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The stock market produced big gains in the past and investors dream about retiring on similar returns in the future. But their plans might be ruined because the market’s gains do not include some major costs.

When planning for retirement, many people start with the 4-per-cent rule. It was popularized by financial planner William Bengen in a 1994 paper called Determining Withdrawal Rates Using Historical Data. He figured that, for a balanced portfolio of U.S. stocks and bonds, a 4-per-cent initial annual withdrawal rate, subsequently adjusted for inflation, could be maintained safely for at least 30 years without running out of money.

The rule can be inverted to figure out how much an investor would need to save for retirement based on their spending needs. If an investor needs to take $40,000 out of their portfolio annually to live on, they multiply that amount by 25 and determine they’ll need to save $1-million before retiring at 65 ($40,000 is 4 per cent of $1-million).

Retirement planning of this sort is only important to the middle class. After all, the poor haven’t been able to save much and may see their standard of living rise in retirement because of government support programs. At the other end of the spectrum, if you’re rich enough to forget you have a spare villa in France then you’re probably not worried about running out of money. Planning matters to people between the two extremes.

Those who work hard and save up the required $1-million to satisfy the 4-per-cent rule to allow for $40,000 worth of real annual withdrawals might breathe a sigh of relief. But they shouldn’t because they’ve just reached the thin line between failure and success.

Sure, with a little luck, they’ll have a happy retirement. But that possibility might come to naught because it doesn’t include costs encountered by most investors. The 4-per-cent rule includes inflation, but it does not factor in fund fees and taxes, which can be sky high.

I’ll use a simplified model to highlight the potential impact of fees and taxes by starting with the annual returns of the S&P/TSX Composite Total Return index, which is a reasonable proxy for the Canadian stock market. Each year, a 2-per-cent fee is deducted and a 20-per-cent tax on gains imposed. To put that in perspective, the fund fee is fairly normal for active funds while imposing the annual gains tax implies a high portfolio turnover rate. (On the other hand, the model also ignores taxes on dividends.)

The accompanying graph shows the growth since the start of 1980 of the Canadian index before and after various costs have been deducted.

The Canadian stock index climbed by an annual average of 8.5 per cent from the start of 1980 to the end of 2018 before fees and taxes. That’s pretty good and may conjure dreams of retiring on easy street.

Deduct a 2-per-cent annual fee (the management expense ratio, or MER) and the average return falls to 6.3 per cent, which is getting thinner. Add a 20-per-cent tax levied on gains annually and the average annual return falls to 5 per cent.

The index’s before-cost annual return has now been cut by 3.5 percentage points. That’s a large reduction compared with the 4-per-cent annual withdrawal rate.

But don’t panic. There are things you can do to improve the situation. The easiest solution is to opt for funds with low fees, be they index funds or active funds. Similarly, try to legally reduce your taxes using tax-free savings accounts, registered retirement savings plans and the like. You can also do harder things such as saving more before retiring, retiring later, or working part-time in retirement. The important lesson here is to be mindful of fees and taxes because when they’re not controlled they can lead to ruin in retirement.

Norman Rothery, PhD, CFA, is the founder of