The 4% Rule is the well-worn retirement planning advice that one can take a first year withdrawal of 4% from a reasonably well-diversified portfolio (e.g., $40,000 from a $1 million portfolio) and then adjust that annual withdrawal for inflation in subsequent years with considerable safety. The concept is buttressed by several academic studies using historical stock market returns.
Most of these academic studies leave out two important costs; taxes and investment fees & expenses. In worst-case scenarios, these costs could absorb the whole $40,000 annual withdrawal and more for a retiree with a $1 million portfolio.
Federal Income Taxes
Using the worst case assumption of a married couple taking the standard deduction, and all of the $40,000 annual retirement withdrawal being taxed as ordinary income, their 2010 Federal Income Tax liability is just $2,358. And of course, many retirees will get part of their annual withdrawal in dividends or capital gains which are taxed at a lower rate, or a return of capital which isn't taxed at all.
Investment Fees & Expenses
Most investors are familiar with a mutual fund's expense ratio which covers the management and operation of the fund. But they may not realize that the expense ratio doesn't include brokerage commissions that the fund manager incurs on his or her trades, nor the implicit trading costs (e.g., the bid/asked spread, and the market impact costs of acquiring or disposing of a large position in a stock over a short period of time.) These costs may dwarf the expense ratio for a more actively-traded fund.
Money market funds and short-term bond funds typically buy securities directly from the issuer and hold them to maturity. Thus, they don't incur any of the brokerage fees and trading costs that one finds in the secondary market. For stock funds, most of the securities in the portfolio are purchased in the secondary market, so it's important to find a fund with low turnover to keep this trading costs at a minimum. The table below illustrates the implicit trading costs for stocks of various market capitalization.
The Investment Company Institute reported that for 2010 the average US equity mutual fund had an annual expense raio of 1.47% while the top 10% most expense funds had expense ratios of 2.25% or more. The average bond fund had an expense ratio of 1.04% with the top 10% at 1.70% or more. The table below shows the combined affect of both expense ratio and trading costs for several mutual funds.
Fortunately, for the simple two-asset allocation found in most of the academic studies, you can buy low-cost index funds at minimal cost. The table below shows the full cost (i.e., expense ratio, brokerage commission and bid/asked spread) for a portfolio consisting of an S&P500 index fund and a short-term bond fund.
Most financial advisers would argue that a retiree should diversify the stock portion of the portfolio beyond the domestic large capitalization stocks of the S&P 500. You can include foreign stocks as well as mid and small cap stocks by replacing the S&P 500 fund with two Total Stock Market funds at little additional cost.
Modern Portfolio Theory and the work of Kenneth French and Eugene Fama (i.e. the Three-Factor Model) suggest that investment portfolios overweighting small-cap and value stocks outperform over the long run. You could easily assemble a diversifed portfolio of low-cost index funds (such as the one below) at a reasonable cost today. Here's a sample portfolio you can put togther using Vanguard and Bridgeway funds. The portfolio includes foreign and domestic exposure; large-cap, small-cap and micro-cap stocks as well as REITs. The fixed income portion of the portfolio is split between short-term bonds and TIPS.
The chart below compares fees, costs, expenses and "What's Left?" for the three Vanguard portfolios examined.
DFA funds are a collection of "enhanced" institutional index funds managed and marketed by Dimensional Fund Advisors headquartered in Santa Monica, CA. The company has some $230 billion of assets under management (versus $1.6 trillion for Vanguard.) DFA funds are generally well-regarded, but only available to individual investors if they are clients of a DFA-approved financial advisor. Financial advisors typically gain this 'DFA-approved' status after undergoing a selection process and attending a seminar on the advantages of the DFA approach to investing.
The requirement that a client hire a DFA-approved advisor in order to buy DFA Funds adds two additional layers of expenses for investors: the advisor's fee, and the Custodian's transaction costs. Below is a sample DFA Fund portfolio. DFA has slightly lower trading costs than Vanguard, but DFA's expenses ratios are about double Vanguard's.
Unfortunately, adding a financial adviser to the mix can add a great deal of cost to the equation. The chart below shows what our millionaire retiree has left after fees, costs and expenses for several DFA advisors. FPL Capital Management of Metairie, LA is the lowest cost DFA advisor on the list. FPL will manage a portfolio of any size for a $1,000 annual fee as long as you choose one of their 10 standard core asset allocations. My favorite high-fee DFA advisor is Mark Matson of Mason, OH. In addition to managing over $3 billion of client's assets, Mr. Matson runs a thriving business teaching financial advisors how to extract ever larger fees from their customers using his Million Dollar ModelTM -- sweet work if you can get it.
Indeed, if you're withdrawing 4% for your living expenses and letting your mutual fund manager and investment advisor take another 3% for a total of 7% of assets annually, historically there is less than a 50/50 chance your money will last 30 years. Limiting the investment costs to 0.25% of assets or less allowed a 4% retirement withdrawal to survive for 30 years in every payout period examined from 1871 to 2006. As Warren Buffett once observed, "The average investment manager adds nothing,' Buffett said. `He subtracts something from your investment performance. It's almost unique among professions that I can think of.'
Resources for more information
Bengen, William P, “Determining Withdrawal Rates Using Historical Data”, Journal of Financial Planning, October 1994, pp 171-180, Volume 7, Number 4.
The Hidden Costs of Trading -- NYU Stern School of Business
Evaluation of the biases in execution cost estimation using trade and quote data Peterson, M., and Sirri, E.
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Copyright © 2011 John P. Greaney, All rights reserved.