Investing Fees Will Leave You Broke During Retirement

If you’ve been paying attention you probably know that investment fees will reduce the value of your retirement portfolio over time.

For example, Questrade argues that by switching to a lower cost investing platform you could retire 30% richer.

All this is true. Essentially, whatever you pay in fees is foregone wealth. I.e. if your annual fees are 2% and your gross return is 8%, your net return is reduced to 6% after fees.

Remember: fees can be layered (often covertly) into your portfolio in multiple ways – advice fees, investment management fees, tax, operating expenses, and so on. Sometimes the fees are bundled, sometimes they’re charged separately. Buyer beware.

Unfortunately, high fees will do much more damage than leave you ‘less well off’ at retirement. High fees could mean the difference between going broke or not.

Check out the following example for Joe Smith retiring at age 65 with a $1,000,000 portfolio. Sounds like plenty of money for retirement, right? Well, the level of fees mean the difference between Joe eating ham sandwiches and cat food for lunch.

Start with the following assumptions for Joe:

  • Requires a frugal annual income of $40,000, adjusted for inflation
  • Will live until age 95
  • Builds a balanced growth portfolio consisting of 80% stocks and 20% bonds
  • Has a 10% average tax rate

What are the odds Joe goes broke before he dies?

Calculation methodology for the data geeks: Using data made available by , the probabilities are calculated by using stock and bond returns between 1871 and 2016. For example, if an investor expects to be live for 50 years in retirement, all historical 50 year periods are analyzed. One historical cycle would be from 1871 to 1922, another one from 1872 to 1923, and so on until 1965 to 2016. Thus 95 different historical cycles are considered (in this example).

The chart below shows the portfolio failure rate, based on historical precedent, for Joe Smith at various fee levels. “Portfolio failure rate” essentially shows how often during the historical periods the portfolio ran out of money before the end of the period (in Joe’s case 30 years).

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Investment fees have a significant impact on the portfolio failure rate. In Joe Smith’s case, the portfolio failure rate rises from 18% when the investment management fee is 0.30% to a whopping 42% when the investment management fee is 2.50%.

Hold up…think about what this really means. Imagine what it would be like to run out of money as a senior citizen.

This is a deadly serious issue and a catastrophic failure of the wealth management industry. The average retiree is getting screwed out of their money leaving them completely broke during retirement. This creates massive hardship, as a broke retiree often has no way of recovering and has to rely on the state, charity or family for food and shelter. Dignity and independence, however, are lost forever.

While the difference between 0.30% to 2.50% sounds very wide, this is the realistic range for investors in Canada.

For example, Cambridge Canadian Equity Fund charges an MER of 2.48%. AGF Global Strategic Balanced Fund charges 2.63%. Mackenzie Canadian Growth Balanced Fund charges 2.29%.

Meanwhile, at the other end of the spectrum, Questrade provides all-in portfolio services for 0.38%. Finally, a DIY investor can combine Vanguard’s FTSE Canada All Cap Index ETF, which has a 0.06% fee and Canadian Aggregate Bond Index ETF, which has a 0.09% fee.

Investors who do a little investigating will better understand their costs and be able to shift from one end of the spectrum to the other.

Bottom line: Pay close attention to fees, as this is one of the few parts of investing that is totally within your control. Over the long run it will have a huge impact to your standard of living and independence.


How to Generate Retirement Income

Picture this. It’s September 1981 and you’ve just retired. You want to live a comfortable life so you figure you need to generate a retirement income of about $50,000 in today’s (2019) dollars.

That means you need $18,172.17 in 1981 (chart below).

Inflation-adjusted income required to match a $50k income in today’s dollars.

How do you proceed to generate a sustainable retirement income from your investments?

In 1981 the solution was pretty simple and low-risk. You could buy and hold 10 year US Treasury bonds that, at the time, yielded over 15%. Investment required: $118,587.78!

Of course, $118k in 1981 is worth more than $118k today because of inflation. In today’s inflation-adjusted terms (adjusting for Consumer Price Index) that’s the equivalent to $326,289.62.

Unfortunately, for those retiring today, this retirement income strategy is totally infeasible. This is because the yield on 10 year US Treasury bonds has dramatically declined.

The chart below shows how the 10 year US Treasury yield has declined over the decades. Currently the yield is flirting with all time lows of about 1.5%. These lower yields mean that an investment in US Treasury bonds doesn’t generate the income it used to. Said differently, to generate the required $50,000 annual income today using low-risk US Treasuries, you’d need to invest way more money than you would need to in 1981.

10 year US Treasury Bond Yield

As of September 1, 2019 you’d need to invest almost $3.5 million (chart below) into 10 year US Treasury Bonds to generate a $50,000 annual income. In inflation-adjusted terms, that’s about 10x more than you’d have to invest in 1981.

(Final chart below shows inflation-adjusted investment required to generate the inflation-adjusted equivalent to $50,000 in today’s income.)

Investment in 10 year US Treasuries to generate $50k (in today’s dollars).
Inflation-adjusted investment in 10 year US Treasuries to generate $50k (in today’s dollars).

With Yields So Low, How Can you Generate Retirement Income?

Now you’re probably thinking you wouldn’t rely on just your straight investment income to pay for retirement. You might intend to draw down your capital and rely on a pension. This is what most people do. But I would argue it is not the right strategy.

If you have a good defined benefit (DB) plan pension that replaces at least half your current income, God bless you. You can probably stop reading…that is, unless you think your company has even the slightest risk of going bankrupt sometime between now and the time you die or if you think your company will find a way to weasel out of paying its obligations (because with lower yields it is becoming increasingly difficult for defined benefit plans to remain fully-funded).

On second thought, keep reading even if you have a DB plan.

The Retirement Income Rule of Thumb

The wealthy of the world strive to pay their retirement bills from their returns ON capital…not the return OF capital. In order to build lasting, generational wealth, enough income must be generated from a combination of dividends, interest income and capital gains to cover living expenses.

You may be familiar with the 4% rule of thumb. This rule states that – based on historical market returns – an investor can withdraw up to 4% from their portfolio each year without eroding their capital. In essence, the 4% withdrawal is offset by returns from a combination of dividends, interest income and capital gains that equals to 4% or more.

Generating a satisfactory income aligned with the 4% rule while maintaining a high degree of safety was easily achievable in 1981 – US Treasuries are considered risk free assets. Today, however, the environment is far more challenging.

How do you generate sustainable income from your investment portfolio today? Unfortunately, you might not like the answer.

You can do some or all of the following:

  1. Learn to live with a lower retirement income by living more frugally.
  2. Work longer and delay withdrawing from your portfolio. This allows your portfolio to grow larger and reduces the income-generation burden on your portfolio and the risk you outlive your savings (i.e. longevity risk).
  3. Build a larger portfolio by earning more income and saving a greater proportion of that income throughout your working life.
  4. Take greater risks with your money by investing in assets with higher total returns potential (combination of dividends, interest income and capital gains). The downside is that you might lose more money than you’re comfortable with if things go south.

Of course, you can avoid all this if you have $3.5 million to invest in 10 year US Treasury Bonds. Without $3.5 million to invest in risk-free assets, you must stretch across the risk spectrum to find assets with higher dividend yields, higher interest income and greater capital returns potential. Of course, moving up the returns spectrum requires you to take on more risk.

Beware of Risk

Whatever you do, don’t go chasing higher returns without paying attention to risk. Same goes for higher yields. Not all yields are the same – for example, a company might have a high dividend yield because the market anticipates a dividend cut or worse. (When it comes to dividend yields, I always look at a company’s payout ratio to assess the sustainability of the dividend.)

While you won’t be able to escape greater systematic risk (i.e. market risk) when investing in asset classes with higher total return potential, you can eliminate idiosyncratic risk (company-specific risk) by diversifying across companies. Moreover, systematic risk can be mitigated by investing in a variety of assets classes with low-or-negative correlations.

Don’t make the mistake of ‘diversifying’ across asset classes with similar risk exposures – e.g. dividend paying stocks, corporate bonds, high yield bonds – and thinking you’re set. Many (probably most) asset classes are exposed to the business cycle and risk sentiment, so you need to find a way to balance out your risk exposure using assets that are negatively correlated to these factors, such as sovereign bonds and gold.

But I just said US Treasuries yields are super-low, right? And gold is more of a currency than income-generating asset. True. This simply underscores today’s challenge with generating retirement income from a portfolio.

Once you have to start worrying about risk, it becomes exponentially more difficult to generate retirement income using investments, like you might have in the past. It can be done – investing doesn’t need to be hard – but it’s not like 1981 where any monkey could fund their retirement without taking on risk or making lifestyle tradeoffs.

Today, it is inescapable fact that you’ll need to do some combination of the four options noted above: 1) Live on less, 2) work longer, 3) save more, 4) take on more risk.

See. I told you you won’t like the answer.