During retirement or any other time we’ll be withdrawing from our investments, it is important to make sure we have a portfolio that will beat inflation and allow us to reach our goals without taking on unnecessary risk. To determine what percentage of a portfolio should be in stocks during retirement, I researched safe withdrawal rates over different time periods using a variety of portfolios.

       Using the Monte Carlo method, I found the optimal portfolios and safe withdrawal rates we should use over different withdrawal periods for a 90% probability of success. (This means you’d have a 90% chance of not running out of money before you die.) The safe withdrawal rate represents the percentage of your portfolio that you can withdraw at the beginning of the indicated time period. I assumed after the first year you would increase the dollar amount you withdrew by a 3.8% inflation rate every year. You can read more about safe withdrawal rates during retirement by clicking here.

       The chart below shows the time period (years left in retirement), safe withdrawal rate, successful portfolio range, and the recommended portfolio for someone with average risk tolerance. If you have a high risk tolerance, you could increase the percentage of your stocks to the upper end of the successful portfolio range. If you are risk averse, you could use a lower percentage of stocks as long as you do not go lower than the bottom of the successful portfolio range. If you don’t keep enough in stocks, you run the risk of not meeting your retirement goals because of inflation.

       Finally, it is very important to note that all of my simulations were completed using a diversified portfolio of index funds. You can read more about what a diversified portfolio looks like by clicking here.





       My next project is looking at how much you need to save so you can even get to retirement. This is more complicated because you have people starting at different points in their lives with differing amounts of money already invested. I’m also looking at the savings rate in terms of your target retirement income instead of the income you’re earning right now. This makes more sense because saving 10% of your current income isn’t a very accurate rule of thumb for the majority of people. It doesn’t guarantee that you’ll have enough saved up to meet your retirement goals—your savings should be based on how much you’ll need in retirement and not how much you’re making now. If you have any questions, please feel free to leave them in the comments below!

       This week’s Personal Finance Bible Scripture comes from Proverbs 21:20.

   ²⁰ In the house of the wise are stores of choice food and oil,
       but a foolish man devours all he has.

Proverbs 21:20 (NIV)

       Same verse but in the New Living Translation:

   ²⁰ The wise have wealth and luxury,
       but fools spend whatever they get.

Proverbs 21:20 (NLT)

       I chose two translations this time because I think together they clearly tell us what this verse is saying. The wise save up some of their earnings, but fools spend everything they get.

       When talking about contentment and giving in the Bible, I’ve had people ask me if Christians should even save up money for emergencies or retirement. If we save, aren’t we relying on ourselves or our money instead of God? I think, as with many things, it really depends on the motives in our hearts.

       If we’re saving up because we don’t think God can provide or we don’t trust in God’s provision, then we’re obviously serving money and not God. But God clearly tells us several times in the Bible that the wise save up some of their money. The wise do not spend everything they get, and the wise prepare for trouble they see coming ahead.

       God can take care of us in any situation, but He teaches us that it is wise to save up when we see that we’ll have a need in the future. This is why I don’t think God is against us having emergency funds or saving for a time in our lives when we won’t be able to work for pay. I’m not sure God wants us saving for things that don’t glorify Him, like a retirement where we golf every day or travel around the world purely for pleasure. It’s the same with anything really. If it doesn’t glorify God, there’s probably a good chance we should rethink it.

       The next time you want to spend all of your paycheck or when the money in your pocket catches fire, remember that the wise person saves but the foolish person spends everything.

       The financial services industry is great at making you feel good while ripping you off. They’re also great at confusing you so much that you can’t even figure out how badly you’re getting ripped off. To make smart financial decisions, you need to realize how your “advisers” are getting paid and how their pay structure may affect the advice they give you.

       These advisers can include stock brokers, bankers, realtors, financial planners, insurance agents, lawyers, and accountants. Different compensation methods can create various conflicts of interest—situations where your best interests are not the same as your adviser’s best interests. This is a long article, but what you’ll read here can save you many problems and oceans of money.


Commission-based Advisers

       These advisers get paid a commission when you buy a product. The products they sell can include stocks, bonds, mutual funds, insurance policies, annuities, real estate, mortgages, other loans, and much more. (When you take out a loan, you’re essentially buying a product and the banker typically gets a commission or bonus.)

       The problem with this compensation structure is that the advisers are influenced to sell you products that give them a higher commission. This could mean selling you inappropriate or sub par products with high fees, telling you that you need permanent life insurance coverage, convincing you to buy the most house you can afford, or encouraging you to take out the biggest loan the bank will let you. You often don’t realize the cost of these decisions because the commissions are rarely disclosed in an honest, upfront, and easy to understand manner. It may seem like you’re getting cheap or free advice, but you end up paying much more in the end because of the commissions that are built into the products you buy.

       Commission-based advisers are also much more likely to persuade you to make many transactions (buying and selling investments many times) because this increases their pay. There are strict rules against “churning” in investment accounts, so be sure to seek help from the government or a lawyer if you believe your account is being churned.

       While there are some commission-based advisers who are trustworthy and do give their clients good advice, you’re best served by steering clear of commission-based advisers whenever possible. If you must work with someone who earns their fees by commissions, make sure you get full disclosure on their compensation and always get a second or third opinion on their advice. Do your homework, and you can avoid getting ripped off by commission-based advisers—but there are often better ways you can get help with your financial decisions.


Fee-based Percentage of Assets Advisers

       Fee-based percentage of assets advisers are paid a percentage of the assets they manage for you. This business model is also called the assets under management (AUM) model. This is generally seen in the investment world, though it can crop up in other areas. The typical fee is about 1% of your assets, but this can vary wildly between advisers. It’s important to keep in mind that this fee is almost always in addition to the fees in the products you purchase.

       The first conflict of interest with fee-based AUM advisers is the fact that they get more money when they manage more of your assets. They’ll often encourage you to transfer more of your assets to them and justify the advice with some compelling reasons. However, it isn’t always best for you to move your assets to an AUM adviser. Additionally, when you take money out of your account the adviser’s fee goes down. If you’re weighing the decision to pay off a loan with money the adviser is managing, how likely do you think it is that he will tell you to pay off the loan? If you pay off the loan, the adviser gets a pay cut.

       The next problem with fee-based AUM advisers is cost. When you pay 1% of your assets in management fees every year, the total cost can really add up. Let’s assume the adviser takes a 1% fee at the beginning of each year and your investment returns are 8%. Over 25 years, you’d pay $62,527 in fees for every $100,000 you had invested at the beginning of the 25 year period. Over a 65 year period, you’d pay $1,104,280 in fees for every $100,000 you initially invested. Most advisers will justify this cost by saying that you wouldn’t have received 8% investment returns if they hadn’t been there to advise you along the way. While this may be true, you can duplicate their results if you educate yourself enough about the long-term history of the markets and learn how to avoid stupid mistakes. You can also look into using an hourly or flat-fee adviser for a better deal without having to learn everything on your own.

       During retirement, these costs can be especially hazardous. My research has shown that a 5% withdrawal rate is probably safe for most people. If you have to pay an investment adviser a 1% fee to manage your assets, your safe withdrawal rate goes down to 4%. This means a $1,000,000 would only provide you with a $40,000/year income if you’re paying an investment adviser. Alternatively, you could have a $50,000/year income if you didn’t have to pay 1% of your assets to the adviser every year.

       The AUM model also isn’t very fair to the clients. If Bob has $100,000 and Joe has $200,000, Bob only has to pay $1,000/year but Joe has to pay $2,000/year. Why does Joe pay more? It’s only because he has more money. How is this fair for the clients? Having worked in the investment industry, I can personally tell you that not much more work goes into managing Joe’s $200,000 portfolio versus Bob’s $100,000 portfolio. Why should Joe have to pay twice as much for the exact same services? He shouldn’t, and that’s another reason why I am not too fond of the AUM model. Fee-based AUM advisers will try to justify this problem with different arguments, but there’s rarely a legitimate argument that would hold up when viewed by an unbiased party.

       Finally, fee-based AUM advisers are generally restricted to working only with wealthier clients. It’s much more profitable to spend 10 hours working with someone who has $1,000,000 than to spend 10 hours working with someone who has $100,000. This means young people and late starters with little money saved up are going to have a hard time getting a fee-based AUM adviser to work with them.

       Fee-based AUM advisers usually give much more appropriate advice to their clients than commission-based advisers, but there are still many conflicts of interest and problems with this compensation structure. Advisers using the AUM model like to advertise that their compensation structure eliminates many conflicts of interest present in the industry, but you should be aware that it does not eliminate all possible conflicts—no compensation structure can do that.


Fixed-fee Advisers

       Fixed-fee advisers are paid a flat fee to provide certain services you agree upon. There are few of these advisers around, but their fee structure can eliminate many of the problems with commission-based and fee-based AUM advisers. You may also hear this fee arrangement referred to as a “retainer”.

       You’ll want to ensure that the flat fee you pay fixed-fee advisers is the sole source of their compensation. If the adviser still receives commissions for any products you may buy, then they will still have a conflict of interest in selling you the highest-paying products.

       You’ll also want to make sure you do not pay for more services than you really need with a fixed-fee adviser. Because these advisers are charging a flat fee, you can end up overpaying if you do not fully utilize the services and time included in the package. This is especially true for those who have a simple situation or for those who have the biggest areas of their financial plan implemented already. Since fixed-fee advisers often charge upwards of $1,500 or $2,000/year, it may not make sense to use them if you do not need much help.

       Since fixed-fee advisers are paid a flat fee, it is to their benefit to spend as little time as possible on any one client as this maximizes their hourly rate. While this is short-sighted, it is still a possible downfall of using fixed-fee advisers. If you feel your fixed-fee adviser is not providing the level of service you agreed upon, you should confront him or her to get an explanation. If you’re not happy with the service, you may want to change advisers.

       The major benefit of fixed-fee advisers is that they will not be tempted to advise that you purchase high-fee products or to put more money under their management. Since their compensation structure is separated from your assets, they are able to focus on your best interests when they provide advice. You’ll still want to make sure you’re not paying for more than you receive, and you should carefully consider any personal finance decision no matter where your advice comes from.


Fee-based Hourly Advisers

       Fee-based hourly advisers get paid an hourly rate for the time they spend working on your situation. This time could include meetings with you, researching your situation, completing paperwork for you, or meetings with your other advisers. Most accountants and lawyers work under this compensation method, but you will hardly find this fee model in the investment, insurance, banking, or real estate industries. Fee-based hourly advisers eliminate many of the conflicts of interest present in commission-based and fee-based AUM models, but they are not without their issues.

       Because fee-based hourly advisers are paid for their time, they may try to give you complex advice to justify their fees and keep you dependent on meeting with them. If you feel like your fee-based hourly adviser is giving you the runaround, be upfront and let him or her know that you need a better explanation of why the advice is so complicated. If the adviser does not try to educate you, it’s probably time to seek another adviser. Any adviser should be more than willing to educate you about what is going on in your financial situation. If not, they could be hiding something or trying to keep you dependent on their advice.

       You may need to be more involved with your finances if you use a fee-based hourly adviser. Since you are paying the adviser by the hour, your costs will be lower if you can do as much as possible yourself. The fee-based hourly adviser should be willing to provide you with any instructions you need to complete simple tasks on your own. This could include setting up accounts, transferring assets between accounts, placing trades, purchasing products, or meeting with other professionals as needed. If you need help, you can always ask the adviser to assist you but your costs will be much lower if you do most of the grunt work yourself.

       With a fee-based hourly adviser, all clients are treated the same because they all pay the same amount per hour of the adviser’s work. These advisers can work with people who have few assets or people with a high net worth. As long as they only receive their compensation from you, they won’t be tempted to advise that you purchase high fee investments. On the contrary, they are likely to give you the best advice possible for your situation because they know that exceptional advice and education is the only thing that can really keep you coming back for their help.


Other Things to Keep in Mind

       You might find an adviser who uses some combination of these fee structures. Proceed with caution! The more complicated the adviser’s compensation the harder it is for you to understand exactly how he is getting paid. With any type of adviser, make sure you get full disclosure of their compensation in writing.

       Never be afraid to get a second opinion on your adviser’s recommendations. You can easily go to a fee-based hourly adviser for a one-time project when you’re making a major decision. For a few hundred dollars, you can get this second opinion and avoid a much more costly mistake. Even better, you could do substantial research on your own so you learn in the process and understand the situation better.

       Always remember that your advisers should be teaching and educating you throughout the process. If the adviser is reluctant to explain his recommendations, I would be very wary of trusting him. By finding an adviser who is a true teacher at heart, you can be more confident that the adviser is honest and trustworthy. The best adviser should be working to make himself completely unnecessary at some point!

       Don’t fall for slick marketing, a round of golf, free dinners, or nice gifts! Advisers who spend a lot of money in these types of “client appreciation” or advertising areas are simply using the money you pay them to give you “free” stuff just to make you feel good about getting ripped off. You should remember that the adviser is not going to give you so much “free” stuff that they don’t make a profit. While it may feel good to get that “free” round of golf or gift card to your favorite restaurant, you should never forget that you’ve already paid for it when you paid the adviser’s fee. Don’t fall for the illusion that it feels good to get ripped off! If you really want those things, pay for them yourself and stop paying through the nose to get it from your advisers.

       Last week, we talked about a definition of Active Investing. This week, we’ll talk about Index Fund Investing and how it differs from Active Investing.


Characteristics of Index Fund Investing

       Just as I started last week’s discussion of Active Investing by describing its characteristics, we’ll being talking about Index Fund Investing by looking at its characteristics and the behaviors of Index Fund Investors.

1.  Index Fund Investors understand that stock prices change unpredictably based on unexpected news. Index Fund Investors know that no matter how much research you put into a company random events will occur that you could never have predicted. They also understand that free financial markets (no government intervention) are mostly efficient. All known and publicly available information is already reflected in current stock prices, and these prices change almost instantly as new information becomes available. These factors make it nearly impossible to “beat the market” (appropriate benchmark) without some dumb luck.

2.  Index Fund Investors understand that Market Timing, in any form, is a loser’s game. They understand that the bulk of stock market returns are often contained in the best few days—and missing those few days means your return ends up much lower than it would have been if you had just held tight. Index Fund Investors know that no one in history has a long term (10-20+ year) track record of being able to figure out when to get in or out of the market. They also realize that Market Timers end up paying more in taxes because of their excessive trading—often negating any gains they might have had from their activities.

3.  Index Fund Investors understand that it takes more than an S&P 500 Index Fund to be diversified. A true Index Fund Investor will have their portfolio split between several different asset classes: Large U.S. Stocks, Large Value U.S. Stocks, Small U.S. Stocks, Small Value U.S. Stocks, Large Int’l Stocks, Large Value Int’l Stocks, Small Int’l Stocks, Small Value Int’l Stocks, U.S. Short-term Bonds, U.S. Intermediate-Term Bonds, and Global Bonds to name a few.

4.  Index Fund Investors know that investment returns are related to the risk you take. They understand diversification is a way to lower risk, and they have a feel for their risk tolerance. They also understand the risk of not meeting their goals and are willing to take the risk necessary to achieve their goals.

5.  Index Fund Investors read and understand the academic research about free markets and investing. They know that university professors and Nobel laureates are proponents of Index Fund Investing because it has been proven and backed by academic research. Index Fund Investors know that nearly all of the academic research available points to Index Fund Investing as the superior long-term choice for investors.

My Definition of Index Fund Investing

       Index Fund Investing is an investment strategy backed by academic research and over 80 years of history. It doesn’t try to “beat the market”. Instead, it attempts to duplicate market returns by keeping costs as low as possible. Index Fund Investors don’t have to be as worried about the short-term fluctuations in the market because they match their portfolios to their goals based on their time horizon. This means they’re much more relaxed than Active Investors and have more time for the things they really enjoy in life.


       If you want more great information on Index Fund Investing and why you should consider it, check out Trent’s post at The Simple Dollar on The Chorus of Voices for Index Funds.

       I often talk about a low-cost, tax-efficient, diversified portfolio as one of the keys to investment success. So what does such a portfolio look like? Here’s an example of a diversified portfolio with an overall allocation of 70% in stocks and 30% in bonds:





       You’ll probably have a few questions about the logic of this portfolio. I’ve put the answers to the questions I could think of below. If you have some questions I didn’t answer, leave them in the comments and I’ll answer them as soon as I can.


Why So Little in U.S. Stocks?
Why So Much in International Stocks?

Why Add Value Stocks?

What’s Up with the Bonds?
Why Aren’t There Long-Term Bonds?
Why Aren’t There Global/Foreign Bonds?
Why Aren’t There High-Yield Bonds?

So How Can I Invest in a Diversified Portfolio Like This?

       I highly recommend using Vanguard to invest if at all possible. This could mean investing directly through Vanguard or buying their mutual funds in your retirement or brokerage accounts. Why Vanguard? They are by far the lowest-cost provider of Index Funds in the industry. Additionally, they have a long track record of great customer service. If you invest directly through Vanguard, you can avoid commissions and many other fees (especially if you sign up for their e-delivery option).

       So which Vanguard funds should you use to replicate the diversified portfolio shown above? Here’s the list (starting at the top of the pie chart going around clockwise):

       A 70/30 portfolio using these funds and the allocation shown above would have a total expense ratio of only 0.25%. You would need to invest $54,000 to meet the fund minimums. If you have $54,000 invested directly at Vanguard in the allocation I provided, this portfolio will only cost you $135/year in investment management fees. That is just one reason why Vanguard is so great! (Note:  I do not work for Vanguard and gain nothing if you decide to use them except for the satisfaction of knowing I have helped someone save a ton of money and invest wisely at the same time.)


A Word of Caution

       Before you run off and invest your money with Vanguard or any other mutual fund company, I want to caution you first. I am in no way recommending that you invest in a 70/30 portfolio, since I do not know your personal situation. Your asset allocation is very dependent on your goals and somewhat on your risk tolerance (but not much). Exactly how you should invest also depends on where your assets are held and in what types of accounts. I highly recommend you talk with a fee-only, hourly financial planner if you’re uncomfortable with learning how to do it yourself. I also encourage you to do your own research if you’re skeptical of my endorsement of Vanguard. I’m sure you’ll find that they really are the best provider of Index Funds, but it will do you well to confirm it for yourself.

       In the future, we’ll talk more about how to figure out how much you should have in stocks vs. bonds. I’ll also discuss why you should use Index Funds and keep your costs low in addition to providing more background information so you can understand it all much better. If you have any questions, leave them in the comments and I’ll try to answer them as soon as possible!

       If you’re new to investing, you’ll soon hear about the two main styles of investing – Active Investing and Index Fund Investing. Before we can really discuss either of them at length, we need to have a definition for each approach. I’m going to set out here my definition for Active Investing, and next Friday I’ll discuss my definition of Index Fund Investing and what it means.


Characteristics of Active Investing

       Rather than start out by giving a simplified definition of Active Investing, I’m going to start out by describing some of the characteristics of Active Investing and the behaviors of Active Investors.

1.  Active Investors believe they can pick specific stocks that are going to “outperform”. They also often believe that there are other people, usually Active Mutual Fund Managers, who can pick the “right” stocks as well. The idea is that with enough research and the right insights or methods, you’ll be able to find values that other people have missed and make a fortune in the process.

2.  Active Investors think they can figure out when to get in and out of the market or a specific type of investment. They believe it is possible to tell when they should sell all their stocks and put everything in cash. Or they think commodities (or any other specific asset class) are overvalued and it’s time to start buying foreign stocks (or some other specific asset class). This is often called “Tactical Asset Allocation”, but it’s essentially Market Timing any way you look at it. Active Investors often apply the same line of thinking to individual stocks or bonds.

3.  Active Investors often think a mix of U.S. Large Company stocks provides adequate diversification. The truth is there are many other types of assets in the investment world, and you need a mix of several to be truly diversified.

4.  Active Investors often invest without thinking about risk. If an investment is a good value, you should just put your money in it, right? Wrong! You first have to consider the risk of the investment and your own risk tolerance before investing. You also have to consider the risk of not meeting your goals.

5.  Active Investors often invest without first reading the academic research about free markets and investing. Academia offers us a much less biased view of investing than the materials we see in the financial media and the advertisements of financial services companies. If you really want to understand investing, you need to learn a bit about what academic research tells us.

My Definition of Active Investing

       Active Investing is basically any investment strategy aimed at “beating the market”. This means Active Investors are attempting to get a higher net return than a relevant benchmark or index. The net return should be adjusted for all additional commissions, loads, fees, expenses, and taxes. You should compare the results over at least 10 years, but preferably over 20 or 30 years, to get a meaningful comparison. Most Active Investors fail to take all of these factors into account when comparing their performance with an appropriate benchmark. They usually don’t even pick an appropriate benchmark!


A Better Way

       Next Friday, we’ll talk about the alternative to Active Investing – Index Fund Investing.

       Bob at Christian Personal Finance has a great post about how cars affect your financial freedom. Definitely check out his post. He estimates that eliminating a $400/month car payment could mean $1,000,000 more by the time you retire. Even a $200/month payment could mean an additional $600,000 over 40 years. Granted that’s not adjusted for inflation, but it could easily mean the difference between retiring and having to work a few more years for many people. It’s just another great reason you shouldn’t buy into consumerism. There’s nothing wrong with buying a used car, and it could save you a lot of money in the long run.

OR

?

Your Choice!

       Be sure to check out this week’s Carnival of Personal Finance hosted at The Digerati Life! It’s a very interesting theme this week!

       “How much money can I safely withdraw from my portfolio during retirement so I won’t go broke before I die?”

       This very important question was not answered up until the last decade or so. Prior to that, people went off assumptions and guesses without actually verifying the information. For example, Peter Lynch often said that people could safely withdraw 7% of their portfolio and increase it by inflation each year. This was based on the idea that stocks return 7% over inflation, so Mr. Lynch assumed you could withdraw that entire 7% because your principal would keep growing with inflation. However, Scott Burns, a columnist for the Dallas Morning News, challenged Peter Lynch’s assumptions and explained the error behind his thinking.

       Numerous studies have been completed since then with most of them agreeing that 4% is a “safe” withdrawal rate. You can find a short summary here at The Retire Early Homepage. My biggest issue with these studies is that they often look at a very simple portfolio consisting of just the S&P 500 and a Bond index. This leaves out international stocks, emerging markets, small U.S. companies, real estate, and a mix of short and intermediate term bonds. A well-diversified portfolio would have all of these, but they are not included in the portfolios used in these studies.


The Crackerjack Greenback Study

       I decided to do my own study of sorts using a combination of historical return information on Vanguard funds and supplementing it with appropriate index data all the way back to 1927. From that information, I compiled the returns of various portfolios and calculated the statistical data I would need to run Monte Carlo analyses so I could test these “safe” withdrawal rates.

       I won’t go into the details of all the math and data here, but you can contact me if that information interests you. I will tell you that my portfolio return and risk assumptions are based on historical data and inflation was assumed to be about 3.8%. Mutual fund expenses were accounted for but asset management fees were not included. (So if you pay an investment adviser to manage your assets you’ll have to take that out of the amount you can safely withdraw.) I also looked at scenarios that had a 90% success rate, which means 90% of the time you would not run out of money before you die. Attempting a higher success rate is almost foolish because of all the built-in assumptions in Monte Carlo models. My results mostly agree with the previous studies, though I would say their estimates for a “safe” withdrawal rate are a bit low. The chart below shows the results from my own study (click to enlarge).

       Most people will be in retirement for 20-45 years depending on their life expectancy and when they retire. Most of us will be retired for 25 or 30 years (if we’ve saved up for it), so a safe withdrawal rate would be somewhere between 4.75% and 5.25%. We can say 5% is a good estimate.


Why Is This Important?

       Figuring out your safe withdrawal rate is important for retired people and those still saving for retirement. Those who are retired or nearing retirement need to know how much they can safely withdraw without running out of money before they die. For someone with a $500,000 portfolio, a safe withdrawal rate of 5% means they could safely withdraw $25,000 in the first year of retirement and increase that by inflation every year. You’d need to pay income taxes and any investment management fees from that amount in addition to your living expenses.

       Safe withdrawal rates are also important for those still saving for retirement because it lets us know how much we’ll need to have saved before we can retire. Assuming a safe withdrawal rate of 5%, your portfolio would need to be 20 times your required retirement income in the first year of retirement. For example, if you need $30,000/year in retirement then your portfolio would need to be $600,000 before you can safely retire. (This is assuming you’re trying to decide if you can retire today. If you’re talking about the future, you need to account for inflation.)

       We’ll discuss this in more depth later on and also explore the implications. We’ll also talk about what kind of portfolio allocation you need to have for these numbers to all work out. In the meantime, feel free to post your questions or comments below.