Last Updated Aug 25, 2011 4:26 PM EDT
Here are the basic features of the rule: Invest in a portfolio split between stocks and bonds, withdraw four percent of the total amount of your portfolio in the first year of retirement, and give yourself raises for inflation each year. (See my prior posts for more details on the four percent rule.)
The good thing about this strategy is that you can adjust the initial four percent withdrawal amount to account for specific circumstances, such as retiring at a later age or changed expectations for investment returns and inflation.
But there's one big problem with the four percent rule: All of the analyses that support the four percent rule assume you'll earn investment returns in line with historical indices for stocks and bonds, and that no investment management fees or taxes will have to be paid from your retirement savings. In reality, though, all mutual funds charge investment management fees, in many instances exceeding 100 basis points (one percent) or more. And many fee-only investment advisors charge between 50 and 100 basis points year after year. Also, you'll pay income taxes on any investment income that's earned outside tax-advantaged accounts such as IRAs and 401(k) plans. All these costs can put a serious drag on your net investment earnings.
Investment advisors and mutual funds might claim this isn't a problem because they can generate returns in excess of historical index returns and hence justify their additional fees. But as fellow CBS MoneyWatch blogger Larry Swedroe has so convincingly demonstrated, it's very hard to beat the indices over long periods of time, such as during the period over which you'll be retired.
According to Larry's recent post, the average fund underperformed its benchmark by 1.75 percent per year, and only 22 percent of funds measured outperformed their benchmark. This average underperformance is before taxes are even considered -- it increases to 2.58 percent per year if you consider taxes on investment earnings. This is important if some of your retirement savings are held outside of tax-advantaged accounts such as IRAs or 401(k) plans.
This underperformance can significantly increase the odds that you'll outlive your retirement savings using the four percent rule.
However, there are two strategies you can implement that address this problem.
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