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How to Retire on Half as Much Money

Over the last ten years or so, there’s been a great deal of discussion about what constitutes a “safe withdrawal rate” during retirement. The most common rule of thumb (resulting from the famous “Trinity Study“) is to start with a withdrawal rate equal to 4% of your portfolio value on the day you retire, and adjust your withdrawals upward each year for inflation.

Using the 4% rule, the amount you need to have saved in order to retire is 25 times your annual investment-funded spending needs (that is, spending needs not already met by social security income or part-time job income).

Adjusting for Costs

The catch is that the Trinity Study doesn’t account for investment costs at all. It assumes that investors receive the entire return earned by the market. Not exactly the reality for most investors!

According to Deloitte, 401(k) administrative fees average roughly 0.72% per year.

According to the Investment Company Institute, fund expense ratios and sales loads together constitute an average annual cost of 0.99% for stock funds and 0.75% for bond funds.

According to data from the Investment Technology Group cited in Bogle’s new Common Sense on Mutual Funds, portfolio turnover costs average approximately 1.6% annually for equity funds. (I’d guess that it’s lower for bond funds, but I can’t find any good data either way.)

When you add all that up, it’s not hard to imagine an investor paying roughly 2% per year in investment costs. If you’re paying 2% per year, that 4% withdrawal rate won’t be “safe” in any way. You’ll need to look at something closer to a 2% withdrawal rate.

…and at a 2% withdrawal rate, you don’t need to save 25 times your annual spending needs. You need to save 50 times your investment-funded annual spending needs before you can retire retire.

Frugality Where It Counts

Since the economic downturn began a little over a year ago, frugality has been trendy to write about. I think that’s wonderful–I’m all for living a simple lifestyle and cutting costs where you can.

But there are few things you can do that will have as much of an impact on your financial future as being frugal with your investing. Two easy changes can literally halve the amount of money you’ll need saved in order to retire:

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  1. Excellent advice. Thank you.

  2. Mike,

    Good job here. You are right…all the studies show a withdrawal rate based on index investing. If 80% of the funds perform worse than the index (because of fees partially), we have a problem.

    One way to reduce the “drag” is, as you suggest, go with the low-cost funds.
    I think it’s important however to remember that reported results are always net of fees. So, if an investor is comparing an actively managed fund with a passive fund, s/he can look at the reported results and know that the returns are shown net of fees.

    Anyway, this is a very important point you bring up and one that has been completely ignored. Bravo!

  3. Mike,

    That’s a great point- I’ve often heard the 4% rule but I wasn’t aware it didn’t include investment fees. When it comes to investing over the long term 1% is a big difference, 2% is gigantic! People just don’t really get compound interest but even as small a difference as 0.75% over many years can make a difference of hundreds of thousands because interest rates matter a lot!

    -Rick Francis

  4. I always enjoy how you’re able to fill in the blanks in the areas that we sometimes ignore e.g. avoiding 401k fees and including fees in the 4% withdrawal.
    One thing I wasn’t sure of though was the 1.6% due to turnover. I rememeber reading somewhere (either here at your blog or in a book or something) where turnover ratio was believed to add like 10% of the turnover rate or something like that so I was wondering if the 1.6% was also based on that assumption? I’ll try to research where I read that, but I thought you might have seen that somewhere as well.

  5. Hi Damilola.

    The 1.6% figure comes from the Investment Technology Group’s estimate that each transaction results in costs (market impact, plus any commissions, plus bid/ask spread) equal to 0.8% of the value of the transaction.

    Combining that with figures regarding portfolio turnover (available via Morningstar) that show that actively managed funds turnover their portfolios at a rate of roughly 100% per year gives us a total cost of 1.6%.

    (The reason the figure gets doubled is that we assume that for each time something is liquidated, the funds are reinvested–two total transactions. Or, if there was 100% turnover, an amount equal to 100% of the portfolio was sold, and an amount equal to 100% of the portfolio was bought.)

  6. Good commentary. It’s too easy to ignore the real cost of investment expenses, both while saving for retirement and when withdrawing our investments for retirement. An impressive amount of supporting evidence, as well.

    Speaking of good posts, this one was chosen as second best for the latest edition of the Best of Money Carnival. You can catch your fellow good contributors here: Thanks for the contribution, and keep up the great work.

  7. In regards to turnover, I also noticed that index funds also have turnover rates e.g. 5.6% for VFINX, although at a much lower rate than actively managed funds. Are these from transactions that keep the fund in line with the index that they are following? And if that were the case, how often do indexes change their ratios because I assumed that they kept a fixed amount of stock forever, unless a certain stock was removed and another added.
    Now that assumption might be WAY off base, but perhaps you might be able to shed some light on that.

  8. Are these from transactions that keep the fund in line with the index that they are following?

    Yep. The stocks in the S&P 500 change over time, so index funds that track the S&P 500 must also make portfolio changes over time.

    As to the weighting of a given stock within an index, nearly all stock indexes are market-cap-weighted. As a result, an index fund doesn’t really have to do much to keep the weightings correct. (That is, it’s not as if Standard and Poors suddenly decides to double the weight of AT&T in the index, thereby causing each fund to have to double up on its AT&T holdings.)

  9. Thank you for a wonderful article.

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