Do you suffer from Intermediary Drain?
Yes, it’s an embarrassing question. It’s something most people don’t want to talk about at all, let alone in public. Indeed, you may be one of the millions of undiagnosed Americans who have this terrible and largely invisible malady. You may not even know you have it.
I thought about this after a reader letter explained that his nearly $1 million in retirement savings was invested in a variety of index funds that had annual costs of about 1.85 percent, nearly 20 times the cost of the largest and best known index funds and exchange traded funds. He suffered this expense because he chose, or was sold, a variable annuity. But it could have been a number of other investment products.
Intermediary Drain is my technical term for the loss of assets you may suffer due to the cost of managing the investments you have in your IRA, 401(k), 403(b) or taxable investment accounts. One way to measure the impact of this silent killer of retirement security and college funding plans is to compare it to the losses you can identify and see— the rates we pay in federal income taxes.
This year, for instance, we can pay income taxes at rates that vary from 10 percent to 39.6 percent— and that’s after some amount of income that isn’t be taxed at all. We have a habit of complaining about taxes. Generally, we think that others should pay more and we should pay less.
One quick way to see how taxes reduce our financial strength is to examine the tax bill for a single person. Here is the tax table for 2014.
- With a standard deduction of $6,200 and a personal exemption of $3,950, a single person can have $10,150 of income with no federal income tax liability.
- The next $9,075 pays taxes at 10 percent (total income: $19,225).
- The next $27,825 pays taxes at 15 percent (total income: $47,050).
- The next $52,450 pays taxes at 25 percent (total income: $99,500).
- The next $97,000 pays taxes at 28 percent (total income: $196,500).
- The next $218,750 pays taxes at 33 percent (total income: $415,250).
- The next $1,650 pays taxes at 35 percent (total income: $416,900).
- Any additional income is taxed at 39.6 percent.
Don’t complain. As Supreme Court Justice Oliver Wendell Holmes said, taxes are the price we pay for a civilized society. If you pay at a high rate, well, you must have one of the better seats in the ongoing theater of civilization.
As you can see, most people pay taxes at rates of 10, 15 or 25 percent because most individuals earn less than $100,000. Now let’s see how this compares with the cost of managing our money.
A simple way to do this is by calculating the cost of managing our investments as a percent of our expected return. Do that and we see that a typical variable annuity invested in a balanced fund has a total cost burden of 2.19 percent a year. Since the historically expected return from such an account is 8 percent a year, the Intermediary Drain is 27.4 percent— a bit more than the highest tax rate most taxpayers ever pay.
The Intermediary Drain from one of the major low-cost managed balance funds is much lower, only 8.8 percent (the 0.7 percent expense ratio divided by the 8.0 percent expected return.)
Unfortunately, this understates the damage done by expenses. Why? Because the costs we experience today compound each year into the future. This makes the reduction in what we accumulate a good deal larger.
An average variable annuity or smaller brokerage wrap account, for instance will see its 40-year accumulation dropped by 46 percent. That’s higher than any income tax rate. Indeed, costs must be one percent a year or less to have an Intermediary Drain rate under 25 percent (see table below). You should also know that these calculations understate the burden because they include the original investment as well as the gain. If we calculate the reduction in just the return on that investment, the drain would be higher.
Measuring Intermediary Drain
Figures calculated assuming a gross return of 8 percent less expenses on a $100 per month investment over a 40-year period. The figures demonstrate that the most commonly used investment media— insurance products and traditional managed funds— cost investors at all income levels more than they are likely to pay in income taxes.
|Investment Method||Typical Annual Expense||40 Year Accumulation||Intermediary Drain Rate|
|Costless Ideal||0.00 percent||$349,100||0%|
|Do It Yourself Balanced ETFs||0.07 percent||$342,106||2%|
|Ultra Low-Cost Balanced Funds||0.25 percent||$324,817||7%|
|Low Cost Balanced Funds||0.70 percent||$285,666||18.2%|
|Large Managed Accounts||1.00 percent||$262,481||24.8%|
|Traditional Balanced Fund Average||1.32 percent||$240,037||31.7%|
|Variable Annuities, Smaller Wrap Accounts||2.19 percent||$189,177||46%|
|Sources: Morningstar data, author calculations|
Scott Burns is the retired Chief Investment Officer of AssetBuilder, the creator of Couch Potato investing, and a personal finance columnist with decades of experience.