This article was first posted on October 1, 1998. Last update on April 12, 1999
How do mutual fund fees and other investment expenses effect the maximum safe withdrawal rate in retirement ? High fees and commissions can place a big drag on the performance of your investments. If your investment expenses are too high, they may even prevent you from retiring at all.
Table One shows the maximum 100% survivable inflation adjusted annual withdrawal, for various levels of investment expenses. (See, "How do I calculate my investment expenses?" The maximum 100% survivable inflation adjusted annual withdrawal is the largest sum that can be withdrawn from the portfolio each year yet still have the portfolio survive to the end of the 30 year pay out period. This analysis is based on historical stock market returns from 1871 to 1998 collected by Yale University Professor of Economics Robert J. Shiller. The study assumes a 30 year pay out period and a portfolio of 75% stock and 25% fixed income securities, rebalanced annually. The annual withdrawals are adjusted annually for inflation / deflation. The table also shows the median and 25th percentile terminal values of the portfolio at the end of the 30 year pay out period. (Note: The 25th percentile terminal value is the value that is exceeded by 75% of the 30 year pay out periods considered.) For the details of how this study was conducted, click here.
An expense ratio of 0.02% would only be achievable on a "do-it-yourself" basis. This would mean using direct purchase bank CDs or US Treasury securities for the fixed income portion of the portfolio and a diversified collection of 15 to 20 S&P500 stocks bought through a deep discount broker for the stock allocation. You should have an account value of at least $100,000 before attempting this strategy. (See,"Should I invest in mutual funds or individual stocks and bonds.") Less than that, and an index fund would have less fees and less headaches.
Using a low fee mutual fund provider such as Vanguard , USAA, or TIAA-CREF should allow you to assemble a portfolio with an expense ratio approaching 0.20%. A short to intermediate term US Government bond fund could be used for the fixed income portion while the popular S&P500 index fund would be a good choice for the stock portion. Even retirees with sizeable portfolios (i.e., more than $200,000) may prefer this approach since it requires little ongoing maintenance.
The average mutual fund has an expense ratio of more than 1.00%. If you're paying anything close to this you should seek out some of the low fee alternatives. Not only will this allow you to increase your "100% survivable" annual withdrawal, but the terminal value of your portfolio will be higher as well. If you started with $1 million, you have an even chance of being $800,000 richer at the end of 30 years if you use an index fund with a 0.20% expenses ratio rather than an actively managed fund with a 1.00% expense ratio.
High fees and commissions really hurt.
You would probably have to have a variable annuity, a "wrap account" with a full service broker, or a financial planner charging a fee of 1% of assets in addition to your mutual fund management fees to reach an expense ratio of 2.50% or more. You'll also need to be very wealthy if you expect to retire. These types of fee arrangements will easily reduce your "100% survivable" annual withdrawal by 1% or more. As Table One shows, that's a 25% to 50% reduction in retirement income compared to what you could have safely withdrawn from an index fund. The terminal value of your portfolio will also be far lower (50% to 72% lower!) under this scenario.
If anyone tries to sell you any of these high fee "investment products" - RUN! If you're already in a variable annuity, surrender charges and the tax consequences of switching out may mean your trapped. Consider putting any new retirement savings in a low fee alternative. If you're in a "wrap account" or have a financial advisor charging 1% of assets rather than a hourly fee, you really need to evaluate the wisdom of that arrangement.
Earlier this year Forbes magazine had an article about dangers of annuities. (See, "Forbes Magazine - The Great Annuity Rip Off (02/09/98).") It whipped up quite a bit of controversy and elicited a flood of letters from irate annuity salesmen. (See, "Forbes Magazine - Letters to the Editor (03/09/98).") Both the Forbes article and the letters to the editor are well worth reading.
Forbes magazine also had a very enlightening article on financial planners. (See, "Forbes Magazine - Bedlam (06/15/98)" Forbes hired five highly recommended and impressively credentialed financial advisors to prepare a comprehensive financial plan for a 52 year old executive with a net worth of about $2.0 million. The fees charged for preparing these plans ranged from $1,500 to $3,500. Forbes also prepared a plan for our executive using Intuit's Quicken Suite 98 (Retail cost after rebate: $70.) Not surprisingly, the advice ranged all over the map. One planner said put 76% of assets in stocks, another only 20%. The Quicken software advised an asset allocation somewhere in between. The moral of this story? It's important for investors to understand that like soothsaying and tarot card reading, financial planning is not a science. As a result, you shouldn't overpay for these services.
What's the most reasonable interpretation of this data ?
Minimizing expenses is one of the surest paths to investment success. Since most mutual fund managers and "financial advisors" under perform the S&P 500, it doesn't make sense to pay a lot for their "expertise." Even a 0.50% management fee costs a lot in terms of reduced retirement income and the eventual size of your estate. Spending the small amount of time required to learn about financial markets and managing your own retirement assets should reap significant rewards.
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Copyright © 1998 John P. Greaney, All rights reserved.