Why You Should Care About Expense Ratios

Think small

While I understand the basics of what expense ratios are – fees, so the lower the better – I have a hard time explaining what they are and their impact on your money. I’m not a financial professional, so this may be over simplifying. And please, someone, correct me if I’m way off.

I’m going to pretend I’m explaining this to someone who doesn’t want to understand investments, but perhaps should (mom!).

The first official definition I see is from Morningstar:

The expense ratio is the annual fee that all funds or ETFs charge their shareholders. It expresses the percentage of assets deducted each fiscal year for fund expenses, including 12b-1 fees, management fees, administrative fees, operating costs, and all other asset-based costs incurred by the fund.

What?! Am I supposed to know what 12b-1 fees are? The first line says it best: it’s the annual fee charged to shareholder. That’s you, the account holder.

But I don’t see it on my statement. How am I paying this fee? 

Nothing is free. Your investments are managed by people and companies that are in business to make money. Mutual funds and exchange-traded funds (ETFs) bundle their fees into this “expense ratio.” You’re not going to see this as a line item on a statement of your account transactions, but they have an impact on your investment returns.

What are these expense ratio fees for? 

There are different costs with managing different funds and these costs are paid for (at least partly) through the expense ratio fees. These may include paying the fund manager, custodial services, record keeping, legal, marketing, auditing, accounting, etc. Basically, paying the machine that keeps the firm running.

Do I have to pay this? 

Yes, but you have some control in how much you choose to pay.

How much are we talking and how will it impact me? 

Expense ratio fees can range from 0.01% to 2.5%. To any retail shopper, this sounds like small potatoes, but over time, these rates can have a big impact. I searched for a calculator for this example, but found the results varied, so take this just as an example. I used the SEC’s Tool for Comparing Mutual Funds. 

Say you invest $10,000. Assume an average annual gain of a 10% over 20 years:

  • With 0.91% expense ratio = $11,241 in costs; Balance = $56,034
  • With 0.04% expense ratio = $536 in costs; Balance = $66,739

That’s over a $10,000 difference! This is a really simplified example with no additional contributions and without consideration for a host of other factors. But you can control this $10k difference and it only takes a few minutes.

So, what can I do?

Let’s look at your retirement account and see where it’s invested. With Vanguard, I can easily see the expense ratio by fund. Since my IRA is a mash up of multiple 401k roll-overs, my account was invested across over 10 different funds. I have gradually sold them, in order of highest expense ratio, purchasing low cost index funds instead (VTSAX). I’m down to these six (look at that Fidelity at 0.01%!):

I don’t sell them all at once because there’s a $50 fee for making more than one of these transactions within 60 days. And since I’m no good at math, I’m not going to calculate the impact of these waiting periods, I’m just avoiding the $50 hit.

To trade the high expense ratio funds for lower expense ratio funds, I follow the steps from my Vanguard account: 1) buy and sell and 2)  Trade an ETF or stock. I trade “all” of the high expense account. Once that transaction goes through, it will be held in my money market fund until I add it to my VTSAX fund.

I tried to keep this simple, but it’s not a very simple subject for the non-fiscally minded. And I know I don’t know anything – I’m just scratching the surface here.

Retiring early and paying for college at the same time … is it possible?

I have nine years. What will college cost in nine years? It’s a daunting thought and I try my best to avoid it. And think I must I live on Fantasy Island when I say I’m going to retire at the same time I’m sending my two kids off to college. I honestly don’t know if early retirement will be able to happen at the same time. (Loans are not an option – personal parenting goals.)
College is a wild card. Or maybe I want it to be a wild card because all my (limited) research shows tuition will about double and that’s scary. The Vanguard college tuition calculator provides a pretty basic estimate of anticipated costs. Low-ball estimate is that a four-year college education at $100,000 today will increase to $167,000 in nine years.

  • 529s: Today’s standard for college savings. Put it in post-tax, pull it out for education-related expenses without penalty. We have two, established by the kids’ grandfather when they were babies. Our nine-year-old has ~$12k today. We contribute $100/mo. At this savings rate, using a compound interest calculator, this will be almost $40k in 9 years. Maybe enough for one year if we stay at the same contribution rate.
    • We increased our college savings another $100/mo into each of our Roth IRAs. (No, we’re not at the point where we can max these out yet.) Withdrawing from a Roth prior to age 59.5 carries penalties, unless for a qualifying reason. Your child’s education is one.
    • And there’s this: “… most parents should max out their Roth first then look at funding a 529 plan.” With that, we will make a plan to max these out. I wonder if we can squeeze that into 2018?
  • Community College Transfer: I really like the idea of saving on tuition by going for two years at a community college then transferring to a four-year, but there seem to be more drawbacks than positives. Maybe this will shift to being a more common practice in the future, but I can’t plan on that.
  • Having recently moved from Seattle, I’m wondering … perhaps moving back to enjoy the mountains and sound, while taking advantage of UW’s Dual Enrollment would be worth considering. (Reason #458 we should move to Seattle.)
  • Scholarships? This Washington Post article is old, but it probably still stands close to the truth today: 19% of high GPA students receive academic scholarships and 0.7% receive athletic scholarships. This would be really great, but I can’t count on it.
    All PGA players start somewhere
  • Go Pro: Our younger son is eight and has declared that he will be a professional golfer. So be it.
  • Real Estate: Our obvious choice and we’re so so so thankful we have it, because I really don’t think we could achieve the savings rate we’d need to pay for college without loans. We have two rental homes in the crazy Seattle market. We’ve owned one, our ex-primary, for 11 years and the other for four years. Either of them would more than pay for both kids to go to college at today’s average tuition rates. We can’t predict what they’ll be worth in nine years. I don’t have a crystal ball. But this is what will pay for college and enable us to retire around the same time.

    ​I hope.

Why we decided to rent vs sell

cross country driving adventures

We knew we’d return to the East Coast to be closer to family at some point. So, after 10 years of loving life in Seattle, we made the move back to the Philadelphia area.

The Seattle real estate market is insane. We lived in a 1,300 square foot single family home in a desirable neighborhood with great schools and close to downtown (i.e., short commute to Amazon). Prior to purchasing this house in 2006, we sold our Philadelphia home for a nice profit, affording us to pay off my student loans, buy two (used) cars and put 20% cash down on our new Seattle home. This was all without a thought of kids (which came only two short years later). Thankfully, the house worked for our family of four because we quickly realized we couldn’t afford a bigger house that wasn’t a fixer.

During our time in Seattle, we also purchased a smaller investment property in another neighborhood. We didn’t follow the “buy the worst house in the best neighborhood” rule, but we bought what we could afford and got newly renovated (low maintenance) house in a neighborhood we knew was “up and coming.” For three years, we acted as the property managers with no turnover and very few issues.

So, when it came time for us to move, we were torn: sell or rent? The Seattle market has seen such growth: was it a bubble and should we sell now (2016)? Or hold onto the properties with a nice monthly income, hope the long-term growth continues and accept there will be maintenance and management costs? We took a deep breath and decided to rent, turning over the property management to a company that takes 10% off the top of the first rental and 8% off the top of the second. This has proven well worth it! They take care of everything and are prompt to answer any questions of concerns.

In the two years since February 2016, property 1 (primary) has grown in value by 35% and property 2 (investment) has grown by 46%. This doesn’t account for the monthly rent which more than covers the mortgages. So, I didn’t do an entirely accurate comparison, but in the same time period, a $10k investment in VTSAX would have grown around 35%. Selling our properties would provide a much larger investment, so perhaps this would have been a wiser decision, but I like: 1) the passive monthly income and 2) having diversified assets.

The Plan for Property 1:

  • Keep it for the passive income during retirements, or
  • Move back! Right now, we’re thinking about retiring in WA.
  • We also keep in mind that if we sell by 2020, we can avoid paying capital gains tax for having lived there for two of the prior five years.

​We definitely have an emotional tie to this house and neighborhood and simply don’t want to sell it. At least we recognize this!

The Plan for Property 2:

  • Keep it for passive income in retirement, or
  • Sell it to pay for college for two kids in 10+ years, while collecting monthly rent. But, with this, comes real estate market risks and increasing maintenance costs as the property ages.

And, of course, the ever-present threat of an earthquake in the PacificNW that could reduce both properties to a pile of rubble.

The Nightly Rental Option: I recently looked at what nightly vacation rentals would look like for each of these houses, but our steady monthly rent exceeds the estimates. 

We purchased our big, old, inefficient home in the Philly ‘burbs, but the market here is not nearly has hot, so it’s not so exciting to think about. With some improvements coming to the neighborhood that will increase walkability and overall appeal, I’m sure we’ll sell it for more than we bought it, but if you consider the real costs of home ownership, I can’t confidently say we’ll see a profit.

Either way, we’re in a great place with these investments and will keep them for now. I’m not sure what would change that. I’m afraid that if we sell and funnel the profit into investment accounts, we’d be putting all of our eggs in one basket. It’s all about balance!

2018 FIRE Goals

Building on the strong foundation we set in 2017, here are our goals for 2018:

#1: Debt reduction. We made some great strides in 2017 by simply organizing our finances and recognizing that we need to be more aggressive and focused on debt reduction. This will, of course, continue …

Hawaii, 2015

#2: Travel. We haven’t traveled much lately and we NEED to! This is a no brainer: open a Chase rewards card. Actually, I already got mine and my husband will get his soon. We went with the Chase Sapphire. I’m not sure yet if we’ll get as aggressive as the chase gauntlet just yet. We’re thinking a family vacation to the Bahamas … perhaps that’s because it’s freezing cold right now.

​#3: Max out all pre-tax contributions (401k, HSA, FSA).

#4: Increase college savings. Keep 529s at $100 per month and contribute an additional $100 per month into another, separate investment account or Roth IRA for each child.

#5: Save (more) on wireless phone bills. Change DH from Verizon to a Monthly Shared plan with Total Wireless for $60 per month, saving $67 per month. That’s over $800 per year. Cha-ching!

The debt reduction is the biggest nut: credit cards, HELOC, two car loans and three mortgages. It’s daunting, but it’s there and we’re going to make it disappear. POOF!

2017 Recap: Where we started and where we are today

 

We started on this journey in May 2017 and I think that in our first eight months, we accomplished a lot. It wasn’t too much of a stretch for us: we know we need to save, but learning from the FI community, we realized that being more aggressive about both decreasing  debt and saving more will enable us to stop working our traditional office jobs in about 10 years (at age 54) … we hope. College for two kids is such a wild card. And I don’t even want to think about healthcare.

Our first eight months on the path to FIRE looked like this:

  1. Transferred both our Wells Fargo IRAs, rolled over prior employer 401k and an old pension into Vanguard IRAs, focusing on consolidating into VTSAX
  2. 401ks – we didn’t quite max these out in 2017; they will be maxed out in 2018 and super happy to see there’s an increase of $500 more per year in 2018 on the 401k max
  3. Continued to contribute $100/month into each of two 529s
  4. Maxed out pre-tax HSA and Dependent Care FSA
  5. Sold high expense ratio funds to purchase VTSAX (still working on this because there’s a charge of $50 when selling more than one non-Vanguard fund within 60 days)
  6. Successful job arbitrage saving city wage tax, commuting costs and time, plus a bonus and salary increase
  7. Tracked spending with Every Dollar; this was really helpful to understand where and when our money was going and helped us get started. I feel like we’ve got our finger on the pulse of this now and I’m not tracking every dollar.
  8. I’m addicted to the Personal Capital app. I love seeing our money grow and debt shrink and it also provides a spending analysis that has replaced Every Dollar for me, but it’s not as robust in that department. I was hesitant to provide all my account info and logins to a third party, but their superman encryption convinced me it was safe.
  9. Changed one of two cell phones to a low-cost, pay-as-you-go plan with Total Wireless, saving $45/month!
  10. Switched insurance providers for primary house, two rental houses and two cars: saving over $600/year.
  11. Increased rent in both rental homes; this wasn’t by design as much as strongly recommended by our property management company due to market trends in one and tenant turnover in another.

Whew! I’m proud of this. I wish we started 10 years ago, but there’s no looking back, just moving forward. We still have a long way to go: we have goals and we can see how we’ll get there. Here’s to 2018!