The Zero Fees And Expenses Assumption
How many of you invest with zero fees and expenses?
It is amazing that most safe withdrawal rate research supporting the consensus 4% Rule assumes zero fees and expenses. This is another example of an assumption made for the purpose of expediency in research but having no real-world application.
The solution to this problem is not complex. Real-world withdrawal rates must be reduced compared to theoretical research to reflect real-world investment management and transaction expenses.
This issue may seem small, but it is not. Imagine you’ve invested your portfolio with an adviser who charges 1% management fees while investing in mutual funds with 1–2% total expense ratios. That is 2–3% of annual expenses taken out of a 4% withdrawal rate. That doesn’t leave much for you to live on.
Fortunately, you don’t have to subtract the expenses directly from the theoretical withdrawal rate because the math doesn’t work that way. (It is a common mistake.) Instead, you subtract expenses from the investment return first and then calculate the sustainable withdrawal rate. The reduction in withdrawal rate is significantly less than the actual expenses.
For example, Pfau adjusted his 3rd Generation research results for administrative fees of 1.6% for stocks and 1.2% for bonds (similar to recent Morningstar averages) and it reduced his safe withdrawal rate by 0.66 percentage points—far less than the nominal expenses.
Lesson Learned:
If you invest in low cost ETFs without additional advisory fees, then you may be able to ignore the investment expense issue since its impact should be limited. However, if you invest with an advisor in expensive mutual funds, then this issue is a serious consideration that could reduce the amount you can withdraw each month by 10–20%. It is an important issue to consider that few advisors will explain to you—for obvious reasons.
