysis was done using RazorPlan financial planning software. This allowed us to make exact copies of scenarios and control the changes made. It also allowed us to easily measure the impact of fees on four key indicators based on the retirement goals of a client. These indicators include:
- Maximum after-tax income
- Earliest retirement age
- Minimum investment rate of return
- Required investment capital
In addition, the RazorPlan software calculates income taxes and includes recovery taxes such as Age Credit and Old Age Security claw-backs.
When creating a client profile for this study, we wanted to capture a typical client of our three investment platforms, while striking a balance between pre-retirement and post-retirement planning.
We also needed to acknowledge reports by many robo-advisors that an increasing percentage of their users are more mature and of higher net worth.
“To understand the true cost of investment fees, you must first calculate how much after-tax income you can expect in retirement ignoring all related fees.”
In our baseline analysis, we chose an investment rate of return that was consistent with the rate of return used in the many articles and case studies on the cost of investment fees.
In the recent youngandthrifty.ca article The Complete Guide to Canada’s Robo Advisors, they summarized the fees charged by 10 of Canada’s top robo-advisors. Based on a $370,000 investment portfolio, we calculated the average fees at 75 basis points.
To this we added 6% representing the most common rate of return used by many of the robo-advisors when discussing the cost of fees.
Assuming a total investment return of 6.75%, we calculated projected capital at retirement of $1,297,000. This provided an after-tax income in today’s dollars of $81,600 to life expectancy.
“Even a low-cost digital investment platform will reduce the amount of after-tax income you will have in retirement.”
After making an exact copy of our baseline analysis, we implemented only one change, reducing investment return by 75 basis points to 6.0%.
Reducing projected investment return by the 0.75% fee charged by the average robo-advisor had two major impacts:
First, it increased the required capital needed at retirement by $77,000 and second, it reduced projected capital by $116,000.
This created a retirement funding gap of $193,000 and reduced after-tax income by 8.3% to $74,800, a loss of $956,000 in total retirement spending.
TRADITIONAL INVESTMENT ANALYSIS
“Financial institutions that charge investment fees greater than 75 basis points and only deliver basic portfolio services, add no value.”
After making a new copy of our baseline analysis, we reduce investment returns by an additional 100 basis points to 5.0% to reflect the investment fees charged by the more traditional brick and mortar distribution channels.
Reducing investment return in our analysis from 6.75% to 5.0% further Increased required capital at retirement by $151,000 and reduced projected capital by an additional $141,000.
With total retirement funding gap now at $484,000 the after-tax retirement income that can now be supported is only $67,000, a 17.9% decrease from the baseline analysis at 6.75%.
FINANCIAL PLANNING ENGAGEMENT
“The basic portfolio services, asset allocation and risk tolerance, delivered by digital investment platforms or robo-advisors, are not a financial plan.”
When you compare the results of the robo-advisor analysis to the traditional investment analysis, the funding gap increased by $291,000. This would seem to validate the claim that for “average Canadians, the second largest purchase they will make, second only to a home, are the amount of fees they pay to the investment industry”.
But nothing could be further from reality!
A professional financial advisor provides advice on a full range of money related topics. A 2016 study called the Vanguard Advisor’s Alpha calculated the value of an advisor for services relating to portfolio construction was equivalent to 75 basis points, equal to what the average robo-advisor charges. The study also found that the value of an advisor who provides financial planning services was worth an additional 100 to 250 basis points.
It is easy to point to investment fees and calculate the cost of one distribution channel over another. In our example, a $370,000 investment portfolio costs an average of $2,775 with a robo-advisor compared to $6,475 when using a human advisor. Keep in mind that the average human advisor’s portion of the total fee is no more than the amount paid to the robo-advisor.
For their fees, robo-advisors provide basic portfolio construction including asset allocation and risk tolerance.
Financial advisors also provide portfolio construction, asset allocation and risk tolerance in addition to advice on many other topics encompassing:
- Financial management,
- Investment management,
- Insurance and risk management,
- Tax planning,
- Retirement planning, and
- Estate planning.
To analyze the value provided by the above, we again copied our baseline analysis and reduced the investment returns from 6.75% to 5.0%. But this time we also made a few additional changes to reflect the type of financial advice, guidance and coaching a competent financial advisor would provide as part of a financial planning engagement.
Specifically, we implemented the following recommendation:
- Allocate $14,000 from each TFSA and contribute it to RRSP and use the $10,000 tax refund to pay off the high-interest credit card.
- Contribute the $500 budgeted each month for credit card payments to RRSP along with the $2,000 they each have been contributing to TFSA annually.
- Increase savings each year by the assumed 2.5% inflation.
- Use the $6,000 annual RRSP tax refund to increase mortgage payments.
- When the mortgage is paid off in 8 years (6 years sooner), allocate the mortgage payment to RRSP contributions.
- In 8 years when the mortgage is paid off, use the RRSP tax refund to make TFSA contributions.
- Convert RRSP to RRIF at retirement to utilize lower tax brackets and reduce the amount of withholding tax on cashflow.
After implementing the above items in the financial analysis, the required capital at retirement increased slightly due to the higher allocation to RRSPs. Projected capital also increased by $583,000 to $1.6 million, $443,000 more than projected to be available with a low-fee robo-advisor and $327,000 greater than the baseline.
Not only does advice from a human advisor relationship out perform robo-advisor, the financial plan added the equivalent of 1.8% to the rate of return, providing a retirement income of $81,800, slightly more than provided in the baseline analysis.
Too much emphasis is placed on investment fees today, though nobody would deny that fees do make a difference. But low fees in the absence of professional financial planning advice provides little real value to average investors. Perhaps this is the reason that most robo-advisors operating today are trying to collaborate with the human advisor community.
As a tool for financial advisors looking to reduce investment fees so they can focus more time on advice that really matters to the financial wellbeing of their clients, a white-labelled digital investment platform should provide good value.
As a direct to investor platform, for people with average knowledge of financial products and strategies, using a robo-advisor may end up costing them $1,000,000 in lost retirement income!
Comparison of Projected Capital at Retirement
Comparison of Total After-Tax Retirement Income