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Afford Anything | Make Smart Money Choices
The Father of the 4% Rule Finally Sets the Record Straight
00:58:19
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- [00:00]
Paula Pant
You've heard of the 4% withdrawal rule, which is within the financial independence community, a cornerstone of how we think when we think about retirement planning. Well, I'm here today with the guy who discovered the 4% rule. He is an MIT graduate and former rocket scientist and now has some more nuanced things to say about it. Welcome to the Afford Anything podcast, the show that understands you can afford anything, but not everything. Every choice carries a trade off and that applies not just to your money, but to your time, your focus, your energy, your attention to any limited resource that you need to manage. So what matters most and how do you make choices accordingly? Those are the questions this podcast is here to explore. We cover five topics. Financial psychology, increasing your income, investing, real estate, and entrepreneurship. It's double I fire. I'm your host, Paula Pant. I trained in economic reporting at Columbia. I help you prioritize, and I'm sitting here with Bill Bengen, the creator, or discoverer, I should say, of the 4% safe withdrawal rule. Welcome, Bill.
- [01:15]
Bill Bengen
Thanks for inviting me. Glad to be here.
- [01:17]
Paula Pant
Thank you for joining us. My first question is, can you tell us your license plate?
- [01:22]
Bill Bengen
Oh, yes. I just made a recent change to a certain extent. I've been finding the term 4% rule for 30 years and I finally said, can't fight city hall. I'm going to own it. So I converted my old license plate to Mr. 4 pct. Mr. 4%. And I'm driving around Arizona with that license plate right now.
- [01:43]
Paula Pant
Mr. 4%.
- [01:44]
Bill Bengen
Yeah, that's right.
- [01:45]
Paula Pant
That's fantastic. So this is your second time joining the Afford Anything podcast. On your first appearance here as a guest, you talked about the discovery of the 4% rule. So I won't ask too many questions about that because if our listeners want to hear that, they can go back to that original episode and we'll drop a link to that episode in the show notes. But I'd like to ask you, in what ways is the 4% rule misunderstood or misapplied today?
- [02:13]
Bill Bengen
Yeah, absolutely. I think the term rule is inappropriate because it gives the impression that there's one formula that fits everybody. And of course, if you're a financial advisor working with clients, it's simply not the case. Every client has different needs. How it all came about rules from that paper I wrote 30 years ago where I discovered that the worst case scenario had been one retiree retired in 68 and had to live with a 4.2% withdrawal rate. That was the worst. Now, in my database, There are over 400 retirees and that's the only retiree that could take out only that 4.2%. All the others had higher rates and some double digits in some very, very fortunate cases. So it's important just to recall that it depends upon your individual circumstances and the market circumstances when you retire to what your number eventually will be.
- [03:08]
Paula Pant
Now we're just going to jump right into the criticisms.
- [03:11]
Bill Bengen
Let's do it.
- [03:12]
Paula Pant
I want to read a quote from a prominent retirement researcher named Dr. Wade Pfau, who I know is a good friend of yours.
- [03:19]
Bill Bengen
Yeah.
- [03:20]
Paula Pant
And your friends are always the harshest critics.
- [03:22]
Bill Bengen
Yeah, that's good. He's a good guy though. I really respect what he's done. So glad to hear I'm quoting here.
- [03:28]
Paula Pant
From Christine Benz's book, which is how to Retire. Oh, I should mention for those of you who are listening by audio and who can't see us in video, we're sitting here at the Bogleheads conference. So you and I are in Minnesota right now hanging out with people who are super into index funds.
- [03:45]
Bill Bengen
Indeed.
- [03:46]
Paula Pant
All right, here's the quote and it comes from Dr. Wade Pfau. When Bill Behnken developed the 4% rule, it was a research simplification to say that the spending would always adjust for inflation and not respond at all to market performance. That aspect of it creates the most sequence of returns risk and that in turn causes the safe withdrawal rate number to be the lowest possible.
- [04:13]
Bill Bengen
Yeah, and he's absolutely correct. And I think I spoke to that a few minutes ago. It is a worst case scenario. The circumstances in the late 60s were awful for investors. Investor retired in late, let's say October of 68 faced two bear markets, 69, 70, 73, 74 nasty bear markets. And then probably even worse than that, faced about a decade of high inflation where if you're following the COLA kind of withdrawal on which the 4% rule is based, you're increasing your withdrawal dollar draws every year with the inflation amount with no opportunity for having come down. I mean, how often do we expect the deflation? We haven't had a significant time of deflation of falling inflation since the 1930s and I suspect we won't for a long, long time. So that it is just a worst case scenario. It applies to a very, very limited number of individuals and circumstances and shouldn't by itself be used as a basis for one's planning. You have to look at other factors.
- [05:17]
Paula Pant
Hmm, I want to hold on. That shouldn't be used by itself as the basis for one's planning because so many people and particularly in the financial independence, retire early community, very simply say I just need to save 25x my annual expenses.
- [05:33]
Bill Bengen
Okay?
- [05:33]
Paula Pant
And once I have 25x my expenses, I can 4% it and live happily ever after.
- [05:38]
Bill Bengen
Well, good luck with that. And I really mean you're going to need good luck with that first. I think the odds are high that you're going to limit yourself. You probably could have spent a lot more than that. My recent research, and you know, I'll be publishing a book next year which I'll be talking about that says closer to 5% is really the worst case scenario. Since that rule, the so called rule was developed back in the early 90s. You know, I expanded my research, it made more sophisticated, added more asset classes and all those changes have been gradually raising so called safe rate. So we're pushing 5% now. But I've also identified eight elements or variables that you have to study first, such as the length of time, your planning horizon, how long you live, whether you do a drawing primarily from a taxable account, a tax deferred account, and a number of other factors. If you change any one of those factors the slightest bit, you're going to change withdrawal rate up or down. And you have to look at each of those eight before you can come up with a number. Otherwise you're just simply playing the lottery.
- [06:43]
Paula Pant
I want to talk about one of those eight factors that you just named, which is the length of time that you will be retired. Because there are plenty of people who are listening to this who have the ambition of retiring early, many of them will have some supplemental source of retirement income. But putting that aside, if a person were to retire at 45 and live to 100, the original 4% rule of course was modeled on a 30 year retirement.
- [07:12]
Bill Bengen
That's right.
- [07:12]
Paula Pant
What we often hear in buyer forums, people will say, well, because the 4% rule was modeled on a 30 year retirement and you're planning on having a 60, 55, 60 year retirement, just spend less, just draw down 3% instead of 4%. What would you say to that?
- [07:34]
Bill Bengen
Well, I think they're correct in that the withdrawal rate, when you're looking at a very long time horizon like 50, 60 years should be lower than whatever withdrawal rate would have been otherwise. I think if we were looking at a worst case scenario which might be 5%, then for the 50 or 60 year, it might be 4.2 or 4.3. Three percent is an awfully low rate. I can't imagine the set of circumstances that would force you into 3%. If we got there, I'd be scared more about some other things than it would about with a drawing for retirement. But it's accurate. The longer the time horizon, the less you're going to withdraw. Although it's the kind of thing where it doesn't keep dropping, it approaches a bottom line of around 4.2 or 4.3% and doesn't get much lower than that.
- [08:21]
Paula Pant
Yeah, you were saying that it asymptotically approaches 4.2 as life extends to infinity.
- [08:27]
Bill Bengen
That's right.
- [08:28]
Paula Pant
Exactly.
- [08:28]
Bill Bengen
There's a lower limit to it. Exactly.
- [08:30]
Paula Pant
Yeah. That as your lifespan extends to infinity, the safe withdrawal asymptotically is 4.2% is what you found.
- [08:37]
Bill Bengen
Yeah.
- [08:38]
Paula Pant
So 4% then does sound like a very conservative number.
- [08:43]
Bill Bengen
Yeah, I think 4% itself. Once again, it depends upon all those eight elements I talked about. If you're drawing from a taxable gal, for example, we're talking up to this point, all the conversation we've had have been in this underlying assumption is when you're drawing from like an IRA 401K, if you're drawing from a taxable account in a high tax bracket, you may be below 4%, possibly if you also considering another factor. Let's say you didn't want to have a zero balance at the time you die, which is the presumption under all these discussions. Let's say you wanted to have a couple hundred thousand dollars left in your account for heirs. That will also further reduce withdrawal rate. That's why I got to look at each of those eight factors before you come up with a number. It could be a lot lower or could be a lot higher than you might expect otherwise.
- [09:30]
Paula Pant
Now, the model. So one component of the 4% model, as Dr. Faust said in the quote that I read, is that by virtue of tying your withdrawal to 4% in year one and then 4% adjusted for inflation every subsequent year, you're doing that regardless of what's happening in the market. And so as he pointed out, you therefore are exposed to maximum sequence of returns risk. What could a person do to offset some of that sequence of returns risk? And if a person did some things in the first few years of retirement to offset that risk, could they then spend more after year five of retirement? Let's say.
- [10:11]
Bill Bengen
That leads to an interesting discussion. When I first did my first work and we knew we were dealing with a worst case scenario, we know the worst case scenario only applies to very, very small investors, so. And that other retirees have been able to take much higher rates of return. The question is, how do we get people from the worst case to a higher withdrawal rate in a rational kind of semi scientific way at least. I struggled with that for years, decades actually, in this research. In fact, one of the first charts I drew was a probability chart. Says that if you take out the worst case rate, which was 4.2%, 100% of retirees could do it. If you went to 4.3%, maybe 95%, and if you want to, 5%, maybe 85% of retirees would be successful and so on. Draw that chart all the way out and give that to a client. That's all I could see in terms of guidance. And you think about it. How does a client make a determination? What probability is appropriate for them? Is 85? Is 80, 75 good enough? 90. I always felt that when I gave my clients that chart, I was sending them off to Vegas with one of those blackjack charts and say, good luck, do the best you can. I can't figure out. It wasn't till three summers ago I made a huge breakthrough. And we knew from Michael Kitz's work in 2008 that there was a correlation between stock market valuations at the start of retirement and the withdrawal rate. He drew this fabulous chart and very clearly, when stock valuations are low, withdrawal rates are high. When stock valuations are high, your withdrawal rates are corresponding low and move in opposite directions. And it was a great looking chart. I said, maybe this is the answer. And I studied and fortunately the correlation just wasn't strong enough. You could still pick out two different periods which had the same stock market valuation and their withdrawal rates were still too far apart. Then three summers ago, I was sitting there saying, I know inflation, it's got to be in there somewhere because inflation forces your withdrawals up and the worst case scenario happens during a period of high inflation. So how can I work inflation into this picture? And I kept drawing charts where I would try to sort all the inflation rates, withdrawal rates, and it just didn't work. And then I said, oh my goodness, what if we made inflation the most important thing? Set up six inflation regimes, high, low, middle, on the deflation slide, three more high, low, middle, and then sort the withdrawal rates within it. The minute I did that, I said, oh my goodness, I've got something here. Because instead of maybe 75% correlation, now I'm up to 90%. And I was actually able to develop charts where if you look at the chart has the Shiller tape or the Shiller cyclically adjusted PE ratio is a measure of stock market valuation. I was able to set up charts for each of those inflation regimes where you can look at the chart, pick out what the current PE is at the time of retirement, and that gives you your withdrawal rate. And it has a very high correlation historically, although it's happened, that solved that problem to a large extent. You still have a certain percentage of cases where something weird happens in retirement. But then you can make an adjustment. You can admit course correction like they do on their flight to moon or Mars. You know, you can adjust. But I believe that particular method that I developed now gives me enough assurance to know that we have a good starting point, we know what it should be and that we can deal with corrections as retirement moves along.
- [13:59]
Paula Pant
Right. You talked about modeling for deflation, which is something that really something that most of us don't think think about. Can you elaborate on what the average individual listening to this should do as they're thinking through retirement planning in a deflationary environment?
- [14:18]
Bill Bengen
Probably not much because I think the odds are we probably won't see a deflationary environment like we had in the 1930s. The 1930s had the worst bear market. In the last hundred years the market lost 90%. But it's not the worst case. You still could have withdrawn about five and a half percent during the Great Depression. The 1960s that came along, we had inflation, which caused a real problem. It added. It compounded the effects of the bear markets early retirement. But deflation for investor well is probably a pretty good effect because it can turn terrible bear markets into livable experiences. Their costs go down and are for retirees. I always say that the greatest threat for retirees is extended high inflation. Bear markets come and go. They recover. They're temporary phenomenon. Once you get big inflation increases in retirement, it's probably going to live with it for the rest of your life.
- [15:15]
Paula Pant
Right. On that note, we've just had a. Relative to the last 30, 40 years of history, we've just had some fairly high inflation. We know that this has affected retirees. We saw Social Security's COLA increase. It was 8.2%. Not last year, but the year before.
- [15:32]
Bill Bengen
Yeah.
- [15:33]
Paula Pant
Which is the biggest cola increase in 40 years. What would you say to people who are now dealing with what will be the lifelong effect of the fact that prices are high? How should we pivot?
- [15:46]
Bill Bengen
It's an interesting question. Fortunately, the inflation event we just experienced was not very long. We're returning to more normal levels of inflation. Historical average somewhere about 3% over the last hundred years. There's not much you can do unfortunately with inflation other than look at your expenses carefully and control them. I don't think you necessarily need to panic because we've had relatively short period of this high exposure to inflation. But I think you just want to look at your expenses, make sure your plan looks like it's on track. If it's still on track, just let it go on for a few more years and see if what happens to inflation. Hopefully it still continues to come down. I'm a little concerned on that area, but I'm no sure. I don't try to forecast those things. Almost impossible to do that. But you control what you can, right?
- [16:37]
Paula Pant
I want to go back to the 4% rule. That is what you are most known for, whether you like it or not.
- [16:44]
Bill Bengen
I don't have any choice. Not either. That's right.
- [16:47]
Paula Pant
I want to actually circle back to something else that Wade Pfau has talked about. He says that the logic of the 4% rule is to mitigate sequence risk by spending conservatively. But that is one of multiple ways to mitigate sequence of returns risk. That same risk can also be managed by spending flexibly. So adjusting spending to reflect market performance. That's a second option. A third option is to mitigate the volatility of the portfolio with a bucketing approach. And the fourth option is to have buffer assets where you have some types of assets outside of the portfolio that you can tap temporarily during major downturns. What do you think about those as sort of supplements to a withdrawal strategy that is modeled similar to the 4% rule in that it's based on year one and is agnostic to portfolio balance, but then also is mitigated by some of those other options?
- [17:52]
Bill Bengen
Yeah, those options are available. The 4% rule was based upon a spending or withdrawal model or withdrawal scheme which I would call the COLA scheme. That's not the only way you can withdraw money. Obviously it seemed like it would appeal to a lot of folks because mulphiques folks have a standard of living they like to maintain, possibly through retirement. But it's not the only way to spend. I have analyzed other ways of spending. For example, I've taken a look at a model where people spend more heavily early in retirement to reflect maybe heavier travel expenses and then decide to cut back after 10 years in mid retirement. And that has certain withdrawal rates associated with it. I've looked at withdrawal rates based on a percentage portfolio. I looked at a fixed annuity kind of arrangement. If you can reduce your spending model to mathematics, I can Model it with my spreadsheets. I just have to know what that spending model is. All those points are valid and there are ways to use them. I haven't analyzed all of them, so it's hard for me to comment on the specifics. One thing I learned in this research, don't assume anything because you're dealing with phenomena that can be counterintuitive and really can surprise you. For example, I had analyzed using the COLA approach, which gives you a fixed stock allocation during retirement. You rebalance it to keep it like that. And then I took a look at the question of what if we reduced our stock allocation during retirement as some people recommend getting more conservative, and that was a bust. It lowered your withdrawal rates. I never thought actually of taking a look at what happens when you increase your stock allocation during retirement. Turned out two researchers, Michael Kitces and Wade Pfau, looked at that and determined that is a superior way to go about it in terms of asset allocation. So that was a very humbling experience for me. It's good to have multiple researchers in the field doing great work like they're doing.
- [19:54]
Paula Pant
Right. So they call that the what the equity glide path where you reduce your. You reduce your equity allocation right at the time that you retire in order to mitigate sequence of returns risk.
- [20:05]
Bill Bengen
Yeah.
- [20:05]
Paula Pant
And then after a few years, you then increase your equity allocation again.
- [20:09]
Bill Bengen
Yeah. And it almost seems like something like that shouldn't work because you're starting with a lower allocation, maybe 40% instead of 60. But like you said, it mitigates sequence of returns. If you get hit with a bad bear market early in retirement, you're going to be very happy you're at 40 instead of 60.
- [20:24]
Paula Pant
Right.
- [20:25]
Bill Bengen
And then of course, you're going to be raising it into the recovery, which is highly desirable. That's why apparently it works. It's one of those counterintuitive things that just. Thank goodness they looked at it.
- [20:37]
Paula Pant
You just outlined what would happen if somebody retired into a bear market. If you retire into a bull market and the market just continues to grow gangbusters in your first few years of retirement, if you were to take that equity glide path, you would be kind of selling, then there'd be a run up, then you'd be buying again, but at higher prices. So would that be worse then?
- [21:00]
Bill Bengen
No, it works across the entire spectrum. All 400 of my retirees would have benefited. Using the glide path, they get a significant increase in withdrawal rate, like a quarter of a percentage point or more. It's one of the four free lunches But I see in this field.
- [21:17]
Paula Pant
Okay, I want to ask about the other three free lunches in just a second.
- [21:20]
Bill Bengen
Sure.
- [21:21]
Paula Pant
Before we get to the other three free lunches, I want to go back to spending the most in your first few years of retirement and then decreasing spending after that. And I've actually heard the analogy of this as a smile because it's high at the start, then it dips, but then towards the end of your life it goes high again because of medical costs and end of life costs.
- [21:41]
Bill Bengen
Okay.
- [21:42]
Paula Pant
So it kind of takes on the shape of a smile.
- [21:46]
Bill Bengen
The one I looked at wasn't a smile, probably more like a cliff where you just fall off. I would call and you're screaming all the way down to the bottom. I haven't modeled that smile thing. I'm going to take a look at that when I get back because I've seen that in the literature a lot and I like to just test new stuff all the time. But the cliff approach, where you basically, let's say you want to take 10% above the safe rate initially, and then after 10 years you come, bring your expenses down to put you back on the safe curve. You just have to be aware of the fact that the reduction you may take after 10 years may be pretty significant depending upon how exotic you were in your original spending. If you were only, let's say, 10% spending above the withdrawal rate at the start of retirement, it's not going to be too bad. Maybe you just have to reduce your spending by 15 or 20%. But if you wanted to spend 20 or 25% above the safe rate, you may be looking at very large reductions in spending to get yourself back, kind of shake curve after 10 years. You just have to know that in advance so you're aware of it. Build into your plans.
- [22:51]
Paula Pant
Well, let's go back then to the other three free lunches. So you said that modeling around an equity glide path, which means that you decrease your equity exposure when you retire, keep it low for a few years, then increase it again. That's one of the four free lunches.
- [23:08]
Bill Bengen
That's right. Another one, of course, is one everyone is aware of, diversification, which is a stand, you know, goes way back. There was a Nobel Prize given for that. Very, very important that investors have a well diversified portfolio because you never know what asset class is going to do best. I did a chart from my book where I looked at last hundred years and I asked the question for each of these retirees, 400 retirees, if they could pick an asset allocation at the start of retirement, that would last them for 30 years and give them the highest withdrawal rate. What would it. Well, there's no one answer to that. It's all over the map. Some years small cap stocks dominate, sometimes large cap, sometimes international stocks dominate the allocation, sometimes bonds dominate the allocation. And no one really knows what that will be. That's the problem. That's why asset diversification, I guess, is the price we pay for our ignorance. We don't know which asset classes will be outperforming the future. We just know that we stand on the road and we want to be able to get the best from the cars going by. We're going to have to hold all of those assets in a reasonable proportion. Another one is rebalancing. Very, very important. If they're following fixed asset allocation now, glidepath, they're just going to go up, make 1% a year and 2% a year or whatever it is. They're now never going to rebalance the rebalances. You're going to feel a fixed allocation. There's a definite benefit for most retirees to rebalance their portfolio every six months to a year. Bring it back. The reason why that's so successful is that if you've gone through a year and some of your assets have done very well and some have done less well, you'll be selling the assets who have done well and probably are about to do less well and replacing with assets who have done less well and are probably about to do better. Because investing is cyclic to a certain extent. So that covers diversification and rebalancing. Glide path on the fourth is when you establish your allocation. Let's have a fixed allocation. You might be a tendency to give each of your assets an equal amount. My research indicates that if you slightly overweight those asset classes with the highest returns, let's say like small cap stocks, micro cap stocks, just slightly.
- [25:31]
Paula Pant
How much is slightly?
- [25:32]
Bill Bengen
Well, let's say you had five acid classes talk with 11% each. If you went on a small cap and micro, maybe to 14% each, and then reduce the others proportionally, that also gives you a boost about a quarter of a percent. That's why we're starting to get up to 5% and maybe a little bit beyond. So those are the four free lunches, at least the ones I've discovered so far, you know, in the field, which give you higher withdrawal rates without any additional risk.
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- [28:46]
Paula Pant
I'm glad you brought up Small Cat, because one of the things that I hear people talk about a lot these days is look at the performance of large cap. And of course there's recency bias in this, but look at the performance of large cap. Look at the Magnificent seven, all of the market gains are being driven by large cap. And in addition to that, some people would argue that AI has ushered in a new era such that the productivity gains that come from AI will so overwhelmingly benefit the largest companies. Alphabet, Meta, Amazon. That large caps are the new small caps. Basically that the growth is going to come from large caps and that's going to be the outperforming asset class.
- [29:32]
Bill Bengen
That's interesting because that argument sounds very much like your argument. I remember about 25 years ago we're in the dot com boom. I had very much the same kind of approach to things and for a while that worked and then we know what happened. And if you take a look at that bear market which lasted over two years from 2000 to 2003, there are three areas you could have invested in which would have helped. In stocks, REITs outperformed, emerging market equities and small cap value. I'm not ready to accept that. Once again, that's kind of predicting the future based upon very limited information. I'd be very cautious about minimizing the effect of certain asset classes just because they have not performed well recently. You see, my experience is that means they're about ready to go crazy. Just like an example emerging markets. I mean China pushes a switch. What happens to emerging market funds? Boom. Up 3% a day, every day. So yeah, be careful.
- [30:36]
Paula Pant
Yeah. International equities have generally kind of underperformed. They've been a disappointing asset class for 15 years now.
- [30:44]
Bill Bengen
Yeah. And it's really hard for an investor to hang in there and follow the diversification advice. But if you look at over the very long term, it's been wise to do that.
- [30:57]
Paula Pant
Okay, so the four free lunches, equity glide path, diversification, rebalancing and slight overweighting.
- [31:05]
Bill Bengen
Of the higher returning asset classes.
- [31:07]
Paula Pant
The slight overweighting of the highest returning asset classes. Those are the four. I have a follow up question about rebalancing.
- [31:13]
Bill Bengen
Sure.
- [31:14]
Paula Pant
Many people mistakenly assumed that equities and bonds were inversely correlated. And then 2022 happened and we all had a bit of a shock. Are equities and bonds still. Should we be rebalancing one versus the other? Is that still a good way of getting some inversely correlated assets in our portfolio?
- [31:36]
Bill Bengen
Yeah, I feel over the long term, yes, they're not always negatively correlated. You're right. 2022 was a good example. I think we even had an example over the last year where they were moving together at the same time. So it's not always going to work. But historically, it's shown bonds were a great diversifier for stocks. So once again, I wouldn't be panicked out of that strategy by recent results.
- [32:03]
Paula Pant
So in other words, it's directionally accurate, even if it's not 100%.
- [32:07]
Bill Bengen
Yeah. Just you can't depend. Nothing will work in investing all the time. That's a rule I probably. I could subscribe to. Yeah.
- [32:14]
Paula Pant
On that note, so black swan events, when we've seen the last few major market collapses, they were all triggered by things that no one really predicted. The pandemic. We haven't had a pandemic since 1917. No one was really anticipating that. The subprime mortgage crisis. No one was really anticipating that. How do we anticipate the unanticipated?
- [32:39]
Bill Bengen
Well, that's a thing you really can. Was it? Mark Twain once said, predicting is difficult, particularly about the future.
- [32:46]
Paula Pant
Yeah.
- [32:47]
Bill Bengen
And I think that's a fair statement to make. That's why you arm yourself with diversification. You never really know what's going to happen. You probably want to have some inflation hedges in your portfolio, such as gold, precious metal, commodities at all time, a little bit of everything. And you should be able to get through some pretty rough conditions. I have in the past. Yeah. It's hard to emerge unscathed from something like the 70s. I hope we never see anything like that again. But even there, diversification proved the value to investors.
- [33:19]
Paula Pant
You're talking about the hyperinflation of the high inflation of the 70s. What do you think of cryptocurrency?
- [33:26]
Bill Bengen
Well, opinions vary on that. I know Warren Buffett and his partner didn't think much of that. Other people are pretty high on it. I don't see any harm having a small portion where you probably buy a fund and cryptocurrency fund in your portfolio. Maybe 1 or 2%. I honestly don't know where they're going. That may mediate over time. Moderate. So just seems to me maybe a small percentage of your portfolio and that wouldn't hurt as a diversifier. Hmm.
- [33:55]
Paula Pant
I want to play you a question that we got when we recorded episode. We got this question from an audience member. I was myself and Brad Barrett, who is the host of the Choose Fi podcast, the Choose Financial Independence podcast. We were both co hosting episode 500 and we were live on stage. And neither of us, we were kind of trying to workshop this question out loud. Both of us were saying, you know what? We need Bill Bengen here. I think he could answer this. So I want to play this question for you sure? And hear your answer.
- [34:31]
Audience Member
Thank you. Very philosophical episode so far, so I'm afraid I'm going to be a bit prosaic. Throughout both of your podcasts, the 4% rule has been discussed ad nauseam. I was just wondering your thoughts on fixed percentage withdrawals, because to my mind, you take your 4% every year without adjusting for inflation based on your fund balance. As long as you can deal with the income volatility, you remove sequence of return risk and you mathematically at least never run out of money. Rather than adjusting your amount for inflation, you're adjusting it for market returns. Yeah, I think it's the easiest way. But the 4% is based on the balance at year one.
- [35:08]
Bill Bengen
Correct.
- [35:08]
Audience Member
And then that is adjusted in line with inflation from that point forward.
- [35:12]
Shopify
I don't know if that's ever been studied. Intuitively it makes sense, but I haven't modeled it out on a computer screen.
- [35:19]
Paula Pant
To know what that would look like. You have modeled it?
- [35:23]
Bill Bengen
I have. I've studied that. That's one of the four or five different withdrawal schemes that I've looked at. In some cases it's worked very well. And that's usually cases where you start out with a nice bull market for long run early in retirement and you might be able to get away with it. In other cases it's a disaster. You run into a terrible bear market and you're taking percentage of your portfolio. It's also difficult for retirees because let's say in 2008, bear market, some, a lot of people found their portfolios dropped by 25, 30%. If they were using this approach, that means they'd have to reduce their expenses by 25 or 30%. Most retirees don't have that much flexibility or they have a lot of fixed expenses. So that's going to create real difficulties for folks. My goal is to try to find something that'll work for people given a certain set of circumstances. And it's a very high probability. I can't be certain that that approach will work. A high enough probability of time to recommend it. There's a substantial risk of failure. So I, in my book, I'm not, I'm going to say no. Hit the buzzer. No.
- [36:37]
Paula Pant
How do you define failure in this context?
- [36:39]
Bill Bengen
Well, the portfolio starts to collapse and your withdrawals now start becoming far less than you started with. They might drop 60%, 50, 40, you know, and once you get that level, that's a huge adjustment and most people are unable to handle it. I'd rather keep withdrawals in Some sort of a moderate range so that people can adjust their lives, lifestyle to it.
- [37:05]
Paula Pant
So when you say the portfolio starts to collapse, the portfolio collapses due to market conditions. But you technically never run out of money because you're always drawing down 4% of current balance. It's just that you start off with 500,000 and there's a 50% haircut. Now you're drawing 4% of 250,000.
- [37:26]
Bill Bengen
That's right.
- [37:27]
Paula Pant
And that's just not enough to feed you.
- [37:29]
Bill Bengen
Exactly. And at some point, it just keeps declining because it's been damaged so badly by the initial circumstances. There's just no recovery. And that's what I try to avoid in my work and recommending to folks, I don't want to put them in that position. I want to avoid that. We want to get as much as we can, but not more than we can safely do.
- [37:50]
Paula Pant
So what might harm a portfolio in retirement?
- [37:54]
Bill Bengen
That's really a good question. And that really falls on a category of, of managing your plan. It's one thing to have a plan, a withdrawal plan, let's say, just as with an estate plan or investment plan or an insurance plan. You have a starting point, you have certain goals with that plan. But it's important to manage that plan. And there are two important functions to manage. One is to monitor it. And once you discover a problem, make an adjustment. It's what they do, you know, when they send a spacecraft off to Jupiter, which takes six years to get there, okay, we all understand the rules of gravity and the forces that will affect it, but it's just so complicated. Unexpected things can happen. So you have to be ready to make adjustments, and you have to recognize when it is time to make an adjustment. I can give you a couple examples. I've done some studies of plans that look like they might be failing. Let's start for an example with a plan where an investor has gone through all the analysis. All elements come out with his withdrawal rate, which seemed appropriate based upon inflation and stock market valuations at the start of retirement. And then he gets hit with an unexpected big bear market early in retirement. He's tracking what his draw weight would be. And you set up a template showing what it probably should be according to the plan, year by year, so he has something to track his progress again. And it's scary because it shows that, at least for the time being, his withdrawal rate is much higher than he would have expected. If he started out with 5.5%, maybe it's risen to 7 or 7 and a half it'd be easy to panic in that circumstance. But when I did that analysis, the best course of action is to do nothing. Because most bear markets have beginning and an end. They do their damage, but then they start a market recovery. And if you panic and let's say, reduce your withdrawal rate, you may have lost. You'll find out that if you had done nothing, the market would have returned to higher levels and you're back on track with your plan. That's the result in most cases, in fact. So my recommendation, if you come to an unexpected bear market, don't panic. Wait a few years and see what happens to withdrawal rates. My guess is they'll probably return to where they should be. Completely different circumstance with inflation. If you hit an extended period of high inflation early in retirement, it's time to panic. And I'm talking If you have four or five years of 6, 7, 8% or more and you didn't build that into plan, you didn't anticipate a high inflation regime, you probably need to make cuts in your spending and steep cuts because the situation will worsen as time goes on. With inflation, it's not like the bear market, which is over and you get a recovery. You've been permanently damaged by this high inflation and you have to find shelter. So you bring your withdrawals down and how much depends upon how much inflation you had. I ran a model where you had to cut Your expenses by 35% immediately or else you're going to have to have another 35% cut five years down the road. So the lesson there, bear markets maybe do nothing. High inflation, it looks like it's going to last a while. Head for the bomb shelters. In summary, I'd say that if you encounter an unexpected bear market early in retirement, don't panic. Allow the recovery to proceed. Most likely is that your withdrawal rate will normalize and you'll be fine. However, if you encounter a period of extended high inflation early in retirement, it's time to panic. Time to head for the bunkers. Time to cut your expenses drastically. Because if you don't cut them now, you have to make even bigger cuts later. If that explicit continues.
- [41:53]
Paula Pant
Yikes. Okay, bear market, don't panic. Inflation, do panic.
- [41:58]
Bill Bengen
Yeah, that's right.
- [42:05]
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- [43:25]
Paula Pant
Well.
- [43:26]
Shopify
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- [45:08]
Paula Pant
What happens when there are certain categories of spending that rise at above the level of inflation? We've seen this historically with healthcare, which of course, when you're a senior, that's a very different conversation than when you're in your 30s or 40s. We've seen healthcare rise at much higher than the rate of inflation. We've seen the cost of higher education rise at much higher than the level of inflation. And we've seen housing prices. In fact, housing is the one category as. As inflation generally right now in 2024 trends downward. Housing is the one category where it continues to rise. How much should you panic? If inflation as a whole is relatively low, but there are very specific spending categories where prices just keep climbing higher and higher. Let's say that you are a retiree and a renter, but rent just keeps climbing, climbing and climbing.
- [46:12]
Bill Bengen
Yeah, I haven't done a lot of analysis of it, but I have some thoughts on this. I use CPI in the COLA method of withdrawal because that's an available statistic. The fact is each individual has his own individual personal inflation rate. And I think it'd be a good idea for individuals to take whatever the CPI is and adjust it to suit their circumstances. There may be people, for example, have a mortgage with a fixed payment which reduces their inflation rate. Others may be more sensitive to mental expenses, medical expenses in the other areas talked about. And they should probably expect higher numbers and building into their model when they calculate what their safe withdrawal rate will be. That's Keller making a plan to the individual. I think that's useful to do that if find a circumstance that applies.
- [47:03]
Paula Pant
Okay, so individually panic, don't panic, do panic and individually panic.
- [47:07]
Bill Bengen
That's right, exactly.
- [47:09]
Paula Pant
Idiosyncratically panic.
- [47:10]
Bill Bengen
Yeah, I want mass panic.
- [47:12]
Shopify
Exactly.
- [47:13]
Paula Pant
Well, excellent. Is there anything else that I haven't asked about?
- [47:17]
Bill Bengen
Yeah, you've done a wonderful job covering the field. You're very exhaustive.
- [47:21]
Paula Pant
All right, well, in that case, I'm going to switch the subject and ask about, you know, you're a former rocket scientist.
- [47:28]
Bill Bengen
Yes. Former Ephra Sun. Former.
- [47:31]
Paula Pant
When did you graduate from MIT?
- [47:33]
Bill Bengen
1969.
- [47:34]
Paula Pant
1969.
- [47:35]
Bill Bengen
Two months before the moon landing.
- [47:37]
Paula Pant
Oh, wow. What are your thoughts, feelings, observations about all of the new activity in space today and the particularly the push to go to Mars?
- [47:51]
Bill Bengen
Oh, it's Wonderfully stimulating. I wish we had Elon Musk 50 years ago. We might be on Mars by now. It looks like he's planning to be putting people on Mars within five years. And I hope I live long enough to see that. I'm watching my diet, taking my vitamins.
- [48:07]
Paula Pant
Would you go?
- [48:08]
Bill Bengen
I don't think I'd be a good candidate particularly for the fight, but I think it'd be a wonderful adventure to do it. To step foot on another real world where the moon is, you know, it's not a very interesting place, but Mars I think would be fascinating. And it's mankind. We've been around as a species for a couple of million years, but we're still very, very young. We're still at the beginning of our journey, which I hope will last for a long, long time. We have a lot to learn, a lot of wonders to discover about the universe and about ourselves. I'm just glad we're getting started, really doing it, you know.
- [48:46]
Paula Pant
What are your thoughts, you know, as of the time that we're recording this? Recently we saw the very first civilian spacewalk. Non trained astronauts doing a spacewalk for the first time. What are your thoughts on increasing space tourism?
- [49:01]
Bill Bengen
I think it's great. I think somebody once who I think it was an asteroid who had been out in space and said that the view of Earth from space is something that everyone should experience because it'll change their lives forever. To appreciate this beautiful fragile world we live on and how important it is that we be stewards of it because we're going to be living on it for a long time and value what we have. It'd be great, I think if everyone get out in space and see that, it'd be wonderful.
- [49:31]
Paula Pant
Do you have a favorite planet?
- [49:33]
Bill Bengen
Earth's pretty nice. Jupiter will crush you with the gravity and Mercury, you'll burn up and you'll suffocate on Venus. And Titan is an interesting world I'd like to visit too. So a very interesting program. You know, the sun over time is going to get hotter and hotter and bigger and bigger and eventually turn the Earth into crisp. But Titan, in a couple hundred million years, it's very cold now, may start to warm up as the sun expands and it's possible life may develop there. And that might be the place to go for your next vacation, you know.
- [50:07]
Paula Pant
Wow, Titan tourism.
- [50:09]
Bill Bengen
Yeah, it could be maybe a long way off, but I wouldn't be surprised.
- [50:15]
Paula Pant
Well, will you validate my argument that Pluto ought to still be a planet?
- [50:19]
Bill Bengen
I'm very disappointed by what's happening. I left grade school. There used to be a dinosaur called Brontosaurus, and now they have another name for. I think it's Apatosaurus. There used to be nine planets, now there's eight.
- [50:32]
Paula Pant
Yeah.
- [50:33]
Bill Bengen
And they've done a lot of other things. Yeah. There's a movement afoot to bring Pluto back in the fall. I understand the scientific reasons why that's a crazy orbit. It's so different. It appears to belong to another group. But I wouldn't mind if they called it a planet. Again. I call it a planet.
- [50:50]
Shopify
Oh, excellent.
- [50:51]
Bill Bengen
Force of habit.
- [50:53]
Paula Pant
All right, well, thank you for joining us and sharing your thoughts on everything ranging from cryptocurrency to whether or not Pluto is a planet.
- [51:01]
Bill Bengen
My pleasure. I enjoyed it immensely.
- [51:04]
Shopify
Thank you to Bill Bengen, the discoverer of the 4% rule, for joining us again on the Afford Anything podcast. What are three key takeaways that we got from this conversation? Key takeaway number one the 4% rule represents a worst case scenario, not a universal guideline. It's meant to reduce the risk that you will run out of money in a worst case scenario. In fact, the study found that out of over 400 historical retirement scenarios analyzed since 1926, only one circumstance, which is a retiree who retired in 1968, would need to limit withdrawals to 4.2% to make their portfolio last. And that's because if you retired in 1968, then you'd face uniquely challenging conditions. Two bear markets in 1969, followed by a decade of high inflation throughout the 1970s. Retiring in 1968, historically speaking, is the worst case scenario. All other retirees in the study could have safely withdrawn more, in fact, with some even reaching double digit withdrawal rates. Not that we're recommending that, but that is simply how far the range extends. Now, Bengen's recent research suggests that 5% might be a more suitable worst case baseline, but he emphasizes that withdrawal rates should be personalized based on a variety of factors, including time horizon and your tax considerations.
- [52:42]
Bill Bengen
I think the term rule is inappropriate because it gives the impression that there's one formula that fits everybody. And of course, if you're a financial advisor working with clients, simply not the case. Every client has different needs. How it all came about rolls from that paper I wrote 30 years ago where I discovered that the worst case scenario had been one retiree retired in 68 and had to live with a 4.2% withdrawal rate. In my database, there are over 400 retirees, and that's the only retiree that could take out only that 4.2%. All the others had higher rates and some double digits in some very, very fortunate cases.
- [53:24]
Shopify
And so that is the first key takeaway. Key takeaway number two, Bear markets and inflation require different responses in retirement. While market downturns can be frightening for everyone, Bengen advises against panicking during bear markets. Of course, I mean, nobody is going to advise, yes, panic, but you know, don't panic during a bear market because normally they recover. But that being said, sustained high inflation does require immediate action if there's anything to worry about. It's not a bear market. It's high inflation. And that's because the damage compounds over time, and that damage becomes permanent unless we enter a deflationary market. Once prices rise, they stay up. The rate of inflation might slow down, but the prices have normalized at a new, higher level. So in high inflation scenarios, retirees, Bengen said, might need to cut expenses by 35% immediately in order to avoid even deeper cuts later. And on top of the general economic inflation rate, every retiree also needs to consider their own personal inflation rate based on their own personal specific expenses like healthcare and housing. That's just as important as the general cpi.
- [54:50]
Bill Bengen
If you hit an extended period of high inflation early in retirement, it's time to panic. And I'm talking If you have four or five years of six, seven, 8% or more, and you didn't build that into your plan, you didn't anticipate a high inflation regime, you probably need to make cuts in your spending and steep cuts because the situation will worsen as time goes on with inflation. It's not like the bear market, which is over and you get a recovery. You've been permanently damaged by this high inflation and you have to find shelter. So you bring your withdrawals down and how much depends upon how much inflation you had. I ran a model where you had to cut Your expenses by 35% immediately or else you're going to have to have another 35% cut five years down the road.
- [55:39]
Shopify
So that is the second key takeaway. Finally, key takeaway number three. There are four free lunches in retirement planning where you can boost your returns without additional risk. And these four strategies are, number one, using what's called an equity glide path. I don't really like using that phrase because glide path is a whole bunch of, like, financial advisor jargon. What they're talking about is lowering your exposure to equities early in retirement in order to kind of safeguard against sequence of returns, risk and then boosting your exposure to equities later on in retirement. So your equity exposure, it's like an inverted bell curve. It like it goes down and then it goes right back up. It's like a giant letter U, I guess is the less nerdy way of saying that. See, this is how far I'm going to not use the jargon glide path anyway, that the strategy of reducing equity exposure at the beginning of your retirement and then later on boosting it back up again. So that's one of the four strategies that can increase your rate of withdrawal without adding risk. A second strategy is simply staying diversified. A third strategy is regular portfolio rebalancing. And then the fourth is just slightly overweighting the higher returning asset classes, like slightly overweighting towards small cap stocks.
- [57:08]
Bill Bengen
Another one, of course, one everyone is aware of, diversification, which is a stand, you know, that goes way back. There was a Nobel Prize given for that very, very important that investors have a well diversified portfolio because you never know what asset class is going to do best. I did a chart from my book where I looked at the last hundred years and I asked the question for each of these retirees, 400 retirees, if they could pick an asset allocation at the start of retirement that would last them for 30 years and given the highest withdrawal rate, what would it be? Well, there's no one answer to that. It's all over the map. Some years small cap stocks dominate, sometimes large cap, sometimes international stocks dominate the allocation, sometimes bonds dominate the allocation. And no one really knows what that will be.
- [57:55]
Shopify
Those are three key takeaways from this conversation with Bill Bangin, the guy who discovered the 4% rule. Mr. 4%, thank you so much for tuning in. If you enjoyed today's episode, please do three things. First and foremost, share it with the people in your life. With friends, neighbors, colleagues. That's how you spread the message of financial independence. Number two, subscribe to our newsletter affordanything.com newsletter and number three, make sure you're following us in your favorite podcast playing app. In fact, make sure you're following us in all of your favorite podcast playing apps, plural, so that you don't miss any of our amazing upcoming shows. And while you're there, please leave us a review. Thank you again for tuning in. My name is Paula Pant. This is the Afford Anything podcast and I'll meet you in the next episode.