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A Penny Saved is a Penny Earned

Isn’t it amazing how so many people can know something and not know it at the same time?  That’s a teaser question, but likely a fair one.  Allow me to illustrate the dichotomy.

How many humans do you know who have heard and generally agree with the statement, “a penny saved is a penny earned”?  My guess: nearly all.  Now, for the corollary…  How many financial planners take product cost into account when doing retirement projections for their clients?  My guess: nearly none.   The lesson here is simple.  If you honestly believe that a penny saved is a penny earned, then the surest way to earn more money is to pay less money.

For nearly two years now, Questrade has been running an ad campaign that encourages Canadians to #asktoughquestions.  That campaign is being run in conjunction with the value proposition of retiring with 30% more money as a result of lowering costs.

What is not unambiguously expressed in the ads is whether the cost savings come from not paying a human advisor or not paying for traditional active management.  The impression I get is that the difference is explained at least somewhat by both choices.  I also get the impression that the 30% number depends on one’s timeframe – meaning that the percentage may well be substantially higher for people who start early and live a long life… but I digress.

In my advisory practice, we do financial independence projections for clients and we use assumptions that are broadly in keeping with the guidelines set out by the FPSC/ IQPF.  Those guidelines include the recommended best practice of lowering return expectations by the amount of costs incurred.  The blended return assumption we use for equity is a 5% real return.  For income, it’s a 0% real return.  Real return is the return above inflation, which we assume to be 2%.  In other words, a 5% real return is a 7% nominal return and a 0% real return is a 2% nominal return if inflation runs at 2% (which is about what it has run at since the early 1990s).

Using model portfolios that increase the equity exposure in 10% increments and starting at a 50% equity, 50% income portfolio, we get six model portfolios ranging in their expected return from 2.5% real (50/50) to 5.0% real (100% equity/ 0% income). Here’s where it gets interesting.  The difference in cost between low cost products and high cost products is usually between 0.5% and 1.0%.

Now, I want you to stop for a moment and process what you’ve just read.  What does it mean?  Do you see it?  I ask because when it comes to projecting people’s terminal wealth, my financial planning brethren seem determined to deliberately not know what everyone else already knows… a penny saved is a penny earned.

Lowering your cost by 0.5% to 1.0% is the same as increasing your equity exposure by 10% to 20% in terms of return expectation.  Simply put, lower costs = higher expected returns. The real beauty is that the substitution to use low cost products in the place of more expensive products is that the risk profile is unchanged.  In other words, one could increase expected return by 1% by moving from a 60/40 portfolio to a 80/20 OR by substituting high cost products out and low cost products (1% cheaper) in.  Both get you retired at about the same time, but only the low-cost substitution option does so without increasing your risk.  In the words of one of my heroes, John Bogle: “you get what you don’t pay for”.

It used to be said that in planning for retirement, there were really only four variables that could be manipulated in order to reach a particular goal.  They were:

  • Save more (easier said than done);
  • Invest more aggressively (not recommended and often not even allowed given the need for advisors to know their clients);
  • Retire later (which I have long felt is the most sensible option – especially given increased life expectancy); and
  • Accept a lower standard of living in retirement (the default option if you fail at the first three)

Now, I believe financial planners can safely add a fifth option to their retirement projection toolkit – one that is easy to understand and easy to implement – for investors.  The fifth option is simple: lower your product costs. The trouble is that many advisors seem to act as though product cost is immaterial, when in fact, it is of extreme importance.  Old habits die hard.  Anyone who is serious about doing what is best for their clients owes it to those clients to provide low-cost investment options.

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