If you know what an expense ratio is, you might prefer to skip this page. However, if you know what it is, but think an expense ratio is the only way you pay for your mutual fund, read on...
This discussion is oriented towards retirement (403(b)) variable-annuity customers. Much of it applies to all mutual funds, but since TIAA-CREF has developed a large number of new products since 1997, you should understand that I'm talking primarily about CREF's flagship product. That is, a tax-deferred account (like an RA, SRA, or IRA) which invests in the largest and most traditional CREF product, the "CREF Stock Fund".
It costs money to run a mutual fund. There's no way around that. The primary way we (customers, participants) pay for our mutual fund operations is visible (with difficulty!) through the expense ratio. (Brokerage houses, particularly, sell "Load" funds, which are not the subject of discussion here.)
Because the daily expenses of a mutual fund (offices, employees, utilities, and so on) are subtracted from the value of the stocks and other assets, before the daily "net asset value" per share (or as we say at CREF, "Accumulation Unit Value") is calculated, you might never see them. If you're like most mutual fund investors, you haven't seen them!
If you take the total expenses for the whole year, and divide that by the Average Net Assets (roughly, all the investments the fund owns minus the money the fund owes anyone, averaged over all the days the stock market was open that year), you get the Expense Ratio.
Why is it expressed as a ratio? First of all, the dollars spent (and subtly billed to us) are spread over the shares and dollars invested in the fund. The dollar amount alone would not express how much each customer/participant pays for expenses. A second reason is that it provides a number which can be used to compare two different funds. It also makes it clear that the management company will benefit if the fund is attractive enough to attract more dollars, and is well-managed enough that the assets grow in value, even without additional investments. By taking the ratio with respect to average net assets for the year, it becomes meaningful to talk about numbers that actually vary all year long.
For example, no one can actually have a $10,000 balance in a mutual fund all year long. But the $10,000 example (see below) is one of the biggest improvements the SEC has made in mutual fund reporting in recent years. It's much easier to understand than an expense ratio!
If you read the semi-annual or annual report, or the prospectus carefully, you can find the expense ratio listed in a table that looks like this:
STOCK ACCOUNT
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------------------------------------------
2002 2001 2000 1999
--------------------------------------------------------------------
PER ACCUMULATION UNIT DATA:
Investment income $2.476 $2.432 $2.472 $2.567
Expenses .638 .693 .626 .607
-------- -------- -------- --------
Investment income-net 1.838 1.739(a) 1.846 1.960
Net realized and unrealized
gain (loss) on total
investments (35.535) (27.951)(a)(19.231) 34.478
-------- -------- -------- --------
Net increase (decrease) in
Accumulation Unit Value (33.697) (26.212) (17.385) 36.438
Accumulation Unit Value:
Beginning of year 162.513 188.725 206.110 169.672
-------- -------- -------- --------
End of year $128.816 $162.513 $188.725 $206.110
======== ======== ======== ========
Total Return (20.73)% (13.89)% (8.43)% 21.48%
Ratios to Average Net Assets:
Expenses 0.44% 0.41% 0.31% 0.33%
Investment income-net 1.28% 1.03%(a) 0.91% 1.07%
Portfolio Turnover Rate 31.19% 29.41% 32.65% 29.26%
Thousands of Accumulation
Units outstanding at end
of year 493,295 508,889 525,111 543,589
- -----------------------------------------------------------------
There's lots of interesting and important material here, relating directly to how pleasant your retirement may or may not be! For now, we're looking at "Ratios to Average Net Assets: Expenses". This is made up of several sub-components that you can read about in the footnote section of this page if you're interested.
This number is the actual (that is to say, historical) expense ratio, in this case, for the calendar year. Note that the most recent data available are from 2002. That's because this is the May 1, 2003 Prospectus for the CREF Stock Fund. The prospective rate for 2003 is in a later table, with the slightly higher number 0.48%, which you can also see on the 2003 inserts with your quarterly statements.
(There's a small window open to 2003, since the 2003 Annual Report [but not yet the 2004 Prospectus] was posted in March, 2004. (You can also find this on the SEC/EDGAR web site, but the .pdf file on the TIAA-CREF site is a much smaller download. The actual [historical] expenses in 2003, as a Ratio to Average Net Assets were a whopping 0.52%!)
If you use this number, remember that it's a percent. So the number in the first column is actually .0044 . If you had $10,000 in the CREF Stock Fund in 2002, you expected to pay $44 for the basic expenses of the fund for 12 months. But wait, there's more! This does not include brokerage commissions.
You can stop here, but there's more below if you want to continue.
Looking in another May 1, 2003 document, The Statement of Additional Information (however, in most of the SEC filings I looked at, it was in the same data file as the Prospectus), we find the text statement (not a table-that would be too easy to find...):
"The aggregate amount of brokerage commissions paid by the Stock Account during 2002, 2001, and 2000 was $61.7 million, $71.7 million, and $78.4 million, respectively."
Although we'd like to know the Average Net Assets for 2002, the best we can do from the documents available is an approximation. This is done by using the Annual and Semi-Annual Reports to learn the January 1, June 30, and December 31 Net Assets. Averaging those three numbers for 2002, we get $87.4 Billion. (CREF can average 250 or so numbers, one for each day they value the Accumulation Unit.) The brokerage commissions, as a percentage of (rough) average net assets are 0.07%. That may seem like a tiny percent, but after all, it's $61.7 million dollars, isn't it? And not too long ago, we were paying 0.08% of Net Assets for all of the Investment Management we bought for our well-run fund!
What's more, $25.4 million, or 41% of those 2002 commissions were "Brokerage Allocation" dollars. That means, to oversimplify it, CREF paid them for securities transactions with the understanding that the brokers "might" charge more than the going rate because they are going to provide goods or services, as well as the execution of the ordered trade.
I hasten to add that this does not mean a new room for someone's house, or a dinner at a steakhouse. It means research reports or perhaps a Bloomberg video terminal service. (Theoretically, it could also include a cappucino machine, with paper cups imprinted "Best Brokers In Town, Trade at *********".) The problem is that these expenses are "really" either Investment Management or Administrative expenses. But you can't find them there; They are in a primarily verbal paragraph, in the Statement of Additional Information, once a year.
This is often called "soft money", because they transfer our assets to the fund's vendors, in the guise of buying a different product (namely, execution of securities trades). There is a small chance that the SEC or Congress may prohibit Brokerage Allocation because of the mutual fund scandals. We'll see. You can read more about hidden mutual fund costs in an interesting 2004 report by The Zero Alpha Group.
Now in fact, 0.44% is a relatively low Expense Ratio compared to the average mutual fund. That's especially so because Annuities are more costly to administer than plain retail mutual funds. On the other hand, the CREF Stock Fund is only 20-40% "actively managed", which is the expensive part of managing a mutual fund. The rest of the fund is "indexed", which means it is managed to match the performance of (for one example) the Russell 3000® index.
Is the preceeding statement reasonable? Well, Vanguard runs an immensely popular, 100%-indexed fund called Vanguard 500 Index Fund Admiral Shares. (not an annuity, however.) To be fair, it has a very large minimum investment (comparable to what people over 55 might have in the CREF Stock Fund...), but the total expense ratio is 0.12% We paid 0.15% for Investment Management alone in the CREF Stock Fund in 2002!
The whole reason I started this site is that for years and years, through double-digit inflation of the 1980s, the expense ratio of the CREF Stock Fund was about 0.32%! The 0.48% figure that's being used in 2003 is a 50% increase between 2000 and 2003!
Elsewhere in the prospectus, the expenses are listed in another way, related to the prospective costs for 2003.
ANNUAL EXPENSE DEDUCTIONS
The following table shows the direct and indirect expense deductions for each of
the CREF accounts.
STOCK
- ------------------------------------------------
PARTICIPANT TRANSACTION EXPENSES
- ------------------------------------------------
Deductions from Premiums (as a
percentage of premiums) None
- ------------------------------------------------
CHARGES FOR TRANSFERS AND CASH WITHDRAWALS
(AS A PERCENTAGE OF TRANSACTION AMOUNT)
- ------------------------------------------------
Transfers Between CREF Accounts None
- ------------------------------------------------
Transfers to TIAA None
- ------------------------------------------------
Transfers to Other Companies None
- ------------------------------------------------
Cash Withdrawals None
- ------------------------------------------------
ANNUAL EXPENSE DEDUCTIONS FROM NET ASSETS
(AS A PERCENTAGE OF AVERAGE NET ASSETS)
- ------------------------------------------------
Investment Advisory Expenses 0.150%
- ------------------------------------------------
Administrative Expenses 0.280%
- ------------------------------------------------
Distribution Expenses 0.045%
- ------------------------------------------------
Mortality and Expense Risk Charges 0.005%
- ------------------------------------------------
Total Annual Expense Deductions 0.480%
=====
This gives us a window on the constituent parts of the total expense ratio we found in the first table.
Investment Advisory Expenses are, for example, the costs of wisely selecting securities to buy and sell. This ratio (not the actual dollars) has nearly doubled from 2000 to 2003. The general reason is that both the number of Accumulation Units and the amount of money in the CREF Stock Fund have decreased over those years, but the Investment Advisory Expenses have remained roughly level. Since the CREF Stock Fund, in effect, guarantees that our Investment Advisory subsidiary will not lose any (that is, of their!) money (see below), one could suggest that they don't have much incentive to economize when the stock market tanks and customers flee.
Administrative Expenses are, for example, office rental. (I suspect that they also include last year's party in the Whale Room at the American Museum of Natural History, and the support we're giving to bicycle racing teams and WGBH's "Car Talk" this year.)
Distribution Expenses (derided by investment columnists under their formal name of "12b-1 Fees") are "... for telling you about the certificates, how you can invest, and helping employers install and manage retirement plans." I intend to ask at an annual meeting whether any Distribution Expenses are paid to any non-TIAA-CREF employees. I hope the answer is no, but most mutual funds with 12b-1 fees do use them, in part, to compensate outside representatives (typically stockbrokers or financial planners).
The Mortality and Expense Risk Charge is "...to guarantee that CREF participants transferring funds to TIAA for the immediate purchase of lifetime payout annuities will not be charged more than the rate stipulated in the CREF certificate." Normally, these charges are made for annuities that have an insurance component. That is, the ones that guarantee your heirs either the amount you put into them (regardless of poor stock market results), or guarantee something like the money you put into them plus some small rate of earnings. However, one reason the CREF Stock Fund is relatively inexpensive is that we have no such guarantee. I happen to prefer that, but there's no reason everyone should agree.
Obviously, no business knows at the beginning of the year, precisely what their expenses will have been by the end of the year. The CREF funds have an unusual clause in their prospectus: At the end of each quarter, the expense charges that were collected are compared with the actual expenses incurred by the fund. The excess (or deficiency) is gradually collected through the following quarter. To be fair, this saves us from having to pay an expense risk charge to cover the chance that the expenses won't be covered. That's saved us money for many years. But we're paying quite a lot now!
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