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SMar 12, 2014

A Good Portfolio In 3 Easy Pieces

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Q. I am 67 years old and retired. I am trying to build a simple portfolio that I can use for the next 20 to 25 years. I am looking to put my money Index Funds and to rebalance yearly. Just wondering if this makes sense: Fidelity Spartan Total Market Index Fund, 40 percent; Fidelity Spartan International Index, 20 percent; and Fidelity Spartan US Bond Index, 40 percent. All investments would be in their very low expense Advantage shares. —D.G., San Antonio, TX

A. Yes, it makes sense. What you are proposing is to use the major home-grown index funds at Fidelity to build a traditional balanced, 60/40 equities/fixed income portfolio at very low cost.

By reducing domestic equity holdings from 60 percent to 40 percent and substituting 20 percent international equities you are getting some diversification that you would otherwise not have. That said, the portfolio would still be considered a US-centric portfolio since domestic equities are over weighted relative to developed country international equities.

Will it be a top-of-the-scale world-beating portfolio? No, but its very low expense level will put the performance wind at its back. With an average expense just under 0.10 percent, most of the return on your money will be going in your pocket.

One advantage you will enjoy by managing your own portfolio of three funds is that you’ll be able to make annual rebalancing buy and sell decisions that will help you avoid selling depressed assets at low prices.

Q. I have often read that one should only withdraw 4 percent, or less, from savings to avoid running short in old age. My question:  Is that net percentage after investment earnings are figured in, or should earnings be ignored?

Last year I earned about $133,000 in my IRA and withdrew $145,000, so my net withdrawal is only $11,479, or roughly 0.7 percent of my IRA value.  Is this the percentage I should be comparing to the 4 percent rule of thumb, or (ignoring the earnings) did I withdraw 9.4 percent?  Obviously there is a big difference in the two.  Which one are the experts talking about?

My homemade Excel forecaster says I will run out of money in about 23 years when I am 92. —J.H., Spring Branch, TX

A. It’s all about principal, not earnings. The famous four percent figure is drawn from research on safe withdrawal rates done by financial planner William Bengen. He found that you could have a starting rate of 4.3 percent from the total value of a typical balanced portfolio. You could then increase that original dollar amount by the rate of inflation each year. If you did that you would have a very high probability of not running out of money for 30 years. Since 30 years is longer than most people will be retired and inflation is our biggest long term worry, his figure became the magical "safe withdrawal rate."

It's important to understand exactly what he was talking about. The 4.3 percent rate was the withdrawal from the value of the fund in the first year. So from a $1 million portfolio the initial withdrawal would be $43,000. In all future years the withdrawal would be $43,000 adjusted upward for the inflation rate. If inflation were zero, the increase would be zero. It's also important to understand that this is not the last word on withdrawal rates.

Additional research over the last 15 years has suggested that withdrawals could be higher if you had some simple spending rules. Other research has suggested that high valuation markets— such as the one we are now in— require a lower initial withdrawal rate.

Whatever the research suggests, however, the withdrawal rate was a starting percentage of the original portfolio. In your case it would have been 4.3 percent of the value of your portfolio on December 31 of the previous year.

And here's where there is a problem. If the year-to-date difference of $11,479 between what your portfolio earned, $133,742, and what you withdrew, $145,221 is about 0.7 percent of your portfolio, your portfolio should be about $1,640,000. If so, a 4.3 percent starting withdrawal rate would be about $70,500, not $145,221.

If you want to experiment with how long your money might last, I suggest a visit to the required minimum distribution calculator on the Fidelity website. It allows you to input your age, current account balance and projected earnings for your account and then displays the value of your account each year until well after age 100. (Note: the calculator does not factor in ups and downs of the market, which have a significant impact.) 

I suggest this because it offers some reassurance you are not getting from your Excel model. According to the Fidelity Minimum Required Distribution calculator, a 70 year old with $1,640,000 earning a very conservative 4 percent would withdraw about $60,000 in 2014. His withdrawals would climb each year, peaking around $107,000 at age 93. But even at age 100 his withdrawal would be $87,000 and he would still have nearly $500,000 remaining. The combination of a relatively conservative portfolio and required minimum distributions turns out to be a very good simple tool to avoid going broke.

Filed Under: Retirement