How AUM Fees Affect Sustainable Withdrawal

One of the great misconceptions about the Sustainable Withdrawal Rate (SWR) framework is how adviser (and fund) fees affect withdrawals from a retirement portfolio.

I bet you’ve heard statements like, ‘Oh, if the SWR is 4%, once you account for total fees of 2% (funds, platform and adviser), then the SWR becomes 2%.’

Or they say, ‘A 1% adviser fee translates into 25% of the withdrawal from the portfolio if the client is taking 4%.’

Genuine concern about the impact of fees is behind some of these statements. But often, they’re wrong-headed arguments by ill-informed consultants and product providers.

Either way, it’s inaccurate to suggest that a 1% AUM fee translates to a quarter of the funds — or income — under the SWR model.

To be clear, fees impact the sustainability of withdrawals and, as we show in this article, excessive fees are damaging. People should be able to make informed decisions about this. That’s why it’s important to avoid misleading people, or to exaggerate the effects.

To demonstrate the impact of fees, we use Timeline software to run a withdrawal strategy for a UK and a US investor.

  • We start with an initial portfolio of 1,000,000 (in £ and $) invested in a portfolio consisting of 60% World Equities and 40% Global Bonds. The portfolio is rebalanced annually.
  • We have an initial withdrawal of 40,000 a year from the portfolio, which is then adjusted for inflation each year over a 30-year retirement period.
  • We test the impact of 1%pa and 2%pa of the outstanding portfolio, deducted on a monthly basis, based on the outstanding balance of the portfolio at the start of each month.
  • We calculate the total fee taken from the portfolio over the entire retirement period, and present this as a percentage of the cumulative income and the terminal balance (or legacy).
  • We use actual historical return of asset classes and the corresponding CPI for each country. For the UK, our dataset runs from Jan 1915 to Dec 2018, which gives us 888 scenarios each lasting 30 years. For the US, our dataset runs Jan 1900 to Dec 2018, which gives us 1068.
  • Given the large dataset, we rank all the scenarios based on how quickly the portfolio was exhausted and/or the terminal balance at the end of the 30-year period. We then select five actual scenarios presented below: the worst, the 25th percentile, median, 75th percentile and best scenarios.

As the results show, 1%pa translates into around 6%-12% (UK) and 9%-13% (US) of the client’s overall income and capital, depending on the scenario. A total fee of 2%pa wipes out around 13%-26% (UK) and 19%-28% (US) of the overall fund, depending on the scenario.

The SWR framework is based on the idea of building a plan that survives the most severe scenarios. That means, under Bengen’s 4% rule, fees swallowed 6% of the overall fund for a U.K. investor and 9% for a UK.

High fees can be damaging to a drawdown investor. You could also think about the impact of fees in terms of how many years the portfolios would have lasted with lower fees. For a UK investor, a 2% fee means that the portfolio ran out of money around three years sooner than a 1% fee in the worst and 25th percentile scenarios. In effect, the additional 1% fee wipes out three years of income for the client. This ultimately creates a lose-lose situation for both clients and advisers; excessive fees risk depleting the portfolio too quickly so that the client runs out of money and the fees invariably stop.

It may seem counter-intuitive that a 1% fee ends up taking 6%-10% (UK) of the overall fund, when it starts as 25% of the withdrawal in the first year. But this makes sense when you understand that the sustainable withdrawal framework, at least as defined by Bengen, works on the basis that withdrawals are adjusted for inflation annually. This means that, as client withdrawals increase in line with inflation, fees adjust downwards under the most severe scenarios. This is illustrated in the charts below; they show the portfolio balance, annual withdrawal and inflation for the historical worst-case scenarios with our dataset.

Of course, if the portfolio experiences good (eg median) or even great (eg 75th percentile) market conditions, fees increase in line with the portfolio balance. Under this scenario, the client can — and should — merely increase their withdrawal from the portfolio. Otherwise they end up with a substantial legacy at the end of the retirement period, as shown in the charts below.

Percentage-based fee structures have come under intense scrutiny in recent times. Some of the criticisms are justified. However, it’s important to remember the inbuilt mechanisms which adjust the adviser renumeration up or down, depending on the portfolio performance. This is particularly useful for the client in poor market conditions, as the percentage-based fee naturally adjusts the adviser renumeration downwards and lessens the overall impact. The mantra amongst advisers using percentage-based fee structures is borne out here,‘When our clients do well, we do well. When they don’t we don’t.’

Of course, this is a double-edged sword, as it raises the question of the long-term profitability of clients in drawdown in the event of poor sequence of return. Is an adviser really going to continue to serve a client as the portfolio value dwindles? Again, this risk is often overstated as it assumes the worst-case scenarios, which are — by definition — very rare. It also doesn’t account for the fact that in these scenarios, the adviser would encourage their client to reduce withdrawals to lessen the chances of running out of money.

All this means that having a robust withdrawal strategy in place is not only an issue of client outcome, it also has a direct impact on the long-term profitability of the adviser’s business.

Some advisers minimise the business risk of declining fees from a dwindling retirement portfolio by setting a minimum fee. This invariably breaks the in-built alignment between the portfolio’s sustainability and the adviser’s renumeration. The adviser benefits from the upside (when the client portfolio does well) but their downside is also covered — at least until the money runs out — in the event of a poor sequence of return. This means the minimum fee level will actually exacerbate sequence risk, because the fees won’t adjust below a certain point as is the case with percentage-based fees. This is also true of the flat-fee model, particularly where the fee increases with inflation.

Let’s be clear, the point here isn’t to advocate any particular type of fee over the other. There are pros and cons, and strangely, we’re still somewhat on the fence on the issue. The point is, it’s important to understand how fees impact the sustainability of retirement income portfolios and to avoid misunderstanding or overstating their impact. It’s also crucial to accept that having a robust withdrawal strategy that ensures the portfolio doesn’t run out of money is not only good for the client, it’s good for the adviser’s bottom line!

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