We’ve scattered examples through the site. Here’s a more complete description.

This page includes sections necessary to prove the assertions. You can skip them if you trust us.

Language

• We use the word ‘return’ on an investment. You can think of this as equivalent to the rate of interest you receive on a bank deposit. Like interest it is expressed as an annual percentage. So a 4% return on an investment of £100 will give you back £4 after a year in the same way that a 4% interest on a bank deposit would do. If you like, a more complete explanation is here.

• We will refer to ‘ad-valorem’ charges. These are administrative or other charges made on you (the saver). But they are not made by reference to the actual costs being incurred (plus a profit margin): they are calculated as a percentage of your savings under management. This is what the phrase ‘ad-valorem’ translates to. Like ‘return’ they are expressed as a percentage, so an ad valorem charge of 2% amounts to £2 in a year on savings of£100.

Significance

Ad-valorem charging is a simple idea with surprising mathematical consequences which can therefore be not obvious to the ordinary saver. This can lead to a practice of encouraging savers to commit to savings products at cost levels which are not justifiable.

We believe that control of costs is the most important issue for an ordinary saver to deal with. The reasons will emerge from the rest of this page.

Issues

Important issues arise from the mathematics of compounding. But you do not need to do the maths; you just need to understand the mathematical effects in general terms. We will explain these first. Then we will move on to maths. This will help if you are maths literate. If you aren’t you will still have enough to use for your money managment.

1. Quite small differences in return make big differences to the outcome of long-term savings.

2. This proportional effect is much the same whatever the return. I.e. a 1% charge on an 8% return takes much the same percentage of your money as a 1% charge on a 1% return.

3. The longer a fund lasts, the more the compounding effect matters.

The numbers behind these assertions are in the following numbered sections. Skipping is optional.

1) Small differences in return

Suppose you invest £1,000 aged 25 and the investment will mature forty years later. Suppose you are advised that the investment should make 1% per annum return. So the first year you get £10. The second year you get 1% on £1,010, which is £10.1, giving you a total after 2 years of £1,020.1. The third year you get £10.20 making a total of £1,030.30. And so on. After 40 years your investment matures at £1,489 (trust us).

Now, suppose your fund manager charges 1% . Then your annual return goes to zero, as does your total return. Instead of £1,489 you get back just £1,000. You have lost £489 of your £1,489 - 33% of your final money. That’s a lot.

Of course 1% is a pretty miserable return. We chose it because it’s easier to understand the difference between 1% and 0% than the difference between, say, 4% and 3%. Perhaps that gives a different result?

No.

2) It’s much the same result for all returns

Let’s try a higher return. 1% is a cautious rate. How about 4%, still over 40 years?

At 4% £1,000 grows to £4,801 (i.e. multiplies nearly 5 times)…….

• but after 1% charges it grows to just £3,262.

• so you have lost 32% of your money . £4,801-£3,262 = £1,539 (which you can see is just over 30% of £4,801)

• almost the same as the 33% you lose on a 1% investment.

And for a bit of fun let’s try a higher return - say 8%.

Does this 32% stay much the same for higher rates of return? Yes it does…… At 8% £1,000 goes to £21, 725, at 7% it goes to £14,974, difference is £6,750 and you have lost 31% of your money.

In passing, notice how enormous your pot has grown - 22 times at 8%. At 4% it has ‘only’ grown 4 times.

3) The longer a fund lasts, the bigger the effect

Return to the example above of 4% return with 1% charges . We’ll just give you the answers, which are:

• After 10 years you lose 9% of your money

• After 20 years you lose 18% of your money

• After 40 years you lose 32% of your money

You won’t be surprised to learn that the results are similar for all returns.

4) And if the charges double to 2%….?

Your losses don’t quite double but you take a big hit:

• After 10 years you lose 18% of your money

• After 20 years you lose 32% of your money

• After 40 years you lose 54% of your money

Lessons from these numbers:

• for investments over long periods small increases in return lead to big increases in results.

• this makes higher-risk investing more attractive over longer periods (because the risk premium delivers rewards and there is more time to recover from bad luck)

• however your investments perform, the addition of a 1% charge over 40 years reduces your outcome by one third. For a 2% charge you lose over half.

….and the message is…

Let’s be clear. The issue here is psychological, not mathematical, and it applies equally to returns as to charges. An extra return of 1% per annum ‘does not sound like much’. Charges of 1% per annum ‘do not sound like much’. But mathematically they mean the same and the consequences are equally significant, particularly over the long term. And ‘long term’ means saving for your retirement when you are young.

You should:-

• Favour fixed charges, not ad valorem

• Make sure your terms do not allow later switching of charging terms

• Make sure your terms do not lock you in