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Retirement Income and Portfolio Expenses

For years you have been accumulating funds for your retirement. When your retirement date finally arrives, it is time to withdraw assets to pay for the retirement phase of your life. Developing a Safe Withdrawal Rate (SWR) is the single most important decision you will make regarding your retirement assets. Before getting into SWRs I wanted to discuss the impact of portfolio expenses on retirement income.

In a previous post I discussed how mutual fund management fees detract from your long term returns of your portfolio. In that post I discussed how paying an average of 2% fund fees versus 1% for the same funds can reduce your overall portfolio balance as much as 20% over 25 years (e.g., $600,000 is reduced to $480,000). I suggested if you are currently using expensive funds in your IRA accounts (such as those run by the big banks), that you consider moving your retirement assets to a less expensive mutual fund family such as Vanguard, Fidelity, or Schwab. Many people do not pay attention to these fund management fees because they are (I think purposely) not disclosed in a very transparent way. In this post I will talk about portfolio expenses in the context of retirement portfolio withdrawals. This discussion should really open your eyes to the importance of portfolio expenses.

In another previous post I described the 4% SWR. I mentioned that any income taxes or investment management fees must be taken out of this 4% withdrawal figure (or whatever SWR you decide to use). Below I show an example of how income taxes, fund management fees, and paying someone else to manage your portfolio impacts your SWR.

For this example let’s make the following assumptions:

• You have a total of $800,000 accumulated in different traditional IRA accounts.
• Your SWR is 4% which translates into a $32,000 withdrawal as ordinary income.
• You are in the 15% marginal federal tax bracket and 5% state income tax bracket totaling 20% marginal tax rate.
• Your retirement assets are invested in “Managed” funds paying the industry average fund fee of 1.4% per year.
• You are paying an investment advisor to manage your assets and they charge you 1% per year of your assets for this service.

In your first year of retirement using 4% as your SWR you are allowed to withdraw $32,000 from your retirement accounts. But $32,000 is not what you get to spend. This $32,000 withdrawal needs to be reduced by taxes and portfolio expenses. Here is the math:

As the table shows, after considering taxes and portfolio expenses, your funds actually available to spend are a lot less than $32,000. Believe it or not there are a lot of people for which these assumptions are very real.

To be clear the 1.4% fund management fees and the 1.0% investment advisor fee are not deducted from the $32,000 withdrawal. These fees are subtracted from your total portfolio by your fund broker and your investment advisor usually once per year. As such these fees are not obvious to the investor and are easily overlooked. But, when determining the SWR, all the industry studies assume the SWR is a gross figure. That is, ANY annual reduction of the total portfolio value must be included in the withdrawal amount when determining the portfolio’s longevity. This includes income taxes and any portfolio expenses in addition to the amount needed for spending.

In our example, if you need $32,000 after tax funds to live on, you are effectively reducing your total portfolio by $57, 600 ($6,400 + $11,200 + $8,000 + $32,000) which is over 7% of the $800,000 retirement portfolio. Withdrawing over 7% of your portfolio at the beginning of your retirement and increasing it by inflation each year means you will have less than a 50% chance that your portfolio will last 30 years. Is this a chance you want to take? For most people I don’t think it is.

In future posts I will discuss strategies on how one might initially withdraw slightly more than 4% of their portfolio. The message of this post however is, unless you can live on 1% to 2% of your portfolio value, it is imperative to lower your tax and portfolio costs as much as possible. How does one do this? I will summarize what I have discussed in previous posts:

1. Get yourself up to speed on portfolio management ASAP and get rid of your investment advisor if you have one (a good start is to read Post #1 through Post #24 of this blog).
2. Move most of your money out of “managed” funds (this includes both stock and bond funds) and into index funds which charge much lower fees; there are now index funds for almost every asset class.
3. If necessary, move all your retirement assets to a lower cost fund family.
4. Withdraw your retirement funds in a tax efficient manner (this will be the topic of a future post).

If you did the above listed steps, you could reduce your average fund fee to about 0.25% with no investment advisor’s fee. In the above example this would reduce your annual portfolio expenses from $19,200 to $2,000 (in addition to any income taxes). I don’t know about you, but I could use an extra $17,000 per year spending money in retirement. Even if you are now with a brokerage firm that does not have a good mix of inexpensive index funds, it is not necessary to move your assets to another fund family. Let me give you an example of what I have done.

I have my retirement assets at T. Rowe Price which has a pretty good selection of reasonably priced domestic index funds. However T. Rowe Price’s emerging market stock fund is expensive with a management fee of 1.27% (it is a “managed” fund). So for my emerging market stock allocation I have purchased, through my T. Rowe Price brokerage account, Vanguard’s emerging market ETF index fund (stock symbol: VWO). Vanguard’s management fee for VWO is only 0.22%. This fee is over 80% lower than the fee charged by T. Rowe Price’s fund. This is one way to lower overall portfolio expenses.

For those of you who want to read more on this topic, there is a really good detailed discussion of this subject on the “Retire Early Home Page.” Follow this link to read it.

As you can see minimizing portfolio costs is very important. The earlier in your investing career you reduce these expenses, the more your portfolio will benefit. I would recommend you review your retirement account funds fees immediately and make the appropriate changes.

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