Investment Fees Can Invalidate The 4% Rule

The 4% Rule has helped generations of retirees estimate how much they can spend each year in retirement. What many don’t know, however, is the role investment fees played, or didn’t play, in the creation of the rule. For example, does the rule still work if a retiree pays an advisor 1% a year in fees? Does it work if a DIY investor pays mutual fund fees of 1% or more?

In this article, we’ll look at five key things every investor should know about the 4% Rule and investment fees. 

1. The 4% Rule Ignores Fees

First, the 4% Rule ignores fees. William Bengen, the father of the 4% rule, published his paper in 1994. In his analysis, he assumed the retiree paid no investment fees. In fact, he didn’t even discuss fees in his paper. Instead, he just assumed returns based on large cap U.S. equities and intermediate term U.S. Treasury bonds.

For those who pay no fees, or virtually no fees, Bengen’s assumption works out just fine. But who pays virtually no investment fees?

2. DIY Index Fund Investors are Safe

If you are a do it yourself investor and invest in low cost index funds, relying on the 4% Rule is consistent with Bengen’s analysis and assumptions. To be clear, a DIY investor doesn’t pay an advisor a percentage of their assets (called Assets Under Management, or AUM) for investment advice.

In addition, these retirees invest in very low cost index funds. For example, firms such as Vanguard, Fidelity and Schwab offer index funds that cost 10 basis points or less. Fidelity even offers some mutual funds that don’t charge any expense ratio. While these funds charge a fee in most cases, the fee is as close to 0% as one can get. As a result, these investors can continue to rely on the 4% Rule as developed by Mr. Bengen.

3. Fees Risk Running Out of Money in Retirement

What about everyone else? For those that pay advisors, invest in expensive mutual funds, or both, what happens if they ignore the fees and continue to rely on the 4% Rule?

In short, ignoring fees increases the risk that one will run out of money in retirement. And the increased risk is significant, particularly for those who spend 1% or more in fees. Bengen’s original 1994 paper gives us some insight into the risk.

In his paper, he considered several initial withdrawal rates beyond four percent. In fact, he considered initial withdrawals ranging from one to eight percent. What he found with withdrawal rates of five and six percent are instructive for our purposes. Why? They give us some idea of how investment fees of one to two percent will affect the longevity of a portfolio in retirement.

To be clear, it’s not a perfect analogy. Unlike spending in retirement, investment fees aren’t adjusted for inflation. Because investment fees are typically calculated as a percentage of a portfolio, the actual fees move higher or lower based on the portfolio’s value. Bengen’s analysis, however, still gives us a rough idea of the effect fees can have on a portfolio. So what did he find?

At an initial 5% withdrawal rate, many retirement years he examined saw portfolios exhausted in just over 20 years. Bump up the initial distribution to 6%, and some years saw portfolios run out of money in about 15 years. There were still years where the money lasted 30 years or more. But the number of years where it didn’t grew substantially. More importantly, there’s no way to know in advance whether a retiree picked a “good” year or a “bad” year to retire. In fact, it may take a decade or more into retirement before one knows. And by then, it’s too late.

4. Fees Reduce What You Can Spend in Retirement

For those not comfortable ignoring fees, and good for you, one option is to reduce spending by the amount of investment fees. For example, let’s assume one pays an advisor 1%, and they in turn invest in mutual funds that cost 1%. That’s 2% that comes out of a retiree’s portfolio every year. 

A $1 million portfolio would pay $20,000 a year in investment fees. In year one of retirement, a retiree could spend $40,000 following the 4% rule. In our hypothetical, however, $20,000 of that, or half of the spending allowance, would go to an advisor and mutual funds. In other words, a 2% fee just wiped out 50% of our budget. Even a 1% investment fee would wipe out 25% of what a retiree could spend.

5. Low Cost Options for Investment Help

For those who need investment help, there are low-cost options. Here I’ll list three potential alternatives that would allow a retiree to get some help and still adhere to the 4% Rule.

Low Cost Advisor

The first is a low cost advisor. And by low cost, I mean 30 basis points or less. One example is Vanguard’s Personal Advisory Service. It costs just 30 basis points and they invest in low cost index funds. Vanguard’s PAS is not perfect. I think they’ve had growing pains as Vanguard has seen explosive growth. You also can’t meet in person. It’s still a solid option from the pioneer of index fund investing.

Flat-Fee Advisors

Many advisors today offer their services on a flat fee basis, rather than charge a percentage of AUM. Now here we have to be careful. We are not talking about fee-only advisors. While they have a fiduciary duty to their clients, so do flat-fee advisors. The difference is that fee-only advisors charge based on a percentage of a client’s portfolio. A flat-fee advisor charges a flat fee regardless of the portfolio’s balance.

An example of a flat-fee advisor is Mark Zoril of PlanVision. He is not going to manage investments and make trades for his clients. Instead, he’ll provide a comprehensive financial plan including an investment plan. With a recommended portfolio in hand, a retiree can then allocate their portfolio accordingly.

More and more advisors are offering low-cost AUM services, flat-fee services or both. You can find a list of some of these advisors here.

Digital Advisory Services

A third option is to use a digital advisory service, sometimes referred to as a robo-advisor. These are companies that use technology to help with everything from portfolio construction to rebalancing to retirement spending. Two examples are Vanguard’s Digital Advisor Services and Betterment. Both charge low fees and offer tools to help retirees invest their money and take distributions for spending.

Whatever approach one takes, the key is to understand how investment fees affect the 4% Rule. Arguably the best approach is to use low-cost index funds that one manages on their own. For those that need some help, seek out one of many low-cost advisory services.