The topic of safe withdrawal rates is critically important to retirees. Earlier this week we talked about retirement withdrawal strategies, but that was a discussion of how to access your money rather than how much money you can safely distribute per year.
What’s a “safe” withdrawal rate?
While there are no easy answers, the stakes couldn’t be higher. If you pick a number that’s too high, you’ll run out of money before you run out of time. If, on the other hand, you pick a number that’s too low, you’ll wind up leading an unnecessarily ascetic lifestyle, ultimately dying with a huge pile of cash.
If you ask around you’re get a variety of answers. By far the most common one that you’ll run across is the 4% rule. In short, this rule holds that you can “safely” withdraw an inflation-adjusted 4% of your nest egg from the year that you retire onward.
Of course, the topic of safe withdrawal rates is very complex, and the reality is that “it depends.” In other words, it depends on your time horizon, the composition of your investment portfolio, whether or not you retire into a collapsing stock market, and so on.
The only thing that we can say for certain is that higher returns will better support whatever withdrawal rate you settle on. But how can you boost your returns without appreciably increasing your risk? Well… What would you say if I told you that the average investor can easily increase their returns by 1% per year while taking on virtually no additional risk?
Maximizing returns by minimizing expenses
Sounds too good to be true, right? After all, 1% can make a huge difference in the size of your nest egg, but there is (typically) no such thing as a free lunch. Well, consider the following.
The average expense ratio for actively managed mutual funds is in the neighborhood of 1.5%. On top of that, numerous studies have revealed that the majority of actively managed funds underperform their target indices, sometimes by a lot. Why? Mostly because of the added expense of the fund manager.
In contrast, index mutual funds (or equivalent ETFs) have dirt cheap expense ratios (often in the 0.1-0.2% range), thereby allowing them to essentially match the returns of their target indices.
So how can you increase your returns without taking on more risk? Simple. Keep a close eye on expenses. Instead of overpaying for underperformance, focus on constructing a portfolio with using high quality, low cost investment vehicles. Of course, this is often easier said than done.
For example, you might have a fee-laden 401(k) with limited options. Sure, you could lobby your employer for changes, but they might resist. In that case, your best option might be to simply contribute enough to get your employer’s match and then focus on investing outside of your 401(k), where you’ll have complete control.