Legacy distribution drains years of savings

In the late 1960s, The New York Times declared that we had entered the age of "people's capitalism." The paper cited the broad increase in mutual fund and stock ownership.

The declaration was a bit premature.

There were fewer than 300 mutual funds at the time. Money market funds did not yet exist. Fixed-income funds were rare. Most funds were sold with a stiff 8.5 percent front-end commission. There were no index funds, no exchange-traded funds, and only a handful of low-load and no-load funds. Most funds were sold, like stocks, by brokers.

That distribution system -- what I call the legacy system -- still exists. Front-end commissions have come down, "B" shares and adviser shares have been added, and insurance companies have gotten into the market by wrapping an insurance contract around a mutual fund and creating variable annuities. Brokerage firms have also added "wrap accounts," substituting an annual-percentage-of-assets fee for transaction commissions.

And the legacy distribution system continues to manage, and charge fees on, trillions in financial assets, usually with a goal of charging about 2 percent (or more) of assets in any account.

But things change.

Just as we are now a nation of wireless cell phone users and many have abandoned land lines altogether, the last 40 years have also produced two major new distribution systems we can use to build and tend our retirement nest eggs. These distribution systems are:

• Low-cost institutional distribution. If you work for a large employer, you probably have a 401(k) plan from a firm like Fidelity, T. Rowe Price, Vanguard or American Century. In these plans your employer selects a menu of funds. Over time, the typical expenses of these funds has declined. As a consequence, it may cost only 70 to 80 basis points (0.7 percent to 0.8 percent) to hold and manage your entire nest egg at a Fidelity or T. Rowe Price, or as little as 20 basis points at Vanguard. Basically, this new distribution system costs two-thirds less than the legacy system. At the far extreme of low costs there is the federal Thrift Savings Plan. It runs at a barely measurable cost -- 3 basis points. That's 0.03 percent.

• Low-cost retail distribution. A parallel low-cost system for individual accounts has been developed for taxable accounts and all the independent qualified-plan accounts such as IRAs, Roth IRAs, SEPs, etc. Using broad "platforms," such as Fidelity brokerage, Schwab and E*Trade, it is now possible to buy no-load funds or low-commission exchange-traded funds using an Internet connection. This makes it possible to build retirement savings at a total cost that can range down to 20 basis points. Like the low-cost institutional distribution system, this system can cost one-third to one-tenth as much as the traditional (and expensive) legacy system.

For most of us, talking about these different systems is as interesting as talking about the differences between copper-wire phone lines and GSM or CDMA wireless phone systems. It's a quick way to empty a room.

What's important is how it works and what it does for us … or to us. So here's the difference. Let's suppose you are 30 years old, earn $50,000 a year and will earn annual raises that exceed a 3 percent inflation rate by 1 percentage point a year. Let's also assume that you save 10 percent of your income each year, whether directly out of income or a combination of your contribution and matching funds from your employer. Your savings are invested in a portfolio with an expected return of 9 percent, before fees and expenses.

How will things look when you retire at age 66?

Well, you'll need a lot more money than you might think at age 30 because your final salary will have quadrupled to $205,000 by age 66. It won't buy a lot more than $50,000 did at age 30, but you'll be making more dollars. If there were no investment expenses, you would accumulate $2,088,800 over the period. That's 10.18 years of final income.

If you have investment expenses of only 20 basis points, your net return will be 8.8 percent. You'll accumulate $2,000,000. That's 9.75 years of final income, or 96 percent of what you'd accumulate in an ideal world with no expenses.

If you invest through a reasonably inexpensive 401(k) plan that cuts 70 basis points a year off your 9 percent return, you'll accumulate $1,797,000, or 8.76 years of final income. Basically, the cost of investing is cutting your investment return by 14 percent.

But …

If you are subjected to the legacy distribution system and lose 2 percentage points of your return to its bloated expenses, you'll accumulate only $1,263,000. That's 6.15 years of final income. In other words, the legacy distribution system will have reduced your accumulation by 40 percent. That's a burden higher than the highest federal income tax rate -- and you haven't begun to pay income taxes yet.

The legacy system, of course, will continue to claim that it has brilliant managers who will overcome their costs. Unfortunately, there is not a shred of evidence to support this claim. There wasn't in the late '60s. There wasn't in the '70s, '80s or '90s, either. And there is no evidence today.

In a future with no corporate pensions and with worry about Social Security benefits, using the legacy system is one of the more self-destructive things a young person can do. It doesn't help retirees, either.

© 2008, Universal Press Syndicate