The Father of the 4% Rule Finally Sets the Record Straight

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28:01I'm glad you brought up small cap 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.

28:47That's interesting because that argument sounds very much like If you're arguing, I remember about 25 years ago, we're in the dot-com boom. Yeah. 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 values. Sure. I'm not ready to accept that. Once again, that's kind of predicting the future based upon very limited information.

29:27I'd be very cautious about minimizing the effect of certain acid classes just because they have not performed well recently. Usually my experience is that means they're about ready to go crazy. Just like, for example, emerging markets. I mean, China pushes a switch. What happens to emerging market funds? Boom. Right. Up 3 % a day, every day. So, yeah, be careful. Yeah, international equities have generally kind of underperformed. They've been a disappointing asset class for 15 years now. Yeah, and it's really hard for an investor to hang in there and follow all the diversification advice. But if you look at over the very long term, it's been wise to do that.

30:12Okay, so the four free lunches, equity glide path, diversification, rebalancing, and... Slight overweighing of the higher returning asset classes. A slight overweighing of the highest returning asset classes. Those are the four. I have a follow-up question about rebalancing. Sure. 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 a—should we be rebalancing one versus the other? Is that still a good way of getting some inversely correlated assets in our portfolio? Yeah, I feel over the long term, yes.

30:54They'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 are a great diversifier for stocks. So once again, I wouldn't be panicked out of that strategy. by recent results. So in other words, it's directionally accurate, even if it's not 100 %? Yeah, just you can't depend on. Nothing will work in investing all the time. That's a rule that probably I could survive to. 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.

31:40The 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? And well, that's a thing you really can. Was it Mark Twain once said predicting is difficult, particularly about the future? Yeah. 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 portfolios, such as gold, precious metal, commodities at all time. A little bit of everything.

32:19And you should be able to get through some pretty rough conditions. 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 a value to investors. You're talking about the hyperinflation of the 70s, or the high inflation of the 70s. Yeah. What do you think of cryptocurrency? 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, And, well, you probably buy a fund, a cryptocurrency fund in your portfolio, maybe 1 % or 2%.

32:57I honestly don't know where they're going. That may mediate over time, moderate. So just say to me, maybe a small percentage of your portfolio, and that wouldn't hurt as a diversifier. I want to play you a question that we got when we recorded episode. We got this question from an audience member. Okay. 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.

33:39I think he could answer this. So I want to play this question for you. Sure. And hear your answer. 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 nauseum. 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 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.

34:18I think it's the easiest way. But the 4 % is based on the balance at year one, correct? And then that is adjusted in line with inflation from that point forward. I don't know if that's ever been studied. Like intuitively it makes sense, but I haven't modeled it out on a computer screen to know what that would look like. You have modeled it. 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 a long run early in retirement. And you might be able to get away with it.

34:54In other cases, it's a disaster. You run into a terrible bear market and you're taking percentage of your portfolio. Well, it's also difficult for retirees because, let's say, in the 2008 bear market, 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. 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 will work for people given a certain set of circumstances, and it's a very high probability.

35:38I 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 in my book I'm going to say no, hit the buzzer, no. How do you define failure in this context? Well, the portfolio starts to collapse and your withdrawals now start becoming far less than you started with. They might drop to 60%, 50%, 40%. 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 lifestyle to it. So when you say the portfolio starts to collapse, the portfolio collapses due to market conditions.

36:27But 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. That's right. And that's just not enough to feed you. 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 so.

37:06What might harm a portfolio in retirement? That's really a good question. And that really falls under the category 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 an 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 when they send a spacecraft off to Jupiter, which takes six years to get there, okay?

37:42We 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 whether there's 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 example, with a plan where an investor has gone through all the analysis, analyzed all the elements, come out with this withdrawal rate, which seemed appropriate, based upon inflation and stock market valuations at the start of retirement.

38:18And then he gets hit with an unexpected big bear market early in retirement. He's tracking what his withdrawal rate 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 7.5%. 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 a beginning and an end.

39:00They 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 plant. 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 your 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.

39:45And I'm talking if you have four or five years of 6%, 7%, 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 have. I ran a model where you had to cut your expenses by 35 % immediately, or else you were going to have to have another 35 % cut five years down the road.

40:28So 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. Well, 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'll have to make even bigger cuts later if that inflation continues.

41:08Yikes. Okay. Okay. Bear market, don't panic. Inflation, do panic. Yeah, that's right.

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43:06Shorts.

43:22What happens when there are certain categories of spending that rise at above the level of inflation? We've seen this historically with health care, which, of course, when you're senior, that's a very different conversation than when you're in your 30s or 40s. We've seen health care 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 inflation generally right now in 2024 trends downward. Housing is the one category where it continues to rise.

44:02How 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. 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 if individuals to take whatever the CPI is and adjust it to suit their circumstances.

44:49There 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, than the other areas we talked about, and they should probably expect higher numbers and build it 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 finer circumstance or it applies. Hmm. Okay. So individually panic. Don't panic, do panic, and individually panic. Yeah, that's right. Exactly. Idiosyncratically panic.

45:24Yeah, I want mass panic. Exactly. Well, excellent. Is there anything else that I haven't asked about? Yeah, you've done a wonderful job covering the fields. Oh, wonderful. Very exhaustive. All right. Well, in that case, I'm going to switch the subject and ask about it because, you know, you're a former rocket scientist. Yes, former. Ephraim former. When did you graduate from MIT? 1969. 1969. Two months before the moon landing. Oh, wow. What are your thoughts, feelings, observations about all of the new activity in space today and particularly the push to go to Mars? It's wonderfully stimulating.

46:06I 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. Would you go? I don't think I'd be a good candidate particularly for the fight, but I think it would be a wonderful adventure to step foot on another real world where the moon is not a very interesting place, but Mars I think would be fascinating. It's mankind. We've been around as a species for a couple 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.

46:50We 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. We're really doing it, you know. 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? I think it's great. I think somebody once who, I think it was an asteroid who would be out in space and said that the view of Earth from space is something that everyone should experience because it will change their lives forever.

47:27To 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 would be great, I think, if everyone would get out in space and see that. It would be wonderful. Do you have a favorite planet? Earth's pretty nice. Jupiter will crush you with the gravity, and Mercury will burn up, and you'll suffocate on Venus. And Titan is an interesting world I'd like to visit, too. It's a very interesting program. You know, the sun over time is going to get hotter and hotter and bigger and bigger, and eventually you're going to turn the Earth into crisp.

48:07But 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. Wow. Titan tourism. Yeah, it could be. Maybe a long way off, but I wouldn't be surprised. Well, will you validate my argument that Pluto ought to still be a planet? 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 it. I think it's Apatosaurus. There used to be nine planets. Now there's eight. Eight, yeah.

48:47And they've done a lot of other things. Yeah, there's a movement of what to bring Pluto back in the fold. 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. Oh, excellent. It's a force of habit. 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. My pleasure. I read it immensely. Thank you to Bill Bengen, the discoverer of the 4 % rule, for joining us again on the Afford Anything podcast.

49:27What 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.

50:17Retiring 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. I think the term rule is inappropriate because it gives the impression that there's one formula that fits everybody.

51:03And 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 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. And so that is the first key takeaway. Key takeaway number two. Bear markets and inflation require different responses in retirement.

51:47While 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.

52:33So 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 health care and housing. That's just as important as the general CPI. 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 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.

53:28I don't 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 have. 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 that is the second key takeaway. Finally, key takeaway number three. There are four quote unquote 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.

54:13I 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 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.

54:56So 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. Another one, of course, one everyone is aware of, diversification, which is a standing, you know, that goes way back. There was an old 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.

55:36I did a chart from my book where I looked at the last 100 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 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. Those are three key takeaways from this conversation with Bill Bangan, the guy who discovered the 4 % rule, Mr.

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56:55Thank 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.