Think cheap index funds or ETFs have your retirement covered? Wrong.

  • The low-cost index fund and ETF revolution has been great for investors, and the cheapest 20 percent of funds now dominate the race for investor dollars.
  • But overreliance on the "cheap" argument can give investors a false sense of confidence and leave them short of retirement goals.
  • Diversification, tax planning and life situation are critical in selecting investments.
Aging population retirement
Mike Blake | Reuters

Calling someone cheap is not often a term of endearment, but it has become exactly that in the investment industry.

According to Morningstar, more than 95 percent of all U.S. retail investments made since 2005 were in the cheapest 20 percent of products in the market. Responding to that trend, average retail investment management prices have dropped nearly every year since then. Now everyone wants to be heralded as cut-rate and discounted.

But just like being cheap can lead people to buy washing machines and cars that break down more often, bargain-basement financial solutions can also be costlier in the long term.

The reason is, the cost of an investment product or service can be much more than the sticker price alone.

For starters, investors should make sure that investment solutions that take a bare-bones approach to keep costs down are accurately investing their money. In a survey of more than 50 different low-fee retirement solutions, for instance, we found that nearly all of them did not consider a client's income or other investments held by competitors as playing an important role in designing an investment portfolio.

That means these products can mis-invest their client's money, either by exposing their client's to too much risk, potentially subjecting them to costly investment losses, or too little risk in the market, which would possibly limit investment gains for their clients (and their solution providers).

It's akin to a doctor prescribing medicine without first considering other prescriptions a patient is taking, an ignorance that can be costly for patients and investors alike.

Similarly, investors should be mindful of the tax implications of the investment products they use. The tax code is full of guidance about depositing, trading and withdrawing investment money, which can unnecessarily drive up clients' tax bills when ignored in a cheap, no-frills approach.

"It's time to relegate cheap to the same meaning it holds in other industries."

Probably the most important hidden cost investors should be on the lookout for, though, is the level of personalization offered by their investment product or service. For instance, investors should pay close attention to how their investment solution responds to the two most important questions most investors need to answer: When they will likely die, and how much they will spend before then. If clients are not asked a single question about their physical health, it's a good signal that the investment solution is relying on a simple rule of thumb rather than personalized assessments.

That means clients can be put in investment portfolios that do not align with their expected longevity or future spending needs — potentially major costs to clients that are pushed out into the future when it could be too late to make adjustments.

To be clear, we found many expensive financial products that have these same costly features, and our firm uses low-cost index funds and ETFs as the primary investment options in portfolio construction, so our advice is not to ignore fees.

Instead, investors, and their financial services providers, need to be mindful of the true cost of an investment solution. Lower fees are necessary, but by no means sufficient to accomplish that goal.

In fact, we found in a recent study that an average retiree today had a 42 percent greater chance of their money lasting through retirement if they used a less-expensive investment solution that also lowered their taxes, accounted for external income and assets and measured their risk preferences accurately compared to a cheap service that disregarded these cost drivers.

But it is not just the average retiree that benefits from this finer focus on costs. Financial services firms profit as well, since their clients are able to build more wealth and more of their clients' money remains under management over time.

For all of these reasons, it's time to relegate cheap to the same meaning it holds in other industries. Instead, investors and the industry alike should adopt quality as the new term of endearment in financial services. This is a win-win for both clients and their providers that aim to help them reach their goals.

By Matt Fellowes, founder and CEO of United Income

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