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Retirement Income Drawdown: How to Fix a Serious Flaw With the "Four Percent Rule"

The four percent rule, or some variation thereof, is widely followed by experts and laymen alike as a strategy for calculating the amount you can safely withdraw from your retirement savings while minimizing the odds of outliving your money.

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.

Next: Keep Your Costs Low

Solution #1: Keep Your Costs Low
If you can keep your ongoing investment and advisory costs very low, and minimize income taxes on your returns, then the analyses that support the four percent rule are still valid. To do this, you should use index funds that have very low fees and will track the underlying benchmarks and analyses that support the four percent rule.

The index funds at Fidelity Investments and Vanguard, for instance, have investment management fees that range from 10 to 30 basis points. You can choose from funds invested in stocks, bonds, or mixtures of both types of assets, such as balanced funds or target date funds. These funds have done a good job of matching their benchmark indices, and they generate low income taxes, if any.

In addition, you shouldn't work with a financial advisor who takes commissions from your investments or charges a percent of assets under management. Instead, you should find an advisor who charges by the hour, such as the advisors from the Garrett Planning Network or Alliance of Cambridge Advisors. Have them develop an investment and withdrawal plan for you that doesn't need constant attention (and the resulting fees). You should be able to go for a few years without revisiting your plan; when you do, you might only need a few hours of their time. And pay these fees from your ongoing withdrawals for living expenses, so they don't reduce your invested assets.

Next: Reduce your withdrawal amounts

Strategy #2: Reduce Your Withdrawal Amounts
If your investments are actively managed and you incur ongoing costs for mutual funds and financial advisors that are 50 basis points or more, you should reduce your initial withdrawal amounts. This reflects the likelihood that your investment returns will be lower over the long run compared to the underlying benchmarks, due to fees and/or underperformance.

There are a few ways you can do this. One is to reduce your initial withdrawal percentage by the expected underperformance. For example, if you expect an average underperformance of 1.75 percent per year, as indicated previously, then you reduce your withdrawal percentage by that amount. (The four percent rule then becomes the 2.25 percent rule.)

In essence, you're keeping your portfolio whole relative to the benchmarks. You're paying your portfolio the expected amount of underperformance and taxes by not withdrawing that amount from your retirement savings for living expenses. This way, the analyses that support the four percent rule remain valid.

Here's another way to do this: Estimate the total charges made against your portfolio from your investment advisor, if applicable, and the investment management fees from your mutual funds. If you're using more than one mutual fund, then figure the average investment charges for your total portfolio. Express these charges as an annual percentage amount, then reduce your initial withdrawal rate by this amount. In other words, if you find that the average amount of your total charges is one percent, the four percent rule becomes the three percent rule. And pay for any income taxes from your annual withdrawals; treat taxes as another living expense. The rationale is the same as described above: You're keeping your portfolio whole relative to the benchmark.

If all this sounds too complicated, then just assume you should withdraw based on a "three percent rule," and then periodically revisit your withdrawal percentage as described next.

If your mutual funds and/or investment advisors are successful at beating the indices for an extended period, say five to 10 years, you can always reset the dollar amount of your withdrawal by applying your withdrawal percentage to the increased value of your portfolio at that time. Personally, I'd much rather be cautious with my withdrawals in my early years of retirement, and reap the bounty of good investment returns only if they're realized.

I'd also want to avoid the opposite result, where you make withdrawals from your portfolio on the assumption you'll achieve average or above average returns and are then disappointed in your later years when you don't realize these returns. At that time, you may be forced to reduce your withdrawals at a time when you might be incurring higher medical costs and/or can't work to supplement your income.

There's one last thing to consider: If you can't afford to retire using a lower withdrawal percentage, then you might need to work a little to supplement your retirement income. That's not such a bad idea, as it gives you social connections and might improve your longevity. If you don't like this idea, however, you could use index funds with low costs, as outlined previously.

All of this illustrates that relying on your retirement savings to generate lifetime income is a serious challenge. It's well worth your time and effort to figure how to do it right.

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