Everyone loves talking about the phenomenal rate of return they get on their investments. What concerns me is that most people really don't have a clue on calculating the real return on your assets in managed accounts.
If you are depending on reports from your managed accounts to tell you what rate of return you are realizing, you're going to be disappointed. That's because they can't really tell you what your real return is the money they are managed for you.
What??? They are managing my money and they don't know what kinds of returns they are getting???
Actually, operators of managed accounts are concerned about returns. That is, the returns they earn by managing your funds!
What's Involved in Calculating Your Real Return
Let's back up a bit.
I just made the seemingly outrageous claim that advisors of managed accounts have no idea what rate of return they are delivering to you.
So how can that be?
It's simple. They don't know your personal situation, which means they don't know what tax bracket you are in.
Since you will likely need to pay taxes on the earnings or gains in your managed fund, you need to deduct the tax liability from your total return before you are able to calculate your real return.
Without that personal knowledge of your tax bracket, they cannot adjust the rate of return to reflect your tax cost. This means they cannot give you a real rate of return on your assets in managed accounts.
But there are two more costs you need to factor in before you can get a real rate of return on that managed account, one of which your asset managers are not too keen to share with you. The cost your advisor would prefer you ignore are the fees you pay in your managed account.
First, you're going to pay them an annual fee, usually 1% of your portfolio value. If there are index funds included in the managed account, you're paying more fees… another 0.10% to 0.25%.
That bumps you to a 1.25% annual fee. But wait… there's one more cost: trading fees. Depending on the volume of trading, you can end up paying at least 2% and likely closer to 3% for your managed account costs.
The other cost, the annual inflation rate, is beyond their control, but you need to be aware that it too takes a bite out of your earnings. That makes paying those extra management fees even more costly, driving down your real rate of return.
Calculating a Real Return On Your Managed Account
Let's run a “what if” scenario to figure out a real return versus the gross return reported by your managed account.
This scenario will run for one year, making an annual return calculation simpler.
We will use the following assumptions:
- Beginning Investment Value – $100,000
- Gross Return from Managed Account – 7%
- Managed Account Annual Fee Rate – 2%
- Income Tax Bracket – 22%
Now let's play out the year…
At the end of the year, your managed account earned a gross return or 7%, or $7,000. Not bad… yet.
After your 2% fees of $2,000 are deducted, your account balance shows a real balance of $105,000, or an actual gain of $5,000. Not awful, but not as good as that $7,000 looked.
Now let's see what taxes do to that annual return.
Your net income from your managed account is $5,000. In a 22% tax bracket, you pay another $1,100 in taxes for that gain.
Now we're down to a net, after-tax gain, of $3,900. Or a 3.9% annual rate of return.
Finally, inflation, which is forecast to run 2% in 2021, drops that 3.9% annual rate of return down to a 1.9% return, adjusted for inflation.
Now we're hurting!
And now that 2% managed account fee really stings!
It effectively can cut your inflation-adjusted rate of return in half… from 3.9% down to a 1.9%.
The Long Term Impact of Managed Account Fees
Seeing it in percentages is pretty bad, but I'm going to convert it to dollars and run this scenario out over a 10-year period.
Again, we are using the same assumptions above, but we will assume that each year you pay the income tax liability out of your pocket, so your money in that managed account can grow as much as possible.
In other words, you eat all the costs EXCEPT the managed account fees and let's see what this is costing you BEFORE taxes and inflation.
Because the earnings remain in the managed account, you're taking advantage of the power of compound interest. Over time, this power becomes substantial.
As the above example illustrated, your net rate of return (before taxes and inflation) is 5%, not the 7% they tout (and you could have earned on your own!).
If, as they claim, you were earning 7% per year, and did so for 10 years, a simple online compound interest calculator shows an ending value of $196,715.14 (almost double!).
However, you are really getting 5% per year, so after 10 years you actually would have $162,889.46. That is $33,825.68 less money or an average of $3,383 per year.
So in 10 years, that itty-bitty 2% fee (as your managed account advisors hope you view it), is closer to a 3.5% annual fee. Or half of that 7% they keep boasting about… and which you never see in your account!
The Final Irony of Managed Fee Accounts
For easier illustration purposes, I generously assumed your managed account earned a steady 7% per year.
Not likely. Not at all likely.
And you know what?
If their gross return for the year is 2%, you get nothing, nada, zip… and they get paid.
Because they work hard and do a great job?
And if they do a good job and get you a better return, they get paid more.
It looks like they are on the right side of this deal… they get paid when they suck and get paid more when they don't suck so bad.
And you get what's left over.
And pay your taxes… and deal with inflation.
This is why I am against wasting valuable money on managed accounts.
Because you can easily do as good a job as they do. And hey, you have a 2% performance buffer, since you're not coughing up that much in fees each year.
More importantly, I can show you 12% return investments, without fees!
Yeah, you may be holding your investment performance back by paying so-called “experts” to do your investments and ending up with 7% returns before their fat fees when you can get 12% returns with ZERO fees!
Need anything else?