- Summary: In most cases, distributions from a 401k, IRA or other retirement account before the account owner reaches the age of 59.5 are subject to a 10% penalty. There are, however, a number of exceptions. Some of the exceptions are unique to IRAs, while others are unique to 401k and other Workplace Retirement Plans.
- Hardship Exceptions
- Death (401k & IRA)
- Total and permanent disability (401k & IRA)
- Military: certain distributions to qualified military reservists called to active duty (401k & IRA)
- Medical: amount of unreimbursed medical expenses (>10% AGI for 2021, >7.5% AGI; for 2017 – 2020) (401k & IRA)
- 401k Loan
- Divorce: to an alternate payee under a Qualified Domestic Relations Order
- Permissive withdrawals from a plan with auto enrollment features (401k only)
- Must elect to withdrawal the funds within the time allowed by the plan (30 to 90 days)
- Forfeit any employer matching contributions
- Invest in Your Future Exceptions (IRAs Only)
- Education: qualified higher education expenses
- Homebuyers: qualified first-time homebuyers, up to $10,000
- Early Retirement Exceptions
- Equal Payments: series of substantially equal payments (for 401k, cannot work for employer) (401k & IRA)
- Payments can be based on just one account or multiple accounts
- Age 55 (401k Only): the employee separates from service during or after the year the employee reaches age 55 (age 50 for public safety employees of a state, or political subdivision of a state, in a governmental defined benefit plan)**
- Roth IRA Conversion Ladder
- Equal Payments: series of substantially equal payments (for 401k, cannot work for employer) (401k & IRA)
The 60/40 portfolio has powered retirements for decades. With 60% stocks and 40% bonds, this balanced fund offers equity-fueled growth and fixed income stability.
Today, however, many are calling into question the sustainability of the 60/40 portfolio. Some even argue that it's dead and that retirees need take on more risk if they want to avoid outliving their retirement savings.
In this article we'll take a deep dive into the 60/40 portfolio and whether it's still a viable approach to investing for retirees.
Table of contents
- A Brief History of the 60/40 Portfolio
- Arguments that 60/40 Portfolio is Dead
- Arguments that 60/40 Portfolio is Still Solid
- Building a 60/40 Portfolio
- Final Thoughts
A Brief History of the 60/40 Portfolio
Dating back to 1926, the 60/40 portfolio has enjoyed an annualized return of 9.1% (Source: Vanguard). Its best year, 1993, saw returns of 36.7%, while its worst year, 1931, experienced a loss of 26.6%. Over those 95 years, 22 saw the portfolio decline in value. The returns combined with relative stability have made the balanced portfolio ideal for retirees.
More recent returns show similar results. From 1972 to 2021 a 60/40 portfolio consisting of an S&P 500 index for stocks and intermediate term Treasuries for bonds has returned 9.61% with a standard deviation of 9.51% (via Portfolio Visualizer). The combination of solid returns with less volatility has been ideal for retirees.
In his 1994 paper, certified financial planner Bill Bengen gave us what is now known as the 4% Rule. In brief, the 4% Rule states the following:
- A retiree can spend 4% of their investments in the first year of retirement;
- In subsequent years, the retiree can adjust the prior year's distribution by the rate of inflation; and
- Following this approach, the retiree should not outlive their money.
Why do we care about the 4% rule? We care because the 60/40 portfolio fits in the sweet spot of the 4% Rule. Bengen found that retirees should hold somewhere between 50% and 75% in equities. In a later book, he identified 60/40 as the ideal portfolio in retirement to avoid outliving a nest egg. Other papers evaluating safe withdrawal rates have reached similar conclusions (as we'll see in a minute). Some have even evaluated its performance back to 1871!
Notwithstanding the 60/40 portfolio's stellar history dating back to the post-Civil War era, many are now calling into question its future.
Arguments that 60/40 Portfolio is Dead
There have been several arguments put forth that the 60/40 portfolio is no longer ideal for retirees. All of the arguments stem from the unprecedented financial times we are currently in.
Argument #1: Bond yields are at all-time lows
The yield on the 10-year Treasury sunk to its lowest in 2020 and remains at historic lows. When viewed on a yearly basis, the yield sunk below 2% back in 1941 (1.95% to be precise). Apart from that one year, it remained above 2.00% until 2012 (Source: Shiller). It's currently at about 1.30%.
During much of the 20th century, the yield was significantly higher. It reached over 14% in 1982. At today's low yields, many question how a 60/40 portfolio could survive a 30-year retirement.
From Money (4/21/21):
“I think the 60/40 portfolio is antiquated,” says Keith Singer of Singer Wealth Advisors in Boca Raton, Florida. “When bonds used to pay 6-8% and interest rates were falling, the 60/40 model worked great. But as they say, past performance is no guarantee of future results, and that is especially true with the 60/40 portfolio.” (Source: Money).
Argument #2: The 40-Year Bull Market in Bonds Is Over
The second argument relates to the fall of yields over the past 40 years. They hit a high in 1982, and then steadily dropped to their historic lows today. As bond yields fall, the value of existing bonds go up. As such, retirees have benefited from falling interest rates. Unless rates go negative, however, most believe the bull market in bonds is over
If the bond bull market is over, and rates begin to rise, the value of existing bonds will fall. Rising rates can also lead to lower asset values on everything from stocks to real estate, which brings us to the third argument.
Argument #3: Equity Valuations are High (and must fall significantly)
Many point to the richly valued S&P 500. The Shiller PE, which measures price-to-earnings over 10-year periods, is at one of its highest levels.
The argument here is simple. Lofty valuations suggest that stock returns over the next decade will be much lower than historical averages.
At the same time, many argue that the 60/40 portfolio should shift to a greater allocation in stocks. The reason is that while stocks are expensive, the additional long-term returns are needed to offset the paltry returns expected from bonds.
A recent report from Goldman Sachs framed the issue as follows:
The beneficial role of bonds in balanced portfolios has more recently been in doubt given that bond yields close to the zero lower bound offer a diminished returns buffer during “risk-off” periods. These doubts have only increased alongside concerns that an accelerating economic recovery from the pandemic-induced recession, amplified by historically large US fiscal stimulus, could lead to a strong rise in inflation and, in turn, the start of a prolonged bond bear market. During most historical bond bear markets, equities have outperformed bonds and have delivered positive real returns. This has been especially the case over the last 20 years, during which bond bear markets tended to be short and shallow.Source: https://www.goldmansachs.com/insights/pages/gs-research/reflation-risk/report.pdf
Argument #4: Negative Correlation May be Over
Finally, many believe the negative correlation that stocks and bonds have enjoyed over the past two decades may be over. In a report entitled The End of 60/40, Bank of America analysts warn that bonds may no longer provide the diversification investors have come to expect.
The authors explain,
The core premise of every 60/40 portfolio is that bonds can hedge against risks to growth and equities can hedge against inflation; their returns are negatively correlated,” Woodard and Harris added. “But this assumption was only true over the past two decades and was mostly false over the prior 65 years. The big risk is that the correlation could flip, and now the longest period of negative correlation in history is coming to an end as policy makers jolt markets with attempts to boost growth.
In short, there's no place to hide.
Arguments that 60/40 Portfolio is Still Solid
All of the above arguments identify real and significant challenges to the capital markets. Interest rates are at historic yields. The 40-year bull market in bonds does appear to be over. And stock valuations are extremely high.
Nevertheless, I believe the 60/40 portfolio is still ideal for retirees. It's not the only reasonably allocation in retirement, but it will continue to support a retiree for 30 years or more who relies on the 4% Rule. Here's why I believe this.
Argument #1: Retirees are long-term investors
Those who retire at a traditional age are long-term investors. For a 65-year-old couple, there is a 1-in-4 chance of at least one spouse living past 97 and a 1-in-10 chance of at least one spouse living to 100 (Source: BofA). Retirees could be in the market 35 years or longer. To put that number in perspective, 35 years ago Ronald Reagan was President and Boy George and Mr. T were filing an episode of The A-Team.
The point is that while both equities and bonds may underperform over the next several years, or decade, retirees must consider a much longer time horizon.
Of course, the first ten to 15 years of retirement are critical. Due to the sequence of returns and inflation risk, a devastating market in the first decade of retirement could spell disaster. And that brings us to the second point.
Argument #2: The 60/40 Portfolio has Worked Since 1871
No, that's not a typo. Researchers have tested the 60/40 portfolio against the 4% Rule with markets dating back to just after the Civil War. It's never failed.
Michael Kitces, CFP, published a paper showing the maximum initial withdrawal rate one could have taken in the first year of retirement without running out of money over a 30-year retirement. His research tested retirements beginning in 1871.
The lowest initial withdrawal rate was 4.4% in 1966. Some years could have seen an initial withdrawal rate of over 10%. The point is that a 60/40 portfolio has sustained a 30-year retirement through the aftermath of the Civil War, the Panic of 1893, WWI, the Great Depression, WWII, the stagflation of the 1970s, the tech bubble, 9/11, the Great Recession, and the ongoing Covid pandemic.
Argument #3: The 60/40 portfolio offers growth and stability
When compared to a portfolio heavily weighted in stocks, the 60/40 portfolio stands out for its excellent growth and muted volatility. That's not to say it's not volatile, but its up and downs are significantly less than a 100% stock portfolio. And that's precisely what many retirees need.
Since 1972, a 60/40 portfolio has returned an annual compound rate of 9.61%. These returns are lower than a 100% stock portfolio, which returned 10.75% over the same period. What's notable, however, is the volatility. The standard deviation of a 60/40 portfolio was just 9.51%, while the stock portfolio came in at 15.25%.
To put these differences in perspective, the worst year for a 100% stock portfolio during this period was -37.45%, compared to just -16.88% of the 60/40 portfolio. At the same time, the worst maximum drawdown for the stock portfolio was nearly -51%, compared to -28% for the balanced portfolio.
The increased volatility that comes with 100% stocks brings us to the next argument.
Argument #4: Retirees can stick with a 60/40 portfolio
Studies have shown that investors are not adept at timing the market. Called the investor gap, studies have documented the gap between an investment's return and an investor's return. Because investors tend to buy high when stocks are rising and to sell low in a panic when investments fall, they consistently underperform the very investments where they place their money.
One Morningstar study found that investors lost on average 45 basis points due to market timing. There was, however, one bright spot. The study found that investors in less volatile investments performed better. From the study,
When we broke down funds within asset classes based on their standard deviation, we found that funds in the least-volatile quintiles consistently had higher investor returns than those in more-volatile quintiles. This suggests that “boring” funds work well because they aren’t as likely to inspire fear or greed.
A portfolio with more stocks may perform better over the long-term. Investors in retirement, however, need to ask whether they can handle the ride.
Argument #5: The 60/40 portfolio survived rising rates and inflation
No two time periods are identical. Today we face challenges the U.S. and world have never faced. We can, however, look back at similar times to gain an understanding of how the 60/40 portfolio might perform when interest rates and inflation rise. Here I'm thinking of the period from 1941 to 1982.
The yield on the 10-year Treasury stood at 1.95% at the start of 1941. In 1982 it began the year north of 14%. Over the decade leading up to 1982, the U.S. experienced double-digit inflation, with low growth, giving way to the term stagflation.
During this time how did the 60/40 portfolio perform for retirees? Just fine. To be sure, this period is why we have the 4% rule. It represents the low water mark on a safe initial withdrawal rate. But that rate still stands at 4 to 4.5%.
The 60/40 portfolio also performed well more recently when rates began to rise earlier this year. The first quarter of 2021 was the worst for U.S. investment-grade bonds in the last two decades. The 60/40 portfolio did just fine:
“The first quarter of 2021 showed that even the worst quarter for U.S. investment-grade bonds in the last 20 years wasn't enough to derail the classic 60/40 portfolio”, says Jason Kephart.
So what’s the take for investors. As long as the correlation between traditional asset classes doesn’t shift dramatically and the portfolio continues to rise over time, then holding a 60/40 portfolio still makes sense.
That doesn’t mean investors shouldn't consider some alternative mixes but perhaps hold those on the margins and keep your core in stocks and bonds. Although, instead of holding broad indexes, they might want to consider diversifying by adding buckets of individual stocks and bonds.
At the end of the day, the most important risk any investor should always think about is the permanent loss of capital and the loss of purchasing power. The 60/40 portfolio still offers the best defence. And even it if did seem to veer off course at one point, it could have been by design.Source: https://www.morningstar.ca/ca/news/213154/does-the-60%2F40-portfolio-still-make-sense.aspx
Building a 60/40 Portfolio
So far we haven't discussed the stock and bond investments that make up a 60/40 portfolio. Most of the studies on a balanced portfolio use an S&P 500 index for stocks and intermediate term U.S. bond fund for fixed income. Given current economic challenges faced by retirees, should we further diversify our asset classes?
Warren Buffett would likely say no. The Warren Buffett portfolio he recommends consists of just two asset classes: S&P 500 index and short term U.S. government bonds. He's bullish on the future of the United States.
At the same time, the U.S. faces significant hurdles. Its population is aging, reducing the workforce while increasing the cost of social programs for senior citizens. The country's debt to GDP ratio skyrocketed as a result of the pandemic and now stands at more than 125% (Source: The Fed). And our politicians in Washington seem willing to continue borrowing at unprecedented levels indefinitely. Eventually we'll have to pay for all of this spending.
As a result, some financial advisors recommend moving beyond U.S. stocks and Treasuries. Bob Rice, the Chief Investment Strategist for Tangent Capital made such an argument when he spoke at the fifth annual Investment News conference for alternative investments.
“You cannot invest in one future anymore; you have to invest in multiple futures,” Rice said. “The things that drove 60/40 portfolios to work are broken. The old 60/40 portfolio did the things that clients wanted, but those two asset classes alone cannot provide that anymore. It was convenient, it was easy, and it's over. We don't trust stocks and bonds completely to do the job of providing income, growth, inflation protection, and downside protection anymore.”Source: https://www.investopedia.com/articles/financial-advisors/011916/why-6040-portfolio-no-longer-good-enough.asp
While I don't share his pessimistic views of the 60/40 portfolio, diversifying to international equities seems reasonable. This could include both developed countries and emerging markets. Other diversification opportunities could include real estate (REITs) and commodities. For bonds, some argue that retirees should take on more credit risk through high-yield bonds and emerging market debt.
Having said that, there's no guarantee that diversifying the portfolio will lead to better results. A well diversified portfolio has significantly underperformed a basic 60/40 portfolio over the last 15 years (commodities data wasn't available before 2007 in Portfolio Visualizer).
At the same time, if we remove commodities and add the 5% allocation back into the S&P 500, we extended the data to 1999 AND see that the greater diversification paid off.
Of course, this time period saw the tech bubble burst, 9/11 and the Great Recession, all of which had significant affects on the S&P 500. And that really is the point. While diversification is generally a sound approach to investing, it's not a guarantee of higher returns.
The 60/40 portfolio is certainly not the only reasonable approach to investing in retirement. Yet for many retirees, it has stood the test of time. It offers both growth and stability, which retirees need for their money to last 30 years or more.
Nobody knows the future. Is it possible that we could see unprecedented economic conditions that could wreck havoc on retirees? Of course we could. Although if that happens, one wonders if any asset allocation would save us.
Moving from a regular paycheck to living off of your nest egg is not an easy transition. At least it hasn't been for me. One of the many decisions retirees must make is how much cash should they have in the bank.
For some it's a question of budgeting. They keep enough to pay the bills over the next several months, but that's it. For others cash acts as a buffer in the event the stock market drops 10%, 20% or more. For those who see cash as a buffer, several more questions need to be considered:
- How much cash should you keep in the bank?
- How do you decide when to replenish your spending account?
- Do you factor the amount of cash you have into your overall asset allocation?
In this article I'll explore these questions. We'll look at some research papers that address these questions. We'll also talk about how you can get the psychological benefits of holding lots of cash without actually holding lots of cash.
The starting for all of this is the 4% Rule. First, however, we need to cover the basics.
Featured Offer: Sallie Mae 14-Month No Penalty CD
- 14-Month No-Penalty CD
- APY: 4.75%
- Min. Deposit: $1
- No early withdrawal penalty
- FDIC Insured
What is Cash?
For our purposes, I define cash as money in an FDIC-insured account (checking, savings, money market account or possibly a certificate of deposit) or a money market fund. The later is not FDIC-insured, but it's extremely safe. U.S. government T-bills would also qualify as cash.
What I don't include in cash are bonds with durations of longer than one year.
What about Social Security, Pensions, Annuities, and Part-Time Work?
Retirees fund retirement from many sources. Most receive social security. Many have pensions or annuities. And some, myself included, still do part-time work to generate some income. All of these sources generate cash for us, typically on a monthly basis.
The question we are addressing is how much cash, over and above any cash these other sources generate, do we need to pull from our investments. In other words, how much do we need to pull from 401k, IRA and taxable accounts each month or year for living expenses.
These other sources will of course reduce how much we have to pull from our investments. But most of us have to pull something out, and that's what this article addresses.
The Budget-Dividend Strategy (My Preferred Approach)
My preferred approach to cash in retirement is what I call the Budget-Dividend Strategy. The nice thing about this approach is that it addresses three liquidity concerns at the same time:
- It guarantees that I'll always have cash on hand
- It helps with budgeting
- And it coincides with quarterly dividend payments, which can be used as a source of funds
Here's how the Budget-Dividend Strategy works.
At the start of the year I pull six months worth of living expenses from our investment accounts. In our case the money gets deposited into our checking account.
When the balance declines to three months of living expenses, we add cash to bring the balance back to the six months of expenses level. If we are generally on track with our budget, this should happen after three months.
The timing is convenient because ETFs and mutual funds typically pay dividends at the end of each quarter. In our taxable account, we do not automatically reinvest dividends. So once the dividends hit our money market fund in our brokerage account, I can move some or all of them over to our bank account.
If we need more than the dividends give us, I withdrawal additional funds from investment accounts. Here I make the decision on a number of factors, such as taxes and which asset classes have performed best.
Once we start taking Required Minimum Distributions (still two decades away), we'll use the RMD to fund living expenses as well.
Benefits of the Budget-Dividend Strategy
The are several benefits to this approach.
First, we keep the vast majority of our capital fully invested. Even assuming an initial 4% distribution per year, we never have more than 2% in cash (6 months of living expenses). And this number drops to 1% (3 months of living expenses) before we replenish the cash account.
Second, the timing of when we replenish the account coincides with distributions from ETFs and mutual funds. This isn't necessary, and may be irrelevant for those without significant taxable investments. But it's convenient for us.
Third, the approach also makes budgeting easier. We track our spending in Personal Capital and Tiller Money. This approach to cash, however, makes it easy to know at a glance if we are on track, over spending or under spending.
The No Cash Strategy
One approach to cash in retirement is virtually no cash at all. One could sell investments monthly to cover just one month of expenses. If most spending is put on a credit card, the no cash strategy could work.
Personally, I find the idea of tapping my investments monthly to be too much of nuisance. Still, it's worth pointing out that one could take this approach. For those who do, finding a broker that offers check writing, online bill pay, and perhaps even a debit card would be useful. Even here, however, you'd be transferring funds from stock and bond funds to a money market fund every 30 days, which many would find tiresome.
The Buffer Strategy
Our approach to cash keeps the vast majority of our assets fully invested. Some advocate a different approach called the Buffer Strategy. The idea is to keep as much as five years worth of living expenses in cash. The strategy has some initial appeal.
Over the past 100 years, the worst stock market performance saw a decline four years in a row (from 1929 to 1932). The market has never been down five years in a row.
Here's a chart of the S&P 500's yearly performance dating back to 1928:
Of course the market could be down 5 years in a row sometime in the future. But the idea of a cash cushion is to avoid selling stocks when the market is down. It has some intuitive appeal.
And it's a bad strategy.
First, if we rebalance our portfolio at least once a year, we won't sell stocks in a bear market. When the market is down significantly, the simple act of rebalancing will cause us to sell bonds and buy stocks. This is true even if bonds decline a bit.
For example, in 1931 the 10-year Treasury Bond was down 2.56%. The S&P 500 (or equivalent) was down more than 43%! In that scenario, we still be selling bonds to buy stocks as part of rebalancing.
Just as important, holding five years worth of cash creates a serious drag on our portfolio's performance. Let's make sure we understand why.
Cash and the 4% Rule
The 4% Rule comes from a 1994 paper written by financial planner Bill Bengen. Using historical returns and inflation data, Bengen tried to answer how much a retiree could spend each year without going broke.
His conclusion was that a retiree could spend 4% of his or her nest egg in the first year of retirement. Thereafter, they could increase this amount by the rate of inflation (he used CPI). Following this approach, he concluded, a retiree's nest egg would last at least 30 years, and in some cases 50 years or longer.
There were, however, some important underlying assumptions in his work. For example, he assumed retirees invested in an S&P 500 index fund for stocks and an intermediate U.S. government bond fund for bonds. He also concluded that stocks should represent 50 to 75% of a retiree's asset allocation. Any more and a big stock market decline (e.g., 1929 to 1932) would shorten the longevity of a portfolio. Any less and a return to double-digit inflation could do irreparable harm.
So what does this have to do with how much cash we should hold?
For his analysis, Bengen assumed that retiree withdrew funds from the portfolio once a year and then rebalanced. The rebalancing did not factor in the cash that was just taken from the portfolio. His focus was not on how much cash to hold. That's just the approach he chose for his analysis.
Nevertheless, it's important to keep his approach in mind. For those choosing to deviate from a once-a-year distribution strategy (at most) to hold significantly more cash, keep in mind that the conclusions from his research may not hold. And indeed, subsequent research confirms this outcome.
Research on the Buffer Strategy
Arguably the most comprehensive study comes from Professor Walter Woerheide, Ph.D., ChFC, CFP®. At the time of publication, he was the Frank M. Engle Distinguished Chair in Economic Security Research, at The American College in Bryn Mawr, Pennsylvania.
In 2012 Professor Woerheide published a paper entitled, Sustainable Withdrawal rates: The Historical Evidence on Buffer Zone Strategies. He evaluated cash buffers of one to four years, using a replenishing strategy based on whether the investment portfolio was up or down the previous years.
If the investments were up, the cash buffer was replenished along with any required withdrawals. If the portfolio was down, withdrawals came from the cash buffer. The only time cash came from the investment portfolio following a down market was if the cash buffer were exhausted.
Looking at several different asset allocations, the results were clear. A cash buffer strategy underperforms a standard rebalancing approach. It reduces the likelihood that a portfolio will last 30 years. It also reduces the portfolio's balance at death.
Here's a summary of his findings:
Several other studies have confirmed these results:
- Cash reserve buffers, withdrawal rates and old wives’ fables for retirement portfolios
- Research Reveals Cash Reserve Strategies Don’t Work… Unless You’re A Good Market Timer?
- Cash Buffers, Sustainable Withdrawal and Bear Markets
Harold Evensky is the father of the bucket strategy. He's also a proponent of the Buffer Strategy for cash. In 2021 he co-authored a paper (The Benefits of a Cash Reserve Strategy in Retirement Distribution Planning) that concluded a cash buffer equal to one year of expenses actually improved the likelihood that a portfolio could be sustained for at least 30 years. His study is the outlier and deserves a brief comment.
He found the a 1-year buffer strategy (he called it the Cash Flow Reserve or CFR) out performed a standard rebalancing approach (RDCA–Reverse Dollar Cost Averaging), particularly with taxes and transaction costs were factored in. Here's a summary of his findings:
There are several serious flaws in the study.
First, it used a 1-year cash buffer that was allowed to fall to just two months. As a practical matter, that's no cash buffer at all.
Second, he used a Monte Carlo simulations instead of historical data. In and of itself this isn't a problem, but the inputs he used heavily favored cash. He assumed an average stock return of 8.75%, well below the historical average. He also assumed a 3.5% return on cash with a 3.0% rate of inflation. This gave cash a 0.50% real return.
In other words, the study was designed to reach a certain conclusion, in my opinion. The fact is that a significant cash cushion represents a significant drag on performance that hurts retirees in the long run.
How to Sleep at Night with Little Cash in the Bank
While it's clear that the Buffer Strategy underperforms, we need to address the psychology factors. As someone who is semi-retired, I understand firsthand the fear of spending investments. That fear grows when the stock market drops as it did at the start of the Covid pandemic.
To address this real concern, here are a few approaches retirees can take that won't do as much harm as holding too much cash.
First, calculate how long you can live on just your bonds. If you have a 60/40 stock/bonds allocation, for example, you can live on just the bonds for about 10 years, assuming an initial 4% withdrawal.
This approach assumes your bonds are primarily U.S. government short and intermediate-term bonds. Riskier bonds, such as high-yield or emerging market debt might not provide as much comfort. The point is that recolonizing just how long your bond portfolio can get you may help you weather a stock market decline.
Second, and related to the first, is to allocate some of your bonds to cash. For most this would mean a money market fund. For example, a 60/40 portfolio would become a 60/30/10 portfolio (stocks/bonds/cash). Studies have found that converting some of the bonds to cash doesn't have a major effect on the longevity of the portfolio.
Bill Bengen actually reached this conclusion in a 1997 paper. He found that a 10% allocation to short-term U.S. Treasury Bills did not significantly reduce the starting safe withdrawal rate of about 4%. Others have reached similar conclusions (see here and here).
Investing during retirement can be stressful. Still, we need to resist the urge to play it “safe” by holding too much cash. What may feel safe could over time do far more harm than good. A simple approach of three to six months in cash keeps are capital invested while still giving us ample room to do with unexpected expenses.
It costs money to invest. We pay all types of fees, some obvious, some not so obvious. In this article I'm going to walk through the most common investing fees you are likely to encounter. Then we'll examine just how destructive a seemingly small amount of fees can be to your wealth and retirement.
Table of contents
Do Fees Really Matter?
Before looking at specific types of investment fees, let's first ask whether fees really matter. To answer that question, the first thing we must recognize is that seemingly small fees, over time, can seriously reduce the value of an investment portfolio.
The Securities and Exchange Commission (SEC) published a paper on this very topic in 2014. It noted that “fees may seem small, but over time they can have a major impact on your investment portfolio.”
Some have argued that fees don't matter. Instead, what matters are returns after factoring in the fees. In other words, paying high fees is not only fine, but ideal, if the investment returns enough to justify the fees. Conceptually this makes sense. In practice, however, it falls apart.
Study after study after study shows that expensive investments underperform inexpensive investments. For example, Vanguard looked at the annualized returns for a 10 year period ending December 31, 2014 for two groups of mutual funds: 25% of the funds with the lowest expense ratio and 25% with the highest. The low-cost funds won.
The primary way we keep fees down, as we'll discuss more below, is to use low-cost index ETFs and mutual funds. It's an approach Warren Buffett, the CEO of Berkshire Hathaway and arguable the best investor alive today, supports:
Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.
My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. . . . My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.
Types of Investment Fees
There are countless fees investors may encounter. I'm going to list them in the order you are more likely to encounter them. Some fees are virtually unavoidable, but can be kept to a minimum. Other fees should be avoided at virtually all costs. Frankly, the only fee that is truly unavoidable is the first one on our list–expense ratio.
Mutual funds and ETFs charge investors a fee. The fee covers the cost of the fund, including payroll, as well as profit for the fund company. Expense ratios are expressed as a percentage. For example, a fund that charges a one percent (1%) expense ratio would cost an investor 1% of the amount invested in the fund (e.g., $100,000 investment would cost $1,000 per year with a 1% expense ratio).
The expense ratio is practically unavoidable. Fidelity does offer a few funds with no expense ratio, but that's the exception. Even low-cost fund provider Vanguard charges expense ratios on its ETFs and mutual funds.
There can be costs to buy and sell stocks, mutual funds and ETFs. By and large these costs are easy to avoid. Most mutual fund companies and brokers have gone to $0 trades if made online. There is, however, one important exception.
Many brokers charge a commission when you purchase a mutual fund (not an ETF). For example, I have an account at Merrill Edge, and the broker charges $19.95 when I purchase certain mutual funds. They do have a list of fee-free funds, but many of the funds I use from Vanguard would require payment of the commission.
For this reason, it's important to understand the types of investments you want to make before choosing a broker. If you know, for example, that you'll invest entirely in Vanguard funds, it makes sense to open an account at Vanguard or a broker that offers at a minimum free Vanguard ETFs. M1 Finance is a good example and a broker I also use.
Investment Advisor Fees
Advisor fees come in two forms: (1) a percentage of assets under management (AUM), or (2) a fixed or hourly fee. The vast majority of advisors charge a percentage of AUM, with 1% the industry standard (although fees do vary based on account size and services provided).
Some lower cost AUM advisors have entered the market over the past 10 years or so. Vanguard offers advisory services for just 30 basis points. A number of so called robo-advisors offer their services for about 25 basis points (e.g., Betterment and Wealthfront).
A growing list of advisors have turned to hourly or fixed fees. These arrangements almost always favor the client, as the total cost is generally far less than the AUM model. One such advisor is Mark Zoril of PlanVision.
As you'll see in a minute, Advisor fees based on a percentage of AUM destroy more wealth than any other fee (although high expense ratios are a close second).
Some mutual funds charge what are called load fees. Front-end load fees are paid when you invest in a mutual fund with this type of fee; Back-end load fees when you sell.
Front-end load fees typically cost 5.75%. For every $100 invested, fees take $5.75, leaving $94.25 in your account. There's absolutely no reason to invest in mutual funds that charge load fees. Ever!
Where to Find the Expense Ratio of a Mutual Fund
There are several easy ways to find the expense ratio of any mutual fund or ETF. For starts, you can Google the ticker symbol of the fund. VSTAX, for example, is Vanguards total stock market fund. Searching “VSTAX” returns the following result, including the fund's expense ratio:
You can also see if a fund charges a load fee AGTHX, an American Funds growth fund:
Another free tool that tracks both the expense ratio as well as any load fees is Morningstar. You can also check the prospectus of the funed.
As for investment advisor fees, you should ask. It's as simple as that. It should also be reflected on your statements. You can also find fee disclosures in the advisor's Form ADV. But asking is much easier.
How to Determine the Expense Ratio of Your Investment Portfolio
While it's important to know the expense ratio of each investment, what really matters is the overall expense ratio of your portfolio. You could calculate this by hand. Just take the weighted average of your expense ratios across all of your investments. If that sounds as inviting as a root canal, there is an easier way. Use Empower.
Empower is a free financial dashboard. Link all your financial accounts (checking, savings, credit cards, retirement accounts, HSAs, loans, taxable investments) and Empower provides a wealth of tools. You can do everything from budgeting to loan payoff to retirement planning. And for our purposes, it will automatically calculate the expense ratio of your investment portfolio.
Here's the results from a demo portfolio I entered into Empower:
Note the 0.10% annual fee to the right. That's the expense ratio of a portfolio that included dozens of investments. You can read my review of Empower or go directly to its free signup page (truly free-no credit card needed–ever).
How Fees Affect Your Wealth
Let's imagine that we make the maximum contribution to an IRA ($6,000) during our working years from age 20 to 65. If we earn an average of a 9% return on our investments, we'll retire with about $3.1 million (gotta love compounding).
Now let's assume we pay an investment advisor a “small” 1% fee. Our retirement fund drops to $2.3 million. Add in a 1% expense ratio on the mutual funds, and our nest egg falls further to $1.7 million. Yeah, fees matter.
How to Avoid Most Investment Fees
There are several important steps to take to keep you fees low.
Low cost index funds: First, stick to low cost index funds (ETFs or mutual funds). They outperform the vast majority of actively managed funds over time. There are plenty of sound “lazy portfolios” that make for great long-term investment strategies. Here are a few of them:
Avoid Expensive Advisors: There's simply no good reason to pay more than about 0.30% of AUM, at the most. Vanguard offers its services at this price. Why pay more? And there are plenty of advisors who charged by the hour, which is even better.
Consider Automated Investment Services: For those that want a little help, you can consider a robo advisor. They come in all shapes and sizes. I like Betterment and Wealthfront for those who want a set-it-and-forget-it arrangement. Cost is about 25 basis points. For those who want more control, M1 Finance is the way to go. It lets you create your own mutual fund (they call them Pies). It's easy to use, easy to rebalance, and free.
My goal for this website is to help readers become better investors and prepare for retirement. To do this, some of the products featured here may be from our partners. This doesn’t influence our evaluations or reviews. Our opinions are our own.
Opening an IRA account is an important step towards saving for retirement. The best IRA accounts have low fees, a wide array of investment options and tools that make investing easy.
- Summary of Best IRA Accounts
- How to Choose the Best IRA Account
Summary of Best IRA Accounts
Best Robo for hands-off investors
I met the founder of Betterment, Jon Stein, about 10 years ago. Since then, I've followed Betterment closely. It is one of a few robo advisors I recommend for IRA accounts.
With Betterment, the only decision you have to make is how much you want invested in stocks and how much in bonds. Betterment even helps you make that decision through a series of questions. Once you set your stock and bond allocation, Betterment does the rest. It automatically allocates your portfolio across about a dozen stock and bond ETFs.
One downside of Betterment is that, like all robo advisors, there is a fee. Betterment's fee is 25 basis points (0.25%) for what it calls Digital Investing. The cost goes up to 40 basis points (0.40%) with Premium Investing, which gives you unlimited calls and emails to Betterment's team of Certified Financial Planners. You can also purchase flat-fee advice from one of Betterment's CFPs. These fees are in addition to the costs of the underlying ETFs.
- Well established robo advisor
- Reasonable costs
- Excellent portfolio construction
- Flexible Portfolios
- Retirement planning tools
- Very easy to use
- Human advisors for an extra fee, including flat-fee advice
- Fees over and above the cost of ETS
Account Types: Traditional IRA, Roth IRA, SEP IRA, Inherited IRA
Account Fees: 0.25% to 0.40%
Transaction Costs: None
Required Minimum: None
Investing Tools: Automatic portfolio construction, diversification, rebalancing, and dividend reinvestment
Promotions: Up to 1 year of waived account fees
Best Overall IRA Account
Fidelity is a full service broker that powers many of the 401k plans and other retirement accounts. As an IRA provider, it gives investors access to virtually every mutual fund and ETF or stock available in the market. It does so without account fees, and its minimum investment requirements, if any, are low.
It spends $2.5 billion a year on technology, enabling it to offer excellent tools. One example is an account aggregation feature called Full View. Powered by eMoneyAdvisor software, you can aggregate all of your financial accounts, including those held outside Fidelity, into the tool. It gives you a dashboard of all of you finances. While I do take advantage of this feature, Personal Capital is a better option in my view.
Fidelity also offers its own version of a robo advisor, called Fidelity Go. Unlike Vanguard's Digital Advisory Service, it requires no account minimum and is free for accounts up to $10,000. For accounts between $10,000 and $49,999, it costs $3 a month. For accounts $50,000 and up it costs 0.35% per year.
Finally, I've found Fidelity's customer service to be very good. It also has physical locations, which I find helpful. It's not often that I need to speak with a Fidelity representative in person, but it's nice to know that I can if needed.
- Excellent customer service
- Fidelity invests heavily in technology
- Wide range of account types
- Wide range of investment options, including low cost index funds
- Robust investing tools
- Low costs
- Cash management (debit card, credit card, online bill pay)
- Website can be difficult to use
- No Roth Solo 401(k) for business owners
- Robo Advisor services (Fidelity Go and Go + are more expensive than alternatives)
Account Types: Traditional IRA, Roth IRA, SEP IRA, IRA Rollover, Inherited IRA
Account Fees: None
Transaction Costs: None
Required Minimum: None
Investing Tools: Stock ETF or mutual fund research and market analysis tools, Full View
Best for Low Cost Advisory Services
I've been a Vanguard client for decades. I'm a huge fan of their mutual funds and ETFs. Of course, you don't need to open a Vanguard account to invest in their funds. In fact, you can invest in Vanguard funds through any of the IRA brokers listed here.
For those who know they want to invest in only Vanguard funds, however, it is a good option for opening an IRA. It's also a good option if you want to use its advisory services. It offers both a digital advisory service for 25 basis points ($3,000 minimum) and a human based advisory service for 30 basis points (minimum $50,000). Otherwise you can invest on your own for just the cost of the Vanguard mutual funds and ETFs.
- Excellent mutual funds and ETFs
- Digital and human powered advisory services
- Website and tools could be better
- Advisory services have minimum investments
- Vanguard mutual funds have minimum investments (typically $1,000 or $3,000)
Account Types: Traditional IRA, Roth IRA, SEP IRA, IRA Rollover, Inherited IRA
Account Fees: None unless an advisory service is used
Transaction Costs: $0
Required Minimum: $1,000 to $3,000 for many of Vanguard's mutual funds, no minimum for ETFs, $3,000 for its Digital Advisory Services, $50,000 for its Personal Advisory Services.
Investing Tools: Asset allocation tool, investment comparison, screen & analyze investments, retirement planning tools, education savings tools.
Best for hands-off investors
Wealthfront is one of three robo advisors to make our list of the top IRA account options. It's very similar to Betterment. You simply select your stock and bond allocation and Wealthfront takes care of the rest.
It has a similar cost structure at 25 basis points plus the cost of the underlying ETFs. It does have a few differences in terms of portfolio construction. Most notably it includes a REIT index fund in retirement accounts, whereas Betterment does not. Wealthfront automates investing. It helps you create a personalized portfolio, and then rebalances it automatically as markets fluctuate.
Wealthfront also offers a retirement planning tool it calls the Path. The tool enables users to connect outside accounts, and then it evaluates your retirement readiness.
For those in retirement, Wealthfront offers a number of cash management features. These include accounts with up to $1 million in FDIC insurance, online bill pay, mobile check deposit and no account fees. It also offers a Visa debit card with over 19,000 free ATMs. Note, however, that its interest rate is well below the best online bank options.
If you have taxable accounts at Wealthfront, it also offers automated tax-loss harvesting and direct indexing.
- Easy to use
- Low cost
- Excellent portfolio construction
- Automatically rebalances portfolio
- Automatically harvests tax losses in taxable account
- It does charge a fee over and above the ETFs
- Limited portfolio construction options
Account Types: Traditional IRA, Roth IRA, SEP IRA and IRA Rollover
Account Fees: 0.25%
Transaction Costs: None
Required Minimum: $500
Investing Tools: Personalized portfolio construction, automatic rebalancing, automatic tax loss harvesting
Promotions: Get the first $5,000 managed for free
Best Free Robo-Advisor
M1 Finance earns our top award for the best free robo-advisor IRA account. It earns this honor for several reasons.
First, it charges no account fees or transaction fees. While I like other automated services such as Wealthfront and Betterment, M1 Finance is the only one that doesn't charge a fee for its services. Second, it enables you to build what it calls pies. You can think of a pie as a portfolio that you can include just about any ETF or stock that you want.
You can use pre-constructed pies that are excellent for retirement investing. In fact, I've created a 3-fund retirement portfolio in M1 Finance that anyone can use. I've also created several more complex portfolios to consider.
With M1 Finance, managing an IRA is easy. You can rebalance a portfolio with the click of a button. And for those that want to invest in individual stocks, you can easily create a pie that contains the stocks of your choice or add individual stocks to a pie that is invested also in index ETFs like the portfolios above.
Creating the pies, while easy, does take some effort. As such, M1 Finance is not as hands-off as other robos, such as Betterment and Wealthfront (see below).
Account Types: Traditional IRA, Roth IRA and SEP IRA
Account Fees: $0
Transaction Costs: $0
Minimum Deposit: $100
Investing Tools: Easily create customized portfolios or use portfolios created by M1 Finance, auto-invest settings, auto-rebalance portfolio
Promotions: $30 bonus when you fund your account with $1,000+
Want help with a 401k Rollover? Capitalize will walk you through the process for free. They do all the leg work to move your 401k to your existing IRA or a new one of your choosing. Not sure where to open an IRA? Capitalize can help you with that, too.
Best for hands-on investors and Bank of America clients
I recently opened a rollover IRA at Merrill Edge. It's part of Bank of America, making it ideal if you bank at BofA. Merrill Edge can be a great way to have all of your accounts under one umbrella. Similar to a Fidelity or Vanguard, you can invest in just about anything through Merrill Edge.
It also offers a robust set of tools for research and analyzing investments, including tracking your progress towards retirement. It does offer its version of a robo advisor, called Merrill Guided Investing. The downside is that it's more expensive than Betterment or Wealthfront.
- Low Cost
- Excellent investment tools
- Integrated with Bank of America accounts
- No automated rebalancing
- Merrill Guided Investing more expensive that other robo advisors
Account Types: Traditional IRA, Roth IRA, SEP IRA, IRA Rollover, Inherited IRA
Account Fees: None for self-directed IRA accounts. Merrill Guided Investing costs 0.45% for online only and 0.85% for online with an advisor
Transaction Costs: None
Required Minimum: None for self-directed IRA; $1,000 for Merrill Guided Investing; $20,000 for Merrill Guided Investing with an advisor
Investing Tools: Research and retirement planning tools
Promotions: Up to $2,500 for new accounts depending on value. This promotion occurs annually for a limited time.
Best for hands-off investors
Ally, the financial institution best known for online banking, brings the same excellent website and mobile app to an investment platform. It offers both self-directed IRAs and its own version of a robo advisor called Managed Portfolios. It also comes with a host of tools to analyze your investments and your portfolio.
For self-directed IRAs, there are no commissions or account fees. The Managed Portfolios option requires just a $100 minimum. Unlike other robo advisors, Ally doesn't charge a fee. However, it does require you to keep 30% of your portfolio in cash, which is a non-starter for retirement investing. As such, I don't recommend Ally Invest's Managed Portfolios unless you have a specific reason for keeping so much in cash.
- Virtually free
- Easy website to navigate
- Excellent tools
- Excellent mobile app
- Managed Portfolios keep 30% in cash
Account Types: Traditional, Roth IRA and Rollover IRA
Account Fees: None
Transaction Costs: None
Required Minimum: None to open a self-directed account, $2,000 for margin accounts, and $100 for a Managed Portfolio account.
Investing Tools: Streaming charts, profit/loss calculator, market and company snapshots, probability calculator, watchlists, market data and option chains.
Promotions: $50 to $3,500, requiring a deposit of transfer of $10,000 to $2 million or more. Ally Invest also credits transfer fees, up to $150, when moving accounts from another broker.
How to Choose the Best IRA Account
Don't focus on what you will invest in
One of the big misconceptions about opening an IRA account is that you should focus on what you want to invest in. When I started investing 30 years ago, this was an important consideration. I couldn't go to Fidelity and buy Vanguard funds. Over time, you could but there were fees.
Today, you can invest in virtually anything at just about any broker with few if any transaction costs. As a result, when opening an IRA account, the focus shouldn't be on what you want to invest in. Instead, focus on how you want to invest.
Focus on how you will invest
There are basically three types of investors. There's the hands off investors, who simply wants to set it and forget it. There's the hands-on investor who wants to control every detail of the portfolio. And then there are those who want to be able to control their investments to some degree, but at the same time automate things like rebalancing the portfolio.
Understanding the type of investor you are will help you pick the best IRA account.
3 Types of Investors
1. Hands-Off Investors
The best IRA account options for hands-off investors are M1 Finance, Betterment and Wealthfront. Strictly speaking, Betterment and Wealthfront are the most hands off types of IRA accounts in our list. As noted above, you simply set the stock and bond allocation and they do the rest. The downside is that they both charge fees for the service of 25 to 40 basis points. While that may not seem like much, over a lifetime of investing it can easily add up to hundreds of thousands of dollars.
With M1 Finance, you do have to decide on the pie you want to use. They're easy to create and there are pre-built pies that are ideal for long term retirement investors. Once you select one, it functions very similar to a robo advisor.
Each contribution you make is divided among the individual investments in your pie according to the allocation you set. In addition, you can rebalance the portfolio with the click of a button. At the same time, however, you get great control over your investments. For example, if you wanted to add the stock of a single company to a three fund portfolio, you could do so in a matter of seconds. You could then allocate whatever percentage of that portfolio you want.
Either way, M1 Finance, Betterment and Wealthfront are all good options for hands-off investing.
2. Hands-On Investors
A traditional broker is certainly a strong option in our list that includes, Vanguard, Fidelity, Merrill Edge and Ally Invest. While they each have their own pros and cons, for most IRA investors it frankly doesn't matter. You can buy any investment you want at any of these brokers and they all function in a relatively similar ways.
Alternatively, hands-on investors could use M1 Finance. As noted above, you can construct the pie or multiple pies as you see fit. You control the rebalancing and at the same time M1 Finance tools make rebalancing very easy.
3. Control with Automation
As you've probably guessed by now, there's only one that fits into this category, and that's M1 Finance. If I were starting as an investor today, I'd probably use M1 Finance. I use it today to invest all of the cashback credit card rewards that we receive.
Understanding the Impact of IRA Account Fees
Investment fees are critical to the long term performance of any portfolio. Most IRA account brokers charge no account fees or transaction fees. The one exception are robo advisors, including automated investing platforms at traditional brokers. Fees for these services range from about 0.25% to 0.45%.
It would be a mistake to dismiss these fees. While robo advisors are a good choice for those wanting totally hands-off investing, it's important to understand how these fees can effect your wealth over time.
Let's assume you invest $500 a month over a 45 year period (we'll ignore inflation). The account would grow to approximately $2.6 million with an 8% return (thank you, compounding!). If we reduce that return assumption by 25 basis points to account for the robo advisor fees, the account balance drops by more than $200,000 after 45 years.
While it's certainly true that $200,000 45 years from now will be worth a lot less than it is today, it's still a lot of money. This doesn't rule out Betterment, Wealthfront or other managed portfolios. But it should be a consideration as you make your choice.
My analysis stems from holding accounts at each of the brokers on the list, with the exception of Ally Invest. I've had a Rollover IRA, Roth IRA, Traditional IRA, SEP IRA or an Inherited IRA at Wealthfront, Vanguard, Fidelity and Merrill Edge. I've held taxable accounts at Betterment and M1 Finance.
Beyond my own experience, I focus on fees and functionality. Fees are always critical, and how each broker works is important. You want to match your own personal approach to investing with the right IRA account. I also considered each broker's website and mobile app, as well as their investing tools.
Where is the best place to open an IRA?
For the vast majority of investors M1 Finance is an ideal option. It's virtually free and gives access to just about every mutual fund, ETF or stock out there. In addition it has excellent tools to manage your portfolio, including automated rebalancing.
Are there any free IRA accounts?
Yes. Most brokerage accounts today offer IRA accounts with no account fees and no transaction costs. One exception would be robo advisor type services, such as Betterment, Wealthfront or Vanguard’s Digital Advisory Services. These tools, while making investing easier, typically cost 25 to 45 basis points, in addition to the costs of the ETFs.
Can I open an IRA account if I have a 401k?
Yes. Having a workplace retirement account does not disqualify you from opening an IRA.
Your income, marital status, and other factors, however, could determine whether you can deduct traditional IRA contributions from your income, or whether you can contribute to a Roth IRA.
The 4% rule is a rule of thumb that can help you figure out how much money you can spend each year in retirement without going broke. If you're many years away from retirement, you can also use it to figure out just how much money you'll need to actually retire. This article is the first of a series exploring the 4% rule, how to apply, its limitations, and alternatives to retirement spending methodologies.
Table of contents
- My Experience with the 4% Rule
- How the 4% Rule Works
- Where did the 4% Rule Come From?
- How to use the 4% Rule for Retirement Planning
- How the 4% Rule can Lead to Bizarre Results
- How the 4% Rule Works–Video
My Experience with the 4% Rule
The 4% rule hit home for me two years ago at the age of 51. I had just sold my business, an online media company that owned a number of finance blogs. And I retired. Yes, I'm part of the FIRE (Financial Independence, Retire Early) crowd.
At the time, I did all the calculations using the 4% rule on a very conservative basis. My wife and I had more than enough to retire. But actually doing it is a lot different than thinking and writing about it. After I sold the business, I was scared to spend the money. In fact, I was so scared, I took a full time job.
I know that doesn't make a whole lot of sense. But that's what I did. Now, in fairness, I worked at Forbes and enjoyed it immensely. It was lifestyle friendly. However much I enjoyed the work, it doesn't change the fact that I built a business, sold it, and retired at the age of 51, only to go back to work out of fear of running out of money.
Now, the good news is it forced me to really take a deep dive into the 4% rule. I've read dozens of papers on the 4% rule. I have read books, I've studied dynamic spending plans, things called guardrails.
I've even looked at how institutional investors like the Yale endowment figure out how much money they can spend each year from the endowment without running out of money. There are a lot of parallels between how an endowment functions on the one hand, and how you and I should think about spending in retirement on the other.
What I learned from studying the 4% rule is that it's a really good rule of thumb. It still works today. Second, almost no one should actually follow it in retirement. I know those seem to contradict each other, but they don't, and I'll explain why as we go along in this series.
In this article we're going to look at four things. First, we cover a high level view of what the 4% rule is and how it works. Second, we're going to look at who created the 4% rule. Third, we'll cover how to use the 4% rule to estimate how much you need to save to retire. Finally, we're going to look at some very bizarre results that can flow from actually following the 4% rule. So let's get started.
How the 4% Rule Works
The 4% rule is simple to apply in retirement. It takes just 3 steps.
Step 1: Add up your retirement savings
The first step in using the 4% rule is to add up all of the money you've saved for retirement. This can include both retirement accounts as well as taxable accounts you expect to use to fund expenses in retirement. For example, you would include any money in a 401k or other workplace retirement plan, any IRAs that you have, and any money in taxable investing accounts, or savings accounts, certificates of deposit, or checking accounts.
Include anything you've saved, that's going to be used to fund your retirement. Typical accounts include the following:
- Roth IRA
- HSA (if used for retirement)
- Taxable investment accounts
- Savings accounts
- Certificates of deposit
There are a few things you don't include. You don't include social security, annuity income or pension payments. You're only factoring in money you've saved and accumulated for retirement. If you use a tool like Personal Capital to track your investments, this step is easy.
That's step one. Let's imagine that you've saved $1 million just to use a round number to make the math a little easier.
Step 2: Multiply your retirement savings by 4%
The second step is to multiply the results from step 1 by 4%. With $1 million, 4% would be $40,000. That's the amount of money using the 4% rule that you could spend in the first year of retirement.
Step 3: Beginning in year 2 of retirement, adjust the prior year's spending by the rate of inflation
It's the second year that trips some folks up. The way you calculate all the years in retirement after year one is different. Beginning in year two, you do not use 4%. Instead, you take the amount of money you were able to spend the prior year and adjust it for inflation.
So in our hypothetical we spent $40,000 in year one of retirement. Let's assume inflation is 2%. In year two, we could spend $40,800. To calculate this number, we simply add 2% to the amount we were able to spend in the previous year. Two percent of $40,000 is $800. Added to our first year spending brings us to $40,800. The following year we'll increase $40,800 by the rate of inflation (or decrease it by the rate of deflation).
Where did the 4% Rule Come From?
The 4% rule dates back to 1994. It comes from an article published in the Journal of Financial Planning by William Bengen, a certified financial planner. He is the father of the 4% rule. The article–Determining Withdrawal Rates Using Historical Data.
Bengen's primary focus wasn't actually the 4% rule as we know it today. In fact, that term doesn't appear in his paper. What he was more concerned with was how you go about calculating how much a retiree can safely withdraw each year from retirement accounts.
At that time, a lot of advisors would use average market returns and average inflation rates to determine the initial withdrawal rate. For example, they might explain to a client that a typical portfolio consisting of 60% stocks and 40% bonds has returned about 8% over the last 100 years. At the same time, inflation has averaged about 3% a year. Based on these averages, financial advisors would tell clients that they could withdraw 5% (8% average return – 3% average inflation) the first year of retirement, and then adjust that by the average rate of inflation. 3%
Bengen's concern was that actual stock market returns and actual inflation rates might not support an initial 5% withdrawal rate. Even if the averages proved to be accurate over a 30-year retirement, really bad markets and high inflation in the early years of retirement could cause a retiree to run out of money before retirement ended.
And that's in fact exactly what Bengen's paper concluded. If you wanted to be completely safe, the most you could take in your one of retirement was 4%.
Now, we will look at the methodology behind the 4% rule and the assumptions he used in later articles. Both are extremely important to understanding how we can and cannot, and how we should and should not, apply the 4% rule.
How to use the 4% Rule for Retirement Planning
You can use the 4% rule to estimate how much you'll need to save before you can retire.
Step 1: Estimate your yearly expenses in retirement
The first step is to estimate your yearly expenses in retirement. If you are near retirement, your current budget may suffice. Just remember to make adjustments if necessary to account for the transition from work (e.g., commuting costs go down, but retirement hobby or travel expenses may go up). If you are many years from retirement, taking a percentage of your current income (say 80%) may be sufficient for a rough estimate.
Step 2: Determine amount of yearly expenses covered by retirement savings
Next, estimate how much of your yearly expenses will be covered by retirement savings. For most people, social security and perhaps a part-time job will cover some portion of expenses in retirement. You can get an estimate of your social security benefits directly from the Social Security Administration.
Others may have a pension, an annuity or both. Subtract these other sources of income from your estimated yearly expenses. What is left is what must be covered by retirement savings.
Step 3: Multiply results from step 2 by 25
Multiply the results from Step 2 by 25. Note that this is the inverse of the 4% rule. If your expenses covered by retirement savings total $40,000 a year, multiplying this number by 25 gives us $1 million. Taking 4% of $1 million brings us back to $40,000.
How the 4% Rule can Lead to Bizarre Results
Now let's underscore some of the difficulties with the 4% rule and why we need to be so careful with it.
Let's imagine two couples are thinking about retiring. They're good friends, and so the four of them go to a financial advisor together. The financial advisor explains the 4% rule–they can spend 4% of their portfolio in the first year of retirement and then adjusted for inflation every year thereafter.
One couple, we'll call them the Retired Couple, decides to retire. They have a million dollar portfolio. They take out $40,000 in the first year, which leaves them with $960,000.
The second couple, will call them the Working Couple, decide to hold off for a year. They're not going to add to their retirement portfolio, but plan to use the next year to pay off some debt before they retire. So they just leave the $1 million in their portfolio.
Now, let's imagine that over the next year the market doesn't do so well. Both portfolios fall by a total of 20%. So where do we stand after the first year?
- Retired Couple: $1 million – $40,000 spending = $960,000 – 20% = $768,000
- Working Couple: $1 million – $0 = $1 million – 20% = $800,000
Now let's imagine the four of them go back to the advisor to find out how much they can spend in year two.
For the Retired Couple, they don't look at their balance to determine how much they can spend in year two. Recall under the 4% rule that beginning in the second year, you simply take whatever you spent the previous year and adjust it for inflation. So if we assume a rate of inflation of 2%, the Retired Couple could spend $40,800 ($40,000 + ($40,000 * .02)).
In year two, the Working Couple who are now retiring for the first time, however, have to take whatever their balance is and multiply it by our familiar 4% number. Since they're down to $800,000, 4% is $32,000.
Now if you think these results seem a little bit odd, it's because they are. Our Retired Couple has a portfolio that's lower than the Working Couple. They're down to $768,000 compared to $800,000 for the Working Couple. Yet they can take out over $8,000 more–$40,800–compared to just $32,000 for the Working Couple. That seems like a pretty bizarre result to me.
|Portfolio Balance||Spending Allowed||Calculation Method|
|Retired Couple||$768,000||$40,800||$40,000 + 2% inflation|
|Working Couple||$800,000||$32,000||$800,000 * 4%|
Now, what do we do with this? Does this mean the 4% rule is invalid? Does it mean it contradicts itself? Is it difficult to apply? Well, not exactly.
It does underscore the difference between theory and reality. And in fact, we're going to cover a lot of realistic scenarios in this article series where the 4% rule, while it's a good planning tool, and it's a good rule of thumb, may not make a lot of sense when you go to actually apply it.
The good news is, I've got a number of alternatives that I'll share with you that I think can be just as effective, but maybe a bit more practical to apply. So in the next article, we're going to look at Bengen's methodology–how he actually went about calculating what we now know is the 4% rule. Once we understand that we can begin to apply this information in a practical way to both retirement planning and retirement spending.