Mutual Funds and Your Retirement

Thinking about investing in mutual funds? Be sure you do your research to avoid surprises.

Introduction

When it comes to investing into today’s world, it’s fair to say the vast majority of people with any money invested in the markets have at least some familiarity with mutual funds.

Proof of that is the fact that according to an Investment Company Institute (ICI) 2023 press release, approximately 54-percent of U.S. households own mutual funds or exchange traded funds (ETFs).

A large number of them do so through employer-sponsored accounts, like 401(K)s, who generally are offered a handful of mutual funds to choose from among when it comes to the investment choices offered within their accounts.

Despite the widespread familiarity, the Financial Industry Regulatory Authority (FINRA) says that the majority of people in the U.S. don’t really know much about where they put their money or the instruments they utilize.

In its 2022 report, Investor knowledge in the United States: The Changing Landscape, they stated the following:

“Investor knowledge is low. On the ten-question investing quiz, the average number answered correctly is 4.7. More than two in five respondents (44-percent) think that the past performance of an investment is a good indicator of future results. Less than a third (29-percent) understand that the main advantage of index funds over actively managed funds is generally lower fees and expenses.”

Wow!!

Given these kind of facts, we thought it would make sense to do a review of some of the basics regarding mutual funds and their use when it comes to retirement, with emphasis on a major mistake many investors and retirees make – not considering fees.

The good

Since we are looking at mutual funds, rather than assume you are completely familiar, even if invested in one or more, let’s review them a bit.

First up, a mutual fund is in fact an asset. They are comprised of money pooled together that has been invested by a group of investors. The money you pay in purchases shares in the fund. In so doing you own shares of the mutual fund – you do not own shares in the underlying asset, such as the stock of a company.

This money is generally invested in securities belonging to a particular asset class, such as stocks, bonds, commodities, currencies, alternatives, et cetera.

That said, certain funds may invest across asset classes. Some funds may also incorporate hedging strategies to offset risk. The objectives, strategies, risk profile and other critical details are contained within its prospectus, which is a legal document governing how the fund operates.

The goals of investing typically include making capital gains, creating income streams, and/or retaining buying power, but to do so in a manner that doesn’t put your savings at undue risk.

To help accomplish this goal, investing in multiple stocks is an example of spreading your dollars around, which helps reduce your risk. Spreading your money across stocks in multiple sectors and industries, let alone regions of the country and globally, can further ensure your eggs aren’t placed in one basket. We call this diversification.

Adding investments in bonds (corporate and government, domestic and globally), as well as other asset classes can further spread your money around, potentially increasing your chances for gain (or capital preservation), and very importantly reducing your risk.

Simply stated, mutual funds are a type of investment vehicle you can invest in to make money, diversify your holdings and reduce your risk.

They also let you gain the benefit of reducing the time and cost if you were to try to do all of these things on your own.

How? They are run by professional money managers who decide which securities to buy and when to sell them. They can decide how to spread the money around and in what amounts, which is referred to as asset allocation.

That’s true whether they are seeking to mimic the securities and the return of an index (e.g., S&P 500 indexed mutual fund), or if instead the managers of the fund are active, thereby giving them the discretion to pick assets that they believe will outperform industry benchmarks and markets in general.

Transactional costs are comparatively low because a mutual fund buys and sells large amounts of securities at a time. The transactional costs are typically lower than what you would pay as an individual investor.

You also gain the benefit of their expertise and research.

In total, investing in mutual funds can help provide you with diversification in your portfolio of assets, deliver some measure of asset allocation, address and potentially reduce your overall risk, give you access to professional money management and reduce your transactional costs when compared to investing on your own.

Major types

As you can imagine, there are many fund families offering all types of funds. Among the primary fund types are:

Equity Funds: invests in shares of U.S. or Internationally-based companies. They can be index-focused or actively managed. They tend to focus on candidate companies based on size (e.g., small-cap, mid-cap or large-cap) as well as objective, such as growth or income.

The amount of research required in actively managed funds can drive up costs – example: small-cap stocks can incur higher research costs as they tend to have less analytical coverage. Alternatively, indexed funds are generally cheaper (they seek to track an index) and can be more tax efficient than actively managed funds. Equity funds can be comprised of dozens of stocks to more than a thousand.

Fixed-Income Funds: these types of funds invest in debt instruments, such U.S. and foreign government securities, as well as investment-grade corporate bonds. They can generate income, provide protection against market volatility and diversify your overall portfolio mix.

Asset Allocation Funds: These funds generally seek to provide growth and income through investment into an allocation of both equities and fixed-income instruments.

A sub-category of asset allocation vehicles are Target Date funds that lower their equity risk over time. When you are younger they can be more geared to growth (more money allocated to growth stocks and equities in general), but as you age and get closer to retirement, the mix can switch more to providing income (higher percentage of fixed income holdings), with a smaller allocation of stocks to reduce equity market exposure and risk.

There are many more, with money market, commodity, hybrid, sector, ESG (Environmental, Social and Governance), balanced and emerging market but just a handful of what’s available.

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Heavy emphasis on ratings

When it comes to investing in mutual funds, investors often focus on historical performance. They often look to ratings companies, such as Lipper and Morningstar, to see how funds they are interested in rank compared to similar funds.

Morningstar offers a five-star scale that measures risk-adjusted performance and the expense ratio of a fund against all their category peers over a three-, five- and 10-year period. The funds with the highest scores receive the most stars, according to the company.

According to the company, Morningstar utilizes a bell-curve system for each of its rating categories:

Top 10-percent receive a 5-star rating

Next 22.5-percent receive a 4-star rating

Next 35-percent receive a 3-star rating

Next 22.5-percent receive a 2-star rating

Bottom 10-percent receive a 1-star rating

 

Lipper utilizes a set of five criterial to rate mutual funds from an array of categories over a three-, five- and 10-year period. According to the company, they evaluate mutual funds based on their consistency of returns, expense ratio, ability to preserve capital, tax efficiency and total return.

They rank for each of those five criteria against peers. The top 20-percent are ranked as Lipper Leaders for the category, while the next 20-percent are rated 4, and on down to the lowest 20-percent rated as 1.

A fund might be rated as a Lipper Leader in one criteria (example – tax efficiency) and a 3 in the total return criteria category.

You pay

All of those features and benefits sound wonderful, but there’s a catch. Each comes at a cost. A major mistake for investors is the fact they don’t get to know the full costs incurred when investing in funds.

In thinking about and evaluating mutual funds, one of the first things you should look at is their costs and fees, which are generally broken down into two categories – fund operating expenses and shareholder fees.

Operating expenses – also known as mutual fund expense ratios or advisory fees, often cost you between 0.25-percent to 1.0-percent of your investment in the fund per year. They consists of management fees (management salaries and research costs), administrative costs (like record keeping), marketing expenses (including 12b-1 fees to promote the fund), legal fees, accounting costs, and other operational expenses.

Shareholder fees – these are not included in the expense ratio cost and are things like loads and commissions (often referred to as front-end or back-end loads), redemption fees, transaction costs (example – brokerage fees), and more.

An important point is the fact that no-load funds are typically cheaper than loaded funds. Managed funds tend to cost more, while indexed funds tend to be cheaper in terms of what you will ultimately pay the fund to invest and remain invested annually.

Most of the fees and the costs are expressed as a percentage and pulled from the fund, so each investor pays these (albeit indirectly), effectively reducing their net investment return.

In terms of actual costs, a fund must publish most of these, but even then they vary considerably, even within a fund family. All the expenses of a mutual fund are listed in the fund’s prospectus.

Oak Harvest Founder and CEO Troy Sharpe, CFP®, CPWA®, CTS®, actually addresses mutual funds and their cost in his video What are Mutual Funds and What do You need to be Aware of Before you invest your Hard Earned Money?.

“I recently did an analysis of several fairly popular mutual funds, and all of these fees when added up came to more than 2-percent per year,” he states. “Be careful which mutual funds you invest in, understand the fees that the professionals behind the scenes are charging you, and how that can drag on performance over time.”

Whether it might be up to 2-percent or higher, which doesn’t sound overly burdensome, this does add up quite a bit over time.

An example is investing $20,000 initially and then $300 monthly into a fund over 20 years. Say the fund preforms decently, returning 9-percent each year and paying 8-percent net of all costs (cost and fees of 1-percent) over that period. You would have contributed a total of $92,000 and your investment would have grown to approximately $265,000 after costs.

If instead you invested exactly the same amount into a fund, and the performance of 9.0-percent annually over 20 years was the same, but the costs in that fund were higher (cost and fees of 2.5-percent), then you would have received 6.5-percent net in total. You would still have contributed a total of $92,000, but your investment would have only grown to approximately $215k.

That equates to a $50k difference in added fees and costs for basically the exact same investment delivering the same performance over the same amount of time.

That’s no small deal, demonstrating that while fees and costs seem inconsequential on paper when considering a fund, in fact they add up substantially over time and can harm your retirement.

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Taxes

Many people fail to recognize there is another important issue they must account for when it comes to investing in mutual funds – taxes. This is a consideration whenever holding a mutual fund in a taxable account.

Just as with any type of investment, if it pays you a return, whether or not you sold any shares in the fund in a given year, you may owe taxes. This is above and beyond the aforementioned fees and costs.

If a fund you own sells an asset in their portfolio (example – shares of stock from an underlying company) and the fund makes money on the transaction, taxes are due.

These are passed on to all shareholders, including yourself. In turn, you will have to report that gain when filing your taxes.

If the asset was sold within one year of purchase by the fund company, it is considered a short-term capital gain. In this case you will have to report the gain and will be taxed at your ordinary income rate (which could be as high as 37-percent), which is usually higher than your capital gains rate. This is true even if you never receive the proceeds, but instead elected to reinvest for more shares of the mutual fund.

If instead the asset was held within the fund’s portfolio for more than a year before being sold for a gain, you will have to report when filing your taxes for that year, but you will do so at your long-term capital gains rate of 0- , 15- or 20-percent, depending on your filing status and income.

Dividends are another issue you must be aware of. A fund company will often be paid dividends by companies they own within their portfolio. When that occurs those are distributed to you unless you elect to have them reinvested, providing you with more shares of the fund.

Either way, you must report and pay taxes on the dividend, which are often considered taxable investment income. Depending on how long the underlying company issuing the dividend has been held by the fund company, your tax obligation will be either your short-term gains rate (ordinary income) or your long-term capital gains rate of 0- , 15- or 20-percent, depending on your filing status and income.

Avoiding the tax

There are several ways to avoid paying taxes each year you are in the fund, but the primary method is to purchase and hold the fund in a qualified account, such as an IRA or 401(K) account.

In doing so you are afforded the same benefit of deferring taxes until you decide to retire and take distributions. The money you would have to pay in taxes is instead allowed to remain in your qualified account, enabling you to take advantage of the deferred savings and increased compounded interest over time.

Yes, you will eventually have to report and pay taxes, but that is deferred until such time as you take distributions in retirement.

It is for this reason that Sharpe warns, “Mutual funds outside of a retirement account, in my opinion, rarely make sense. You have to be very careful about the portfolio turnover percentage, your share of capital gains, and of course, any other transaction costs that may be involved with that mutual fund.”

Final points

There are a couple final points to be aware of while considering investment into mutual funds.

First is the fact you may want to consider an ETF, as there can be some advantages versus a mutual fund:

• Both offer professional management and diversification of your money by purchasing underlying assets in a manner that spreads your money across different assets and asset classes
• ETFs are traded by you on the exchange, allowing you more flexibility, versus end of day at the net asset value (NAV) of a fund. This allows for more flexibility in itself, as you may incorporate shorting, market orders and limits, and even the ability to purchase on margin through the brokerage account you are using. We are not suggesting any of those things, merely pointing them out
• No minimum limit – you can buy a single share
• ETFs often carry less fees and costs, so they can be cheaper, allowing you to implement the same types of strategies (growth, income, hybrid, indexed, et cetera) at a lower cost
• As previously demonstrated, the costs differences can be substantial over time
• ETFs often tend to be more tax efficient, unless you over-trade them, which generates added tax events
• They too can be purchased through qualified accounts, so they offer the same tax-deferred benefits

Whether you are purchasing an ETF or a mutual fund, be mindful of any charges by your broker for buying or selling the security.

One other issue to keep in mind is the fact that advisory fees are not included in the costs and fees we’ve touched on. Those fees are separate.

But unless you feel confident you can deal with all the things that often must be addressed in retirement, especially as you have more assets and issues, you probably need to utilize the expertise and services of a qualified advisor.

Issues you may well need a professional advisor for:

• Creating a well-constructed retirement plan that acts as a roadmap for your retirement journey
• Creating and maintaining an allocation model this is customized to your situation, needs and goals, while minimizing risk
• Tax planning and strategies – can potentially save you tens to hundreds of thousands, and more
• Legacy and estate planning – make sure your assets and savings go where you want them to upon your passing
• Insurance (example – insurance proceeds can be used to pay for estate costs and taxes your loved ones might incur when you pass)
• Protecting your assets from creditors and lawsuits (example – trusts)
• Ensuring lifetime income so you and your spouse won’t outlive your assets
• Health care and long-term care planning
• And more

Conclusion

It should be clear that mutual funds, and ETFs, can be a good way to diversify your money and potentially reduce risk in a portfolio.

But…big but – costs and fees can put a major ding in your savings and what’s available for your retirement over time.

You have to do your homework to thoroughly understand what you will pay when investing in a mutual fund. There’s certainly plenty of potential benefits, but it’s key to know what you will pay for them. Those small-looking fees add up…especially when living in retirement and seeking to maximize everything you have.

And you definitely want to utilize the right vehicle (tax qualified) in order to avoid tax bills each year by taking advantage of the benefits associated with tax-deferral and compounding interest.

On top of all that, you need to remember that there are myriad retirement decisions to be made, many of which can get very complicated. Consider whether you’d be best served working with a proven advisor and team who can help you navigate your golden years.

At Oak Harvest we’d be happy to look at your current funds and ETFs to help you determine if you might be over-paying for the benefits offered. We can look at your current portfolio and retirement plan to determine if it can really meet your goals.

Or we can assist you by creating a retirement plan capable of helping you do so. We can build a holistic, comprehensive retirement plan addressing relevant issues, utilizing strategies that cover proper asset allocation, Social Security, taxes, income, spending, healthcare, legacy, and more, customized to your family’s specific needs.

A plan created with the goal of ensuring you can successfully live out the retirement you and your spouse envision.

If you are ready to take the next step and talk to a team of financial advisors and retirement planners who can advise on all your retirement needs, and who will put your interests first, Schedule a call today!

 

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