Wrong mutual fund can rob years of retirement income

You may not know it, but there's a class system inside your investment portfolio.

At least there is if you own mutual funds, as nearly 55 million households do. Mutual funds are frequently divided into share classes, which essentially means different fee levels. The same fund — with the same manager, investment holdings and performance — may come at a significantly different cost, depending on the share class you're in.

THE DIFFERENCE A LETTER MAKES

All mutual funds carry expense ratios, an annual fee taken out of your investment each year. The expense ratio is charged as a percentage of your investment, and the amount varies by fund.

What mutual fund share classes indicate is whether and how a fund levies a sales charge. Often called a sales load, this cost is paid by you and passed on to investment advisers or brokers as a commission. Share classes are represented by a letter, which is shown on your account statements and in the fund's prospectus.

If you're investing through a 401(k) at work, you may have access to either R shares — available to retirement plans — or institutional funds, called I shares. Both typically waive sales loads. An online brokerage account or individual retirement account you manage yourself should also give you access to a list of no-transaction-fee funds that avoid commissions.

If you work with a full-service broker or financial advisor, however, you might see an A, B or C next to your fund's name. Assets in B shares have recently fallen significantly in recent years, but A and C shares are still common today. All three letters indicate a sales charge.

HOW MUTUAL FUND SALES CHARGES WORK

Mutual fund sales charges can show up in a few ways: As an upfront cost when you purchase the fund, as a fee when you sell the fund or as part of a fund's expense ratio.

Investors in the C share class of a mutual fund will see the latter: A marketing and distribution fee — called a 12b-1 fee — of up to 1%, charged on an annual basis as one part of the fund's expense ratio. That 12b-1 fee can make C shares an expensive choice for investors who plan to hold the fund long-term, as the cost compounds over time.

Investors in a mutual fund's A share class pay a sales load as an upfront cost, called a front-end load. An A share might also carry a 12b-1 fee, though it will generally be lower. Those who invest large sums may get a break on some or all of an A share's upfront commission. Unless you plan to invest in the fund for only a few years — and mutual funds are typically long-term investments — you'll save money in an A class.

"Each share class is generally going to represent the exact same ownership interest in that mutual fund, but your take-home return is going to be less in a C share than in an A share," says James W. Langston Jr., the president of Fiduciary Integrity LLC, a consulting firm that helps investors find and minimize mutual fund and annuity fees.

THE LONG-TERM IMPACT OF FEES

Fees are one of the biggest drains on your retirement savings. On a $200,000 one-time investment, the difference between a 0.25 percent annual fee and a 1 percent annual fee totals over $210,000 after 30 years, assuming a 6% average annual return. If you pay a front-end load, a percentage of your initial investment goes toward that cost rather than into the fund, meaning that money doesn't make it into the market at all.

To keep fees low, look at expense ratios and load charges before you invest — never assume an investment is inexpensive, even if it is offered within a retirement account. Often the lowest-cost options are index funds, exchange-traded funds or open-end mutual funds, which are bought directly from the mutual fund company.

If you'd prefer to work with an adviser who selects investments for you, find one you trust — preferably who isn't paid by commission — or open an account at an automated investment adviser (often called a robo-adviser).

Above all, understand what you're paying and why, says Russel Kinnel, director of manager research at investment research company Morningstar, and choose the most economical share class. "The overriding principle is that you want low-cost funds, and finding the lowest cost share class available to you within a fund is a piece of that puzzle."

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