Investment costs hit retirees with double whammy

Posted by on April 10, 2012 @ 2:02 pm in Retirement

A while back, I wrote about how people often miss the impact of investment costs on wealth accumulation. Today, I want to make sure readers know that it’s as critical for retirees (people spending money) to think about how costs hit their portfolios as it is for people who are still saving. In fact, you might say that by taking a bite out of both income and wealth over time, costs actually hit retirees with a “double whammy.”

The math that demonstrates the “double whammy” effect is simple but worth doing. Suppose an investor retires at age 60 with a $100,000 portfolio and plans to spend 4% of her portfolio balance at the beginning of each year thereafter. Also suppose that she can choose one of three identical portfolios (A, B, or C) to generate a 5% before-cost total investment return, and that these three portfolios differ only by investment cost level (0.25%, 1.00%, and 2.00% respectively). For this example, assume all dividends/distributions are reinvested (included in the return) and there are no taxes on the returns. The portfolios and expense ratios are purely hypothetical and represent no actual investment.

Of course, we all expect that the lower-cost portfolio will generate higher net (after-cost) returns. And since the hypothetical investor changes her spending each year to reflect 4% of her current balance, it’s logical to assume that the lower-cost portfolio will allow the retiree to maintain higher income and wealth over time. The question is by how much.

Let’s look first at the impact of costs on withdrawals on income over time. Because the investor calculates the year’s withdrawal amount at the beginning of each year, all three portfolios start with the same $4,000 withdrawal (4% of $100,000). But after just five years, differences start to show:

                           Hypothetical withdrawal levels based on hypothetical cost differentials

 Hypothetical withdrawal levels based on hypothetical cost differentials

As the table and chart above show, at age 65, the high-expense portfolio (C) generates a withdrawal amount that’s 8.3% lower than the amount for the low-expense portfolio (A) ($3,770/$4,111 – 1 = -.083). After 15 years, the gap grows to over 20% ($3,349/$4,342 – 1 = -.223). This is a major reduction in spending power over time, and these numbers belie the seemingly innocuous single-digit-percentage point differences in expense ratios.

It’s also worth noting that the low-expense ratio portfolio (A) allows the retiree to keep her withdrawals (plus investment expenses) at a level that’s less than the total gross return on the portfolio. That means the balance could keep growing over time, giving her some chance of offsetting potential increases in future cost of living expenses. The only way to achieve a similar result in the higher-expense portfolios is to lower the amount of withdrawals. In other words, your chances of keeping up with cost of living increases diminish.

This thought makes it obvious: if you’re relying on portfolio withdrawals of 4% and paying investment providers 1% every year, you’re forking over an amount that’s equal to a quarter of the total annual amount you’re spending on yourself. Do 1% fees still sound cheap?

But wait … there’s more. The impact on income is only one “whammy.” Whammy No. 2 is what’s happening to the balance over the same period. The percentage differentials in balances across the three identical portfolios at a point in time are the same as the percentage differences in withdrawals above. But when you just look at the dollar difference in balance totals, the amounts may surprise you.

     Hypothetical balances given cost differentials

Hypothetical balances given cost differentials

By age 70, there could be more than a $16,000 difference in the size of portfolios A and C, in favor of the lower-cost option. By age 90, the difference could be over $45,000.

This illustration is ultimately very simple math, and you might imagine there are a lot of ways to make it more complex. For one thing, in the real world portfolio returns don’t “straight line” at 5% like they do in this hypothetical illustration. This typically means that retirees need to smooth out their spending a bit more than their wealth over time, rather than simply taking last year’s balance and multiplying by a fixed number.

The point seems simple enough. So why spend so much time talking about this? Everyone should get it: costs matter, right? Well, I’ll give you a one-link answer. The bottom line from this (pretty astounding) paper* is that even very, very smart people just don’t seem to get that costs are a key differentiator when it comes to making fund investments.

So I—and my colleagues here at Vanguard—will just keep trying.

*Choi, James, David Laibson, Brigitte Madrian. 2010. “Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds.” Review of Financial Studies 23(4): 1405-1432.

Note: All investing is subject to risk

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