What are Foregone Earnings?
Foregone earnings are potential earnings that could have been achieved, but are absent due to charged fees, expenses or lost time. An example are the investment costs incurred by an investor paying fees such as management fees for a mutual fund or exchange-traded fund (ETF) investment or commissions to a stock brokerage firm.
The term “foregone earnings” is a lost opportunity or opportunity cost as the investment capital that is lost to fees could have also generated additional return.
Foregone earnings are also referenced in the context of employment. It usually refers to earnings foregone by choosing to attend a college or university full-time or by taking an extended period of time off from work – such as when a mother chooses to take maternity leave to stay at home and take care of her children.
- Foregone earnings describe potential investment earnings that could have been obtained if their investment charged no fees or expenses.
- The concept of foregone earnings is important because it points out the true cost to investors that investment fees, and lost reinvestment income represent.
- Foregone earnings also describe when one chooses to give up potential income for a lesser actual amount, such as when a person leaves a salary job to go back to school or to raise children.
Significance of Foregone Earnings
Many investors do not realize the full impact on their investment returns that investment fees have. Typical mutual fund sales or management fees of 1%-2% may appear relatively insignificant, but over the long term, they have a substantial negative effect on investment returns.
Assume that you invest $10,000 in a mutual fund that charges an annual management fee of 2%. This means that $200 will be deducted from your total investment capital each year. Now, assume that your mutual fund investment generates an average annual return of 8%.
At the end of 10 years, you will have paid $2,000 – 20% of your original investment – in management fees. But to calculate what those fees have really cost you, you must consider how much more money your investment could have earned if all the money that went to fees had instead been generating an 8% annual profit along with the rest of your investment capital.
In this case, the potential lost additional income is $1,560.88. The figure is calculated by totaling the compound interest on the $200 added each year for 10 years.
Therefore, the real total cost of the seemingly insignificant management fees over 10 years is not $2,000 but $3,560.88 ($2,000 + $1,560.88) in foregone earnings.
In fact, the true amount of foregone earnings would be even higher because the 8% annual return on your investment would increase the absolute dollar amount of the 2% management fee charged each year.
However, we assumed a constant annual management fee in this example.
Foregone earnings are highlighted so that investors can make informed decisions on their investment alternatives and to ensure they seek out investments that maximize returns by minimizing investment costs or foregone earnings.
Earnings Foregone through Education
As the cost of higher education has skyrocketed over the past couple of decades and many graduates have found themselves burdened with staggering amounts of student loans, the impact of foregone earnings when pursuing a university degree has become more important.
Foregone earnings are, in this context, essentially an extra cost of higher education. They represent the income that an individual might have earned by being employed full-time for four years rather than spending that time pursuing higher education.
In short, the true cost of attending a university for four years to get a degree is not merely the university tuition and other associated costs, but includes all the money that could have been earned during four years of full-time employment.
Of course, one must offset that cost with the gains from a higher earning potential obtained by getting a university degree.
Foregone earnings are also referenced with entering the full-time workforce and taking an extended period of time off from work. In this context, you have to consider both lost wages and how the time off from work may impact your future earnings after you return to work.
For example, after taking a year or two out of the workforce, it may require two years of working when you return to obtain a promotion and raise that you might have gotten within one month had you stayed in the workforce.
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