Retirement spending rates are very important. Even for those not yet retired, this report should be useful because it indicates how to set an appropriate goal to enable comfortable retirement.

We generally try to use the phrase “achieve financial independence” rather than “retirement” since some folks don’t plan to retire; but, for the purposes of this paper, we’ll say retirement because we are talking about potentially spending down a portfolio which implies actual cessation of work.

When working with clients, we are actually trying to maximize happiness given an uncertain future. To compare retirement spending strategies, we use a mathematical technique known as Monte Carlo Simulation (MCS), which is used when attempting to model something with high levels of uncertainty (such as the future returns on financial instruments). A successful plan doesn’t run out of money and yet allows the maximum spending possible. (As many people have observed, optimal financial planning would have your check to the undertaker bounce.) These two objectives are obviously opposed to each other, and, to complicate it further, few people know how long the funds need to last (i.e. they don’t know their date of death in advance). MCS can help us analyze the probabilities of various outcomes. As the comedian Henny Youngman observed, “I have all the money I need provided I die by 4 o’clock this afternoon.” How much do we need?

Let me give the general conclusion first and then mention some items that may influence the conclusion. Many studies have been done on what are called “sustainable withdrawal rates” from a portfolio given a number of parameters. We have replicated the research and are comfortable with the conclusions. First, there are assumptions about the future returns and volatility of the portfolio. Sometimes purely historical figures are used; sometimes expectations of the future are used. Second, there are assumptions about what the spending pattern will be. Generally, not only are people uncomfortable with their spending having to potentially decrease; they would actually like it to increase over time to keep up with inflation. Third, people would like a high probability (85-90% chance) of not running out of money.

Let me talk about that last point for a moment. The reason you don’t seek a 100% success rate is that it leads to plans that are so conservative you could maintain your spending rate through two consecutive market crashes and great depressions, but wouldn’t get to enjoy yourself much in all the other situations. Remember, the goal is to maximize happiness by steering a middle course between 1) not running out of money and 2) enjoying your accumulated wealth (by spending it rather than merely looking at it or counting it).

Using those assumptions, for a typical person entering retirement (typical age, life expectancy, reasonable investment portfolio, etc.), the sustainable withdrawal rate is approximately 4%. In other words, if you desire $40,000 each year from your portfolio (in addition to Social Security and any pensions), you need a $1,000,000 portfolio. If you want $100,000 each year from your portfolio, you need $2,500,000. A simple way to compute this figure is to multiply your desired spending from the portfolio by 25 to get the nest egg needed. Alternatively, as you approach retirement, you can divide your portfolio by 25 to see what your initial spending might be.

Caveats and other points:

1. The figures mentioned previously are gross of taxes. In other words, the figures should be reduced by the taxes. If you are in a 25% marginal tax bracket and the funds are coming out of a traditional IRA or 401k, you would only net 3% from a withdrawal of 4%. If the funds are coming out of a Roth IRA, no reduction is necessary since the proceeds are tax free.

2. Many people with relatively modest lifestyles needs may have much of their need covered by Social Security. On the other hand, for younger people, it may be wise to discount the possibility of Social Security. Also, Social Security is very regressive and will replace a much higher proportion of a lower income than it does a higher income.

3. Some retiree costs, particularly healthcare, generally increase at rates higher than the overall inflation rate. On the other hand, many retirees gradually reduce their consumption (of items other than healthcare) as they age. One wag has termed this the three stages of retirement: go-go, slow-go, and no-go. To the extent a retiree does not have good health coverage (for long-term care for example) they may want to reduce their withdrawal rate slightly to have more available for that contingency.

4. The figures above are for someone beginning retirement at normal retirement age. Obviously someone who is 90 years old could consume much more than 4% of his or her portfolio each year with relative safely.

5. In the 10-15% of cases where the projection indicates running out of funds, the retiree shouldn’t literally run out. The problem should be evident early and lead the retiree to take action before actually depleting all of their resources. The cases where failure of the plan occurs are generally where very poor returns happen right at the beginning of retirement (someone retiring at the end of 1999 or 2006 for example). The options at that point would include 1) reducing spending (downsizing possibly), 2) generating more income (part-time job for example), or 3) a reverse mortgage (to tap home equity). This last option is why our retired clients generally have no debt. It leaves the home equity as an emergency back-up in extreme situations.

6. In many cases, spending can increase in later years by more than the initial plan indicated if portfolio returns have been good. This methodology in essence provides for all but the bottom 10-15% of cases working out. If, in fact, the retiree is simply in the middle case (the 50th percentile), they are in very good shape.

One final note: While many people have “don’t spend principal” as a rule of thumb, it isn’t the best way to look at your portfolio for three reasons:

1. It ignores the effects of inflation over time. If inflation is 10% and interest rates are 12%, spending just the 12% “interest” will deplete the purchasing power by 10% per year.

2. It can lead to poor investment decisions as high-yielding investments are selected over investments that might be safer or have a higher return but through growth rather than yield. Many individuals have bought bonds trading at a premium or extremely poor quality investments due to the high current yield. Buying exclusively high yielding investments will also increase exposure to interest rate risk.

3. For younger retirees, focusing on maintaining the real (inflation adjusted) value of the portfolio would make sense, but for someone older the portfolio can decline somewhat in value without serious risk. For example, imagine a 90-year-old with a $1,000,000 portfolio. He or she could spend $50,000 per year of the principle and it wouldn’t run out until age 110.

In conclusion, most people should plan to spend 4% (gross) of their initial portfolio balance in retirement and increase that slightly every year to keep up with inflation. About 10-15% of the time, an adjustment of some sort will be necessary, but the other 85-90% of the time the plan should work out just fine.

Periodically, the financial press discusses costs imbedded in various financial products, especially mutual funds. Some costs are explicit and fully disclosed, but many are not. We fully support disclosure of all costs so investors have information upon which to make good decisions.

Quality financial professionals do not try to make less than their competitors, but they do try to keep their clients’ costs extremely low. That may sound like a contradiction, but many products are designed to pay the salesperson without the client noticing the payment. Furthermore, these products are generally very expensive to own. Following, in no particular order, are some costs investors face. In most cases a good advisor can significantly lower these expenses.

Advisor Compensation. Financial professionals (including us) should be adequately compensated. However, the financial services industry often lacks a correlation between the amount of compensation and the quality of the advice. Among reputable, quality firms, advisor compensation is generally 100 basis points of the assets under management per year. (A “basis point”, or bp, is 1/100^th of a percent, thus 100 bps is 1.00%.) This is true regardless of the method of compensation. However, we believe some methods of compensation align advisor and client interests better than others. Methods of compensation, ranked by popularity, are discussed below along with potential conflicts of interest for each method.

• Commissions – The advisor is paid a commission for a sale. Commission-based fees often cause a tendency to focus on the product instead of the process, to turn over the portfolio too frequently, and to neglect the client unless a sale is imminent. The larger the account, the greater the commissions can be, encouraging a bias toward making the account as large as possible even if it is not in the client’s best interest. For example, rather than building a larger account, it may be better for the client to pay off the mortgage, enjoy spending some accumulated funds, or gift to family members for estate tax purposes. Also, commission-based sales people are just that – sales people. As such, they are held to a lower legal standard because sales people are not fiduciaries. Frequently, significant commissions are hidden from the client in the product cost particularly in insurance products (including annuities), so-called “alternative” investments, and B-share mutual funds.

• Asset-Based Fees – The advisor charges a fee based on assets under management. This is our primary method of compensation, but it is not without its flaws. There can be the same tendency to keep the size of the account high to the detriment of the client (see above), and the advisor gets paid even when not “doing anything.” Even though fees were instituted to reduce conflicts of interest, one of the largest U.S. brokerage firms pays their advisors (at least they did the last time I saw their fee schedule) three times as much to recommend riskier equities (150 bps) over safer fixed-income products (50 bps) in a fee-based account. To remove this bias, it is preferable to have the advisor charge the same fee regardless of the product.

• Hourly Fees – The advisor charges a fee per hour worked. One potential problem here is doing more work than the situation justifies. Also, this method, in effect, causes the client to feel that “the meter is running,” lessening the likelihood of having a deep enough conversation to get all of the questions answered. In addition, this method is less conducive to ongoing management of a portfolio.

• Project Fees – The advisor charges a flat fee for a specific project. We do planning on this basis. It is very similar to the previous method, but removes the “meter running” feeling as well as giving the client certainty about the final cost.

• Retainers – The advisor charges a fixed annual amount. While a few firms have moved toward charging annual retainers, it is not common yet. Since the retainer is normally based loosely on the amount of assets under management and the estimated number of hours of work for the coming year, in practice it works like a hybrid of the previous two methods.

Taxes. Few advisors pay attention to managing a portfolio with an eye toward maximizing after-tax return. If all of the investments are in tax-advantaged accounts like 401(k) accounts or IRAs, this doesn’t matter, but if taxable accounts are involved, the impact could be significant.

Brokerage Costs. When mutual funds make trades, they frequently “direct” those trades to a specific firm, and the commission is paid by, though generally not disclosed to, the owners of the fund. In return, the firm that executed the trade frequently kicks back (though they would never use that term) what are known as “soft-dollar” perks and freebies such as research.

Trading Costs. Each trade in a portfolio generates a cost from covering the bid/ask spread. As with brokerage costs, this is a hidden cost paid by the owners of the fund.

Expense Ratio. Within a product such as a mutual fund, there are fees for the fund management, marketing expenses, etc. The average mutual fund charges about 125 bps (per Morningstar). It would be higher for actively-managed stock funds and lower for bond funds or index funds. As noted above, insurance products, hedge funds, etc. can be significantly higher.

Turnover Costs. Though not a separate cost, high turnover will generally increase the tax costs, brokerage costs, and trading costs listed above.

Conclusion. Investors typically lose significant amounts through costs they are largely unaware of. Decades of research has shown that these higher costs reduce net portfolio performance. It should be noted, however, that while we believe keeping these costs down is not the most important function we serve (the financial planning process, asset allocation, etc. are vastly more important), in many cases selecting more efficient investments for a client can more than cover the advisor compensation.

The title of this post may be surprising considering one would rarely call term insurance an investment. I don’t sell insurance; however, I think there is investment opportunity in certain situations using a term policy with a return of premium rider (ROPR). Essentially, this is a normal 20- or 30-year level-term life insurance product, but you pay extra premiums and at the end of the term get a refund of all of the funds invested. This means that the time value of money has paid the cost of the insurance. It is also a non-taxable event because, from a tax perspective, you simply received your money (basis) back.

Let’s look at an example. This is very close to being a best-case scenario. It is not typical, but it should get your attention. Assume a 25-year-old male in great health needs $1,000,000 face, 30-year, level-term insurance. It will cost him $770 per year, but he could also get it with ROPR for $1,095 per year “investing” the difference of $325, which is put in at the beginning of each period. At the end of 30 years, he will get back the total premiums or $32,850 ($1,095 x 30 = $32,850).

[Note: It is important to compare the best policy without the rider to the best policy with the rider. Many times the company that offers ROPR doesn’t have the best rates on the insurance without the rider. The “investment” should be the differential between the insurance that would actually be purchased in each case, not a single policy with and without the rider.]

On a financial calculator, the calculation is simply:

In beginning mode (because premiums are paid at the beginning of the period)

N=30 (the number of years)

PV=0 (there is no value initially)

PMT=-325 (this is the amount saved each year, it is negative because it is paid out)

FV=32,850 (this is the amount received at the end, positive because it is coming in)

Solving for I, you get 7.0%

In Excel, the same calculation looks like: =RATE(30,-325,0,32850,1)

This is a guaranteed, after-tax return (assuming you live and pay the premiums) and should be compared to the rate on investment-grade municipals.

Another way to look at it is to assume the funds would be put in CDs instead. If the taxes were paid out of the fund and you are in the 25% federal bracket and a 6% state bracket (combined a 29.5% rate assuming they itemize), the rate needed on the CD to accumulate the same amount of wealth is 9.9% [7/(1-(.25+(1-.25)*.06))]. If you are in the top federal bracket (35%), it would be 7/(1-(.35+(1-.35)*.06)) or 11.5%.

A few caveats:

1. Obviously that is significantly higher than current rates, but it is a 30-year program and is thus very illiquid.
2. A Roth or IRA would be better if you could get 7% on a guaranteed investment in them.
3. Even if you can’t quite get as high a guaranteed return in a tax sheltered account, if the rate difference were small, I would be inclined to use the retirement account for the improved flexibility.
4. You must need the insurance anyway for risk reduction. The numbers are abysmal if the insurance is not needed. In that case, the entire amount of the premium is the investment rather than just the differential over the cost of pure insurance.
5. In general, the younger and healthier you are, the higher the return.
6. Your asset allocation target should be kept in mind.  The asset allocation should drive the investment selection rather than the reverse.
7. Of course, if the insured dies, he/she paid too much for the insurance, but the probability of dying with a term policy is so low that including that eventuality (and weighting it appropriately) shouldn’t change the results more than a very trivial amount.

You may wonder how the insurance companies can afford to have implied rates this high. I can think of two reasons: 1) lapses allow the insurance company to pay better; and young (healthy) customers are more likely to lapse their coverage, 2) the purchaser of this product has perhaps “signaled” to the insurance company that he/she is a good risk – poor risks wouldn’t tend to buy it. In other words, the purchase of the rider may give useful mortality information to the insurance company that can’t be captured another way.

I ran calculations a few years ago for a male in excellent health at ages 25, 35, and 45; and for 20-year and 30-year time horizons (i.e. six different scenarios). The 20-year policies were not as good relatively speaking, and in one case (35-year-old), a company had a 20-year term policy without the rider priced so attractively that buying the policy with the ROPR would actually be worse than just saving the difference in municipal bonds.

I was also curious if the same results could be achieved with traditional insurance. Because of the much larger contribution amounts, this would be a significant strategy if the numbers were similar. To make equivalent comparisons, I used a non-participating whole life policy so the returns would be just as guaranteed as the previous calculations. I also liquidated the policy at the same 20- and 30-year horizons and compared the results. Unfortunately, the non-participating whole life strategy underperformed buying term insurance and investing the difference in munis by almost 2% per year on average. It also underperformed the term with ROPR strategy by about 2.6% per year – again averaged across the six combinations of age and term. Throwing out the one case where the ROPR shouldn’t be used (see previous paragraph), the difference actually averaged 2.8% annually (again, net of tax).

If an individual is relatively young and healthy, needs life insurance coverage, and can afford to save in an illiquid vehicle, these products are certainly worth investigating.

The possibility of suddenly coming in to a large sum of money may be pleasant in our daydreams, but in reality, sudden wealth can cause a great deal of stress. The source of sudden wealth doesn’t necessarily have to be winning a lottery or receiving an unexpected inheritance. Many people face adjustment issues even from the sale of a business or the rollover of a large 401(k) upon retirement. In these cases, even though net worth is unchanged, having the wealth more accessible and liquid somehow makes it seem more real. Following, in no particular order, are some instructive comments for those contemplating the use of a large sum of money:

1. People who are prudent with small amounts of money tend to be prudent with large amounts of money. People who are profligate before an unexpected inflow will be profligate with that inflow. In other words, more income or wealth won’t solve what is fundamentally a spending problem. This is undoubtedly the reason that studies have found that between one third and one half of lottery winners eventually declare bankruptcy.

2. Far too often, people who come into sudden wealth seem almost to be trying to lose the money. Most people become comfortable with a certain lifestyle, self-image, etc., and when something happens to change that, they may try (perhaps subconsciously) to get back to where they were previously. This is the financial equivalent of the biological process of homeostasis.

3. People think that lump sums will go further than they actually will. If you have made $50,000 per year all your life, you may see the $500,000 in your 401(k) at retirement as an incredible amount of money, when it really isn’t. The most extreme example of this that I have seen is that of a very successful attorney approaching retirement. His main assets were about $1,000,000 in his 401(k) and the value of his partnership share which his partners would buy from him for about $500,000. I asked the couple how much they needed to live on in retirement, and his wife replied, “We have a fairly modest lifestyle. If we continue to get what he makes now, we should be just fine.” I asked the obvious follow-up question, “What do you make now?” To which he responded, “About $500,000.” I wanted to ask what they planned to live on in year four (but I didn’t). I also didn’t get them as clients. My guess is they went with an advisor who said they were in fine shape.

4. People sometimes try to “prove something” to someone such as a spouse or a parent (even if the parent is deceased). It is not uncommon for someone to lose a great deal of sudden wealth in investments or businesses trying to demonstrate how skilled they are at investing or business.

5. Sometimes people don’t know what to do, so they ignore the funds completely. I once did a financial plan for a 30-something school teacher who lived very frugally on her salary to build up a sizable emergency fund and she would also receive a nice pension at retirement. Her primary concern was whether she could afford to buy a small condo to live in rather than continuing to rent an apartment. Her father had left her some stocks when he died more than 20 years previously, and she not only didn’t spend any of the money, she had never bought or sold anything in the account. It had been untouched for more than 20 years, and her net worth was just under $1,000,000.

6. The receipt of sudden wealth can also strain relationships with existing friends and family members. Many wealthy people are treated differently and not uncommonly feel taken advantage of. Of course, new “friends” and “advisors” become prevalent as well.

So, what is the solution? The main thing is to proceed slowly. It is perfectly fine to leave the wealth in cash while becoming acclimated to the new situation. It may not be prudent to immediately move to a nicer area, a bigger house, etc. As a first step, paying off all debt and committing to remain debt free is probably advisable. In addition, thinking of the wealth as an income stream rather than a lump sum may be helpful. The sustainable withdrawal rate from a portfolio is about 4% per year. Thinking of a million-dollar windfall as being able to pay off a $500,000 mortgage and then having $20,000 per year from the remaining portfolio to spend may lead to vastly different decisions than thinking about what to do with a million dollars.

I have posted on How to Evaluate an Investment Advisor but thought it was worth another, somewhat different take on it focused more on recent investment performance.

There are many things that we do that we believe will add value to the portfolio performance over time, but the big two are:

• Broad diversification across a variety of asset classes.
• Factor tilts (particularly to value) that have outperformed over time (and seem likely to going forward).

Lately both of those have underperformed just holding large U.S. stocks.  Our challenge as investment professionals is to keep everyone on track through this period of underperformance – and it’s not just us, all of my peers that I consider competent are in exactly the same position.  My guess is that we will lose some clients in the short run that will come back to us in the long run after their performance suffers from doing what has worked lately.  (Investing by looking in the rearview mirror is generally a mistake.)

Coincidentally, Anitha had lunch recently with an advisor that works with very high net worth clients (just under $20 million in average assets per family).  Because of this periodic underperformance problem they (quite understandably) don’t tilt to value, even though they think that is best long-term, because it is so hard to explain even to their sophisticated clients.  Arguably, if clients don’t stay clients, and they chase performance (buying high) somewhere else you haven’t really helped them.  (The advisor intends to refer us “smaller” clients because she likes our approach, and Anitha.)  It’s a marketing and sales problem for us, but since we tend to have more sophisticated clients (not necessarily in net worth, but in knowledge of investing principles) I come down on the side of doing the long-term right thing even though it will periodically make our clients feel worse – and potentially cost us a few who don’t understand – in the short run.

So, if you can’t rely on recent performance to know whether the advisor is doing a good job, what can you do?  I suggest asking two questions:

1) Is the advisor competent?  In other words, do they seem to have:

• A high enough IQ to do the job.  They don’t have to be geniuses necessarily, but smarter than average is good.
• Sufficient knowledge in their field.  Someone can be smart but know nothing about investments or financial planning, so this is where you should look for credentials like CFP, CFA, etc.
• The right temperament.  Many (most?) advisors who have the above two items can’t stick with a well-thought-out investment strategy through the inevitable periods of underperformance.  (William Bernstein made a similar point in one of his books a few years ago, as did Larry Swedroe recently in an article.)

2) Is the advisor trying to do a good job?  In other words, do they:

• Have a business model as unconflicted as possible.  If there are no incentives to do the wrong thing (sell expensive products for high commissions for example) that is obviously good.
• Eat their own cooking.  Advisors who have their personal portfolios invested like their clients seem likely to be trying to do the very best they can.
• Seem like they aren’t lazy.  Very occasionally an advisor will do a sub-optimal job out of simple slothfulness because they just ignore their clients and the portfolios.  I don’t mean hyperactive trading is good, but paying attention to things like tax loss harvesting and rebalancing is important.

So, to recap, if the advisor has every reason to do the best job they can (not lazy, not conflicted, invest personally just like their clients) and are competent (knowledgeable and smart, with the right temperament for investing) – that is a good advisor, regardless of short-term performance.