Tuesday, February 11, 2014

Adjusting the 4% Rule for Portfolio Fees

The 4% rule for retirement spending comes from a 1994 paper by financial planner William Bengen called Determining Withdrawal Rates Using Historical Data. Bengen showed that portfolios with 50% to 75% U.S. stocks and the rest in intermediate-term treasuries would last for 30+ years with yearly inflation-adjusted withdrawals of 4% of the starting portfolio value. However, Bengen assumed that you don’t pay any investment fees. Here I replicate Bengen’s study and look at how fees affect the results.

The retirement spending plan tested by Bengen differs from my ideas on Cushioned Retirement Investing in two main ways. With cushioning, you adapt your spending somewhat if investment returns severely disappoint, and the cushion leads to your portfolio volatility dropping through retirement. Bengen tested a strategy where you choose the withdrawal amount based on your portfolio size at the start of retirement. Once the withdrawal amount is set, you only adjust it for inflation. Bengen also assumes that you stick with a fixed asset allocation throughout retirement.  This inflexible approach is how he calculated his safe initial spending percentage, but he was clear that a real retiree may choose to increase or decrease spending in the face of a portfolio that is declining severely or growing wildly.

So, if you have a million dollars at the start of retirement, the 4% rule says you get to spend $40,000 in the first year and bump that up by inflation every year. Bengen checked how this strategy performed for 51 retirees retiring each year from 1926 to 1976. The retirees were assumed to own U.S. stocks and intermediate-term treasuries in either a 75/25 or 50/50 ratio.

I used Robert Shiller’s online data to replicate Bengen’s results. Shiller only had long-term bond data rather than intermediate-term, but I found it made little difference to the results. The number of years that each portfolio survived differed by a year or two from Bengen’s results in only a few places.

Bengen found that with the 4% rule, all 51 retirees’ savings lasted for at least 30 years and only 5 of them lasted for less than 40 years. So, I used this as standard for what is acceptably safe. Running my simulation, the largest withdrawal that passed the acceptability test was 4.03% for the 50% stock portfolio, and 4.00% for the 75% stock portfolio. So far so good. The results match Bengen’s.

Next, I introduced portfolio fees. For management expense ratios (MERs) ranging from 0% to 4%, I repeated the simulations to see what maximum withdrawal rate would pass the tests. You might think that the maximum withdrawal rate would simply be 4% minus the MER; this isn’t true because the MER is charged on an ever-declining portfolio size, but the 4% applies to the starting portfolio size.

Here are the results:

By the time the MER reaches 2.2% for a portfolio 75% in stocks, the 4% rule has become the 3% rule. You might think that using a 3% rule is just a more conservative approach, but this isn’t the case. Using a 3% rule with a 2.2% MER is just as risky as using the 4% rule with no portfolio costs (not that it’s possible to get away with no costs at all).

If you blindly follow the 4% rule without understanding where it came from, you’ll likely end up running a much higher risk than you realized of running out of money later in retirement.


  1. So looking at your chart,it would seem,roughly speaking,each percentage of MER would reduce the SWR by about half a percent.
    Some incentive to try a get that MER as low as possible.

    1. @Anonymous: You're right that it's pretty close to linear. For most people, I think you have to translate it into dollars. For example, you can draw $5000/month minus $560 for each percent of MER.

  2. I suspect the folks that blindly follow financial advice, and the 4% rule, are the folks that need an advisor.

    I just hope they don't pay 2.2% fees but I suspect many do.


  3. And don't forget that if you only have an RRSP (other than CPP/QPP and OAS) and you convert it to a RRIF you can flush this whole study down the drain as the only year you get to withdraw 4% is when you are 65 (less if younger).
    This really only apprles to non-registered investments as then you are the master of the withdrawal rate that you wish to impose on yourself

    1. @Anonymous: A very late response, but just because you have to withdraw from a RRIF doesn't mean you have to spend all the money. You can invest part of it in a TFSA or non-registered account.