Costs are a necessary part of investing. I don’t know any way of investing without incurring some costs somewhere along the line. But any pound paid out in costs is a pound not working for you. Costs, like some of the other topics we’ve covered, have a direct impact on the value of that, so you need to understand where costs are applied and the impact on your wealth.
Everything You Need to KNOW
1. There are Many Levels of Costs
When investing, there are costs at every turn. Let’s consider an investment into a pension, with a few funds or shares held inside it. Firstly, many of us make these investments on online platforms, all of which charge money for the functionality they provide. There may be dealing fees if you buy direct shares or gilts, but there often aren’t if you buy shares.
The platform may charge you a flat monthly or annual fee for having the account, and/or there may be an ad valorem, that is, percentage-based fee. For example, the platform may charge 0.3% of the money you hold on there.
Sometimes these fees are tiered, so the first £50k attracts a charge of X, then the next £150k a charge of Y% and then anything over £200k a charge of Z%. You may be able to link accounts with your family members to get family pricing, or not.
The pension itself may come with an additional charge, although many platforms don’t charge this. But they do when it comes to managing the pension in retirement. You may have to pay charges for the initial switch into a pension drawdown arrangement, and then another charge every year after that. Ad hoc withdrawals will incur extra charges.
Then, the funds you choose will have costs attached, often expressed as a TER or total expense ratio, which is confusing because it isn’t a ratio and it isn’t the total cost. The nearest you get to a total cost is a number called the OCF, or ongoing charges figure.
Finally, if you have an adviser, they are likely charging you too. Most advisers charge ad valorem percentage-based fees, but some may charge using an hourly rate, others a flat monthly or annual fee unrelated to the amount they manage for you.
And you MUST consider tax. In a pension or an ISA this isn’t likely to be a problem, but in a General Investment Account (GIA) it could be, and could really mount up over time.
2. Costs + Compounding = Trouble
It’s not just the fact that there are potentially lots of costs to pay, it’s the impact that those costs will have on your wealth that are startling. When we looked at compounding, we saw that it has the power to accelerate the growth of your money. Well, any money paid out in costs is denied the chance to compound up for your benefit.
Let’s say you had £10,000 to invest initially, and £250 a month to put away for 20 years. If you incurred no costs at all on the money, and you got a steady 6% annual return, after 20 years you’d be sitting on £212,814.
If you paid total costs each year of 1.5% of the money invested, over 20 years the money would have only grown to £166,991. The costs, plus the loss of compounding on those costs would have amounted to £45,823 over the period. 21.54% – over a fifth – of your total possible return has been swallowed up in costs.
In this example, you’re handing over £1 for every £4 you make over a 20-year period. There’s a good calculator over at Candid Money which shows the impact of both up front and ongoing annual costs on your investments.
3. The Cost/Value Factor is Important
There is a stark difference between cost and value. Some things are worth paying for, but only you can determine that value of things in your own situation; it’s a very personal thing.
For instance, you may be a very busy person, with very little interest in investing and its mechanics. You know that if you focus your mind elsewhere, you can make more money or be more fulfilled than you will be by spending time poring over performance charts of Morningstar research. For you, it’s likely worth paying an adviser to invest and to keep an eye on things for you.
If by contrast, you love investing, and are never happier than when checking the markets and their impact on your portfolio, then why pay someone else to do that for you? Clearly there’s merit in paying for an investment fund and an adviser, for the right people at the right time.