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Financial Advisors Eat Your Nest Egg

March 18th, 2008 at 06:13 pm

Ahhhh...retirement. Those fun-filled golden years. Dennis Hopper telling us to live like we are 16 again with the help of Ameriprise financial planners.

But something isn't quite right here. Leaving aside that while you are working and saving investment fees will be busy delaying your retirement, what happens when you are IN retirement?

Let's find out!

The most agreed upon 'safe withdrawal rate' in retirement is 4%. This is what studies indicate you can take out of your investments without fear off going broke before you die. The mother of them all is called the Trinity Study which looked at the "success rate" of various portfolios from 1926 to 1995.

There are issues with a 4% withdrawal because if you retire just before the market dumps and are taking out 4% while the market is down for several years, you could be in trouble. But that's for another blog entry. On this one we'll stick with the 4%. Please note that the Trinity Study also took the effect of inflation into account and adjusted the withdrawal rates upward each year accordingly.

So, now you have retired with your nestegg of $1 million. You can take out 4% and live well on $40,000 (well, that is before taxes).

But wait! There's more!

The Trinity Study (and other studies) did not take into account the fees you pay for investing. Let's assume that you, like many other people, are paying 2% in total fees. So, if you have an additional 2% coming out of your investments you really should not be taking out 4%.

At first I thought the investing fees of 2% would cut your safe withdrawal rate in half, but there's a more interesting way to look at it. Plus we get to play with a cool tool!

This tool will help you figure out the impact your investing fees have on your safe withdrawal rate's success:

Text is http://fireseeker.com/firecalc.php and Link is
http://fireseeker.com/firecalc.php

Let's try it.

I want $40,000 a year and want my nest egg to last 35 years. I have $1 million in my nest egg at retirement. I'm entering 2% as my expense ratio - but it includes an expense ratio of 1% and a wrap fee of 1%. And I have 40% of my portfolio in equities (stocks). Let's discover my success rate:

"Your plan is to spend $40,000 a year, or 4.00% of your starting portfolio.

FIRECalc looked at the 102 possible 35 year periods in the available data, starting with a portfolio of $1,000,000 and taking out $40,000 the first year of your retirement, and the same amount after adjustments for inflation each year thereafter.

(FIRECalc assumed your retirement portfolio is in investments that perform about like the US stock market as a whole. Mutual funds report each year how well they have performed relative to the stock market as a whole. Such information can help you see how relevant this information might be to your situation.)

The key result: a 30.4% Success Rate

For our purposes, failure means the portfolio was depleted before the end of the 35 years. FIRECalc found that 71 cycles failed, for a success rate of 30.4%."

Yikes! I'm having a heart attack!

OK, let's try that again with investment costs of .2%.

"FIRECalc Results
Your plan is to spend $40,000 a year, or 4.00% of your starting portfolio.

FIRECalc looked at the 102 possible 35 year periods in the available data, starting with a portfolio of $1,000,000 and taking out $40,000 the first year of your retirement, and the same amount after adjustments for inflation each year thereafter.

(FIRECalc assumed your retirement portfolio is in investments that perform about like the US stock market as a whole. Mutual funds report each year how well they have performed relative to the stock market as a whole. Such information can help you see how relevant this information might be to your situation.)

The key result: a 76.5% Success Rate

For our purposes, failure means the portfolio was depleted before the end of the 35 years. FIRECalc found that 24 cycles failed, for a success rate of 76.5%."

MUCH better. I think I'll fire that advisor, get myself into some low-cost index funds and cut my spending needs to $36,000. Let's see....

The key result: a 97.1% Success Rate

Hooray!!!!

Now if I could just control the future of the stock market.....

Folks, this is serious. Please use this tool and show it to others. Talk to your 'financial advisor' if you have one and please don't let him doubletalk you. If he promises you higher returns, get it in writing. (If you do, contact the SEC.)I do not want to see anyone trading work stress for money stress.

I'm betting that no one has a 'financial advisor' that showed them this tool and the impact that fees have on your nest egg.

More about the safe withdrawal rate in retirement:

http://www.retireearlyhomepage.com/safewith.html

Quote for the day:
"This message (that attempting to beat the market is futile) can never be sold on Wall Street because it is in effect telling stock analysts to drop dead."
Paul Samuelson, Ph.D., Nobel Prize laureate

5 Responses to “Financial Advisors Eat Your Nest Egg”

  1. Caoineag Says:
    1205865145

    I am a big fan of firecalc. Its definitely a useful calculator to play with.

  2. merch Says:
    1205875649

    There are different type of fincial advisors out there. Yes some are just shills paid to sell mutual funds, some are not.

    You talk about fees as if all fees are bad. I know a Canadian hedge fund that averaged 30% return for 10+ years. There fees were 3% of assets plus 30% of profits and they were earning 30% net fees. A lot higher then the 2/20 in the US. Are those bad fees?

    I would rather be in that fund with high fees then a muni fund.

    The point I am making that fees are not necessarily bad or good, especially if a portfolio managers compensation is align with your return.

    I believe you should be looking at net returns for long periods of time. And not all finacial advisors are bad and not all actively managed portfolios are bad.

  3. Anniebird Says:
    1205893517

    Merch, yes there are different kinds of financial advisors out there but 95% of them are really brokers that take commissions. Some take a percent of assets AND commissions and that can end up being the most expensive of all. 5% are fee ONLY and out of those some have little to no education.

    I figure that about 3% of financial advisors are 'good', meaning they offer value for value, are fee ONLY with no conflicts of interest with clients, are sharp, know proper investing principles and have specialized knowledge and are ruthlessly honest. How will an ignorant investor find one of them?

    Yes, there are some brokers that have good intentions. But their good intentions don't matter when your returns are on the line:
    Text is http://trendfollowing.com/whitepaper/The%20Study%20of%20the%20Decade.pdf and Link is
    http://trendfollowing.com/whitepaper/The%20Study%20of%20the...
    There may be expensive managed funds that have HAD high returns, but we can't go back in time and invest in them, and many more underperformed their benchmark net of fees. And, looking towards the future, none of us knows which investments will do well in the future. But people chase past performance thinking that it will somehow guarantee future performance.

    Some people like to bring up past returns of the few high cost investments that did well in the past as some kind of evidence. It's easy to go back and find those few funds on Morningstar or such. Not so easy to predict the future.

    One thing we can control is our costs. Over time, low cost investments outperform high cost investments as a general rule. Since you can't go back in time and buy funds that did well and you can't know what will do well in the future it only makes sense to go with the odds and buy low-cost funds that, because of their low cost, have the very best chance of doing well in the future.

    I've just started reading about hedge funds. Yikes!
    Text is http://www.thelamgroup.com/WSJ%20Web%20pages/WSJ_com%20-%20Getting%20Going%209-20-06.htm and Link is
    http://www.thelamgroup.com/WSJ%20Web%20pages/WSJ_com%20-%20G...

    I have a couple books about them that I'm delving into.

    Thanks for your comments! Please don't chase past performance. Smile

  4. abbey Says:
    1294120649

    Thanks for contributing. Great story and you have inspired me with it.

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