Compound Interest Explained: Charges

Compound Interest Explained: Charges
Sharm El Sheikh Egypt by Julian Cohen. Why?

The upside to spreading your investment is that it can reduce risk. So what's the downside?

(First published 12 December 2012)

When it comes to your SIPP, spreading your investment can come at a cost.  Arguably, two costs.

  • 1. Spreading Your Investment Can Increase Your Charges
  • 2. Spreading Your Investment Can Reduce Your Return

Let’s Consider This With An Example

  • You have £100,000 to allocate from within your SIPP
  • You’ve chosen to invest for a five year period
  • You want the annual interest paid into your SIPP

1. Spreading Your Investment Increases Your Charges

You’ve heard that ‘putting all your eggs in one basket’ is a bad thing.  So instead of putting it all into the one investment, you consider spreading it across five investments, putting £20,000 into each. 

For the purposes of this illustration, each of the five investments is exactly the same, earning you 13 per cent per year.

Your SIPP operator will normally charge for each investment you make.  Here’s a typical set of fees:

  • You’ll pay a set-up fee of £300
  • You’ll pay an annual fee of £200 to receive the interest, check it’s correct and bank it

The following tables compare a single investment with spreading it equally across five investments.

Single Investment Of £100,000

Interest Received: £65,000

SIPP Charges: £1,300
A set-up charge of £300 and five years of handling the interest at £200 per year.

Your Net Interest Is £63,700

Five Investments Of £20,000

Interest Received: £65,000

SIPP Charges: £6,500
It's the same charges as the single investment, for each of your five investments.

Your Net Interest Is £58,500

Spreading your investment has cost you £5,200.  It’s reduced your overall income by more than 8 per cent.

How To Reduce Your SIPP Operator Charges

Instead of selecting a SIPP operator that charges from a menu, you might well be able to save money by selecting a SIPP operator that charges a fixed annual fee, like a full SIPP.

2. Spreading Your Investment Can Reduce Your Return

In the real world, it’s almost impossible to find five SIPP approved investments that pay exactly the same return.  What’s more likely is that you’ll have to accept a range of returns.

Let’s assume you find five similar five year investments paying 9 per cent, 10 per cent, 11 per cent, 12 per cent and 13 per cent.  Like most people, you’d be willing to accept what seems like a smallish reduction in interest rate, because if one of them goes wrong, you won’t lose everything.  It’s a small price to pay.  Or is it?

Here’s a summary of the calculation for each investment, over the five year term.

compound-interest-charges

By accepting what feels like relatively small reductions in interest rate, it’s reduced your net income from £58,500 in the pink box above, to just £48,500.  That’s 17 per cent less income. 

When you compare five investments to one investment at the best rate in the blue box above, you could be almost 25 per cent down.  From £63,700 to £48,500.

Spread your investment in the real world, and more often than not, you'll find charges and compound interest will work massively against you.

What’s more, it could be argued that you’ve increased your risk.  For now you’re hedging your bets on five investments rather than one.  You see, there's absolutely no guarantee that an investment paying 9 per cent is lower risk than an investment paying 13 per cent.

Here's the point.  If the highest earning investment 'does what it says on the tin' and pays you all the interest due, yet one of the others fails, you’ll significantly lose out.

What Do The World’s Most Successful Investors Do?

Ben Graham

Ben Graham, author of The Intelligent Investor, is known as "the father of value investing". He excelled at making money in the stock market for himself and his clients without taking big risks.

Graham created and taught many principles of investing safely and successfully that modern investors continue to use today. His investment choices were always based on diligent, almost surgical financial evaluation. In short, he used to ‘invest by the numbers’.

 

Warren Buffett

Warren Buffett credits Graham with providing the foundation for his career. But Buffett often became frustrated with Graham’s insistence on focusing on ‘just the numbers’, and disregarding management evaluation or other qualitative analysis. 

Diversification was another key area on which they disagreed. Graham was a staunch advocate of diversification. He believed it was necessary to allocate relatively equal amounts to a large group of stocks with similar characteristics.  Whilst some might die, in aggregate, the insurance bet would pay off.

Buffett on the other hand, analysed qualitatively, feeling he could gain an edge by doing more in depth research.  He visited companies, talked to management and considered the actual prospects of the business.  But he did this alongside Graham’s technique of analysing the numbers. And when he invested, he invested big, rarely spreading his investment.

History shows both men were incredibly successful investors. But Buffett was spectacularly more so.

“You Pays Your Money, And You Takes Your Choice”

Whether you follow Graham or Buffett or someone else is largely academic.  What won’t surprise you to learn is that throughout history, successful investors all do one thing very well.  Detailed due diligence!

And a big part of due diligence is knowing the true effect that compound interest has on diversification and on charges.

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AJ Bell Is Often The Best Value SIPP For Stockmarket Assets

That's our opinion.  Not just because AJ Bell was the first company to offer an online SIPP.  Nor that it's received many prestigious awards.  And not even because the wife of SIPPclub's Founder has an AJ Bell SIPP.  It's because it's one of the most competitive stockmarket SIPPs on the market. 

Over time, charges can wipe out a huge part of your fund.  We like AJ Bell because there are no set-up costs.  If you hold passive funds, which is our preference, or shares, investment trusts, EFTs, gilts or bonds, you pay one small fixed fee no matter how large your fund.  And when you come to draw your benefits either as occasional drawdown or UFPLS payments, there's a small charge for the whole year no matter how many times you access your money (many SIPP and SSAS providers charge more than this for each payment).  However, you should always compare charges in detail, because AJ Bell could be more expensive than other providers, depending on the type of stockmarket assets you hold.

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