Today’s episode is the first that takes a new format we are piloting, where we compile clips from the most valuable conversations we have had in different episodes on a given topic. To kick it all off we will be devoting this episode to inflation-adjusted retirement spending and the nuances of the 4% rule. We start off with a clip from our conversation with Bill Bengen, creator of the 4% rule, where he explains the concept. From there, we pull up an excerpt from an interview with Wade Pfau, hearing him weigh in on how this rule only works in the context of the US and Canada. Next up, Fred Vetesse talks about the changes in stock and bond yields and how they further problematize the 4% rule. After that, Professor Moshe Molevsky makes the case for flexible spending, followed by Michale Kitces with his favourite variable spending rules. We grab a segment from our chat with Scott Rieckens where he argues that the 4% rule should be seen as more of a guideline for making financial decisions than a rule. Bill Bengen’s interview then features again as we hear his comments on the effects of small-cap value stocks and cyclically adjusted price-earnings on safe withdrawal rates. Tune in for this fascinating set of highlights, the main point of which is that the 4% rule should rather be used as a guideline for financial planning and that where actual spending is concerned, a flexible approach is more sensible.

Key Points From This Episode:

• Bill Bengen, creator of the 4% rule, explains how the concept relates to inflation-adjusted retirement spending. [0:03:50.8]

• Wade Pfau speaks about how the 4% rule doesn’t work in an international context. [0:09:15.0]

• Fred Vettesse lays out the contrast between today and the period Bill studied. [0:12:31.1]

• The importance of having flexibility in retirement spending with Moshe Milevsky. [0:14:51.8]

• Variable spending rules with Michael Kitces; ratcheting, guardrails, and more. [0:19:27.3]

• Scott Rieckens on the 4% rule as a tool for making financial decisions. [0:32:33.8]

• Bill Bengen comments on the problems that have been found with the 4% rule. [0:38:35.7]

• The effects of small-cap value stocks on the safe withdrawal rate with Bill Bengen. [0:42:52.8]

• The effects of cyclically adjusted price-earnings on safe withdrawal rates with Bill Bengen. [0:47:20.6]

• Final thoughts on the 4% rule with Ben and Cameron. [0:51:37.8]

Read The Transcript:

Ben Felix: This is The Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making for Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore: This week, coming to life as a great idea that you had, which is something that we pulled together, that you pulled together, focusing on a single topic. So tell us where the idea came from.

Ben Felix: Well, we've done lots of episodes where you and I focus on a single topic, but we've also had lots of conversations with experts on various topics. But one of the concerns that I have as the library of our content increases is that if somebody wants to reference the podcast to learn about a topic, like if they want to learn about the 4% rule, which is what we're going to talk about in this episode, it's dispersed across many, many episodes. So we've produced all of this high quality, we think anyway, information in conversation with some of the world's leading experts on various topics. But if you want to learn about one of those topics, it's not so easy to index the content to do so.

Cameron Passmore: It isn't. And also, when you go through the pieces that you pull together, the audio clip that you pull together, the story really becomes richer when you put it all together, because they often add different ideas to someone else's ideas.

Ben Felix: Yeah. So we haven't explained the format. This new format that we're piloting, we'll explain what it is. So we've taken, like I mentioned for the 4% rule, we've taken that topic and we've gone through all of our existing catalog of content and said, "Who have we had the most meaningful, impactful conversations with on the specific topic of the 4% rule?" And then we've compiled those together into a single episode with additional commentary from you and I in between each clip. And our hope is to do this for other topics in the future, this just being the first one. We've experimented with different formats a couple times as we've progressed with the podcast, and this is our first new experiment in quite a while, so we do hope that people find it useful.

Cameron Passmore: It's kind of like our review episodes that we've done a couple times, but we are going to skip this week sort of book review, news of the week, other investment topics as well as bad advice of the week. So this is a standalone, and others in the future will be standalone on single topics.

Ben Felix: Yep. All right. So should we jump into the first comprehensive overview episode as we're calling them?

Cameron Passmore: Let's go.

Ben Felix: Welcome to Episode 164 of The Rational Reminder Podcast. Today we're doing a comprehensive overview of the 4% rule. So this is a spending rule that we've talked about with, I mean, the world's leading experts on the topic. We've talked to Bill Bengen who created the 4% rule. So I mean, who better to explain what it is?

Cameron Passmore: Literally.

Ben Felix: Literally, the guy. Yeah. We've talked to Wade Pfau, who's one of the world's leading retirement researchers. He's a professor of Retirement Income at The American College of Financial Services. We've talked Moshe Milevsky about the 4% rule. He teaches undergrad, graduate and doctoral students courses on wealth management, investments, insurance, pensions and retirement planning at York University, and he's written a ton of books on retirement income.

Cameron Passmore: Great books. Must-read books.

BenFelix: Yeah, great books. And his thoughts on the 4% rule were fantastic. We talked to Michael Kitces, who's the Head of Planning Strategy at Buckingham, which is a large wealth management firm in the United States. Fred Vettese, who's a former actuary and the author of multiple books on retirement income. And to balance it all out, we had a conversation with Scott Rieckens, who is the creator of the documentary, Playing with Fire. So I mean, when you think about, "Okay, I want to sit down and learn about the 4% rule," I cannot imagine anybody else that you would maybe add to that roster to make it better. Maybe Big Ern, the guy that writes the Early Retirement Now blog. He could be in this roster, too.

But I think what we have is pretty great. So to start, because we haven't explained what it is yet, to explain what the 4% rule is, we're going to go to a clip from our conversation with Bill Bengen, who again, is the creator of the 4% rule. I can't think of anyone better to describe what the 4% rule is.

Cameron Passmore: He was such a nice guy too.

Cameron Passmore: Bill Bengen, it's with great pleasure that we welcome you to The Rational Reminder Podcast.

Bill Bengen: Thanks. Appreciate the invitation. Great to be here.

Cameron Passmore: Yeah, we're so happy to have you. So in 1994, your analysis in determining withdrawal rates using historical data, I think it's safe to say it changed the way people think about retirement planning, and your finding is often quoted as the 4% rule. Can you describe what your 1994 research finding was?

Bill Bengen: Yeah. Your question made me go back and take a look at my original paper, and when I re-read, I did so with quite a few smiles. 27 years ago, knowledge has advanced a lot since then, but my basic findings were still reasonably acceptable in today's world, that if you were withdrawing retirement from a tax-deferred account, and you expect to live for 30 years, and you wanted your money to live for 30 years, a 4% withdrawal rate the first year, and then increasing for inflation each year after that, has always worked historically. And that was just choosing two asset classes. That was using large cap stocks and intermediate term treasuries. And the asset allocation that came out of that was about 50/50. It turned out to be optimal for that.

Cameron Passmore: Okay. So Bengen modeled withdrawals starting as a percentage of the portfolio, and then increasing with inflation each year, so the result being a constant inflation-adjusted spending. And then he tested withdrawals starting each calendar year from '26 to 1976, for 50 years, and observed how long the portfolio lasted at each starting point. So for a 30-year portfolio, half stock, half bonds, he found that the 4% withdrawal rate was always sustainable. So that's the key takeaway.

Ben Felix: Yeah. And then, when Bengen came out with his paper, there was another paper in 1998, Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable, by Cooley, Hubbard and Walz. And that paper is commonly referred to in the Financial Independence, Retire Early community as the Trinity Study. And so these two papers together kind of solidified this concept that 4% is a safe withdrawal rate. And the Trinity Study is where people get the idea that 4% was safe 95% of the time in the historical data.

Now there are some really important points that I've expressed in YouTube videos and on our podcast regarding the 4% rule. It's based in Bengen's research on a 30-year withdrawal period, and it's in the historical data. It's based on a 30 to 65 year old investor, and then Bengen said that he added roughly 10 years on to normal life expectancy to account for longevity risk. But the key here, we're talking about a 30-year withdrawal period. And particularly when we're talking about early retirees, it's probably hopefully going to be longer than a 30-year withdrawal. If you extend that period, so say we looked at 40-year periods for withdrawals, repeating the 4% rule as it was originally analyzed, the success rate drops to around 87%.

Cameron Passmore: Which is fascinating. It's kind of counterintuitive.

Ben Felix: Why?

Cameron Passmore: Just because you think longer periods of time smooths out more of the bumps, but the success rate goes down in longer periods of time. Everyone's told, "Have an investment horizon that's a long period of time. Be patient."

Ben Felix: Your returns might even out. You might be more likely to get the average return over a longer period of time, but I think that the challenge is with the sequence of returns, which is one of the things that the whole concept of the 4% rule, and what is the safe withdrawal rate, answering that question started with. Well, just nobody knew. Nobody had tested empirically. And you didn't know based on the sequence of returns that you were going to get, you didn't know how much you could actually spend. So that's why this was a breakthrough. And when we talked to Bill Bengen, he explained to us why he thought it became so popular. But there are definitely still shortcomings.

And so anyway, I mentioned some of the issues. There are other ones like the fact that this uses US data when there are many other countries in the world that have also had stock return histories. Where I got that information, like when I did my YouTube videos on this topic, it all came from reading one of Wade Pfau's books on retirement spending, where he picked apart the 4% rule. And he was actually one of the first person to publish research using international data to say, "Hey, this thing hasn't actually worked if you look pretty much anywhere except for the US and Canada and New Zealand, are the only ones where it did work." So we're going to now play a clip from our conversation with Wade Pfau to talk about some of the issues around the 4% rule.

Ben Felix: When I read your book, How Much Can I Spend in Retirement?, your research on the 4% rule that you wrote about in that book was to me at the time totally mind-blowing. I know you just mentioned it briefly, but can you expand a little bit on what you found about the 4% rule, and how it probably isn't the best thing to be using?

Wade Pfau: Sure. Yeah, I mean, I got my start in all this. I had a different data set. The 4% rule is based on US historical market returns, and I had global market returns for 20 different countries, and looked at, did the 4% rule work in other countries? And just found that it worked in the US and Canada but not in the other 18 countries in the data set. And if you put all the international data together with a 50/50 allocation, which is kind of a baseline for this research, the 4% rule worked about 68% of the time around the world. And if you wanted a withdrawal rate that worked 90% of the time around the world, you had to drop it down to 2.8%.

And so I thought that was pretty compelling that we shouldn't just base things on kind of US 20th century market returns when the US had such a great century, as well as Canada. But if you look at a more typical international experience, the 4% rule didn't work as well. I would get pushback on this though, that people just especially like in the US context, live and invest in the US, "Who cares about other country market returns?" But then that just led to all these other issues, like the low interest rate issue that we just discussed. It's going to lower return, lower sustainable spending. The idea that the 4% rule is calibrated to 30 years. But if you're planning for longer than 30 years of retirement, you need to look at a lower withdrawal rate.

The idea that the 4% rule assumes investors earn the indexed market returns, so there's no investment expenses, there's no other misbehavior. The 4% rule calls for a 50% to 75% stock allocation, which is on the aggressive side, and people have to really stick to that, and not panic and never misbehave. They have to follow this perfectly rational investor type of logic. So if you take a haircut off of the returns for any of these types of issues, as well I should say is taxes, the 4% rule ignores taxes. So it's fine if you have some sort of tax-deferred account where you're paying taxes out of the 4%.

But in any sort of taxable account where you have to pay taxes on an ongoing basis on interest in dividends and so forth, there's no 4% rule of that either. So that really just led to this idea that we have to look beyond the simple rule of thumb, like the 4% rule, to think about what is a sustainable spending strategy for retirees?

Ben Felix: So that information from Wade Pfau, in my mind kills the 4% rule. And it did. Like when I first read Wade's book, like I mentioned before, it was like, "Okay. Well, there's no counter argument that I can think of. And why would you only look at a 30-year retirement period, using only US stocks to conclude that this is a safe withdrawal rate, while ignoring the international data?"

Cameron Passmore: There's also the question of whether things are different today, high stock valuations, low bond yields. I mean, it's a whole different era than the time period that Bill looked at. So this is exactly what we talked to Fred Vettese about.

Cameron Passmore: So another very common question, Fred, that we all get asked often relates to the rule of thumb about the 4% spending rule, which is you can safely withdraw 4% of your portfolio in the starting year, then adjusted for inflation thereafter. So is 4% a safe withdrawal rate?

Fred Vettese: It might have been a safe withdrawal rate at one point in time. Back in the 1990s, you look at Government of Canada bonds and real return bonds, and the real return that is after inflation would have been over 4%, 5%. When you look at bonds today, the real return is 0%. So you need to get a real return of 4% for the 4% rule to make some sense. And you're not getting it from bonds, so you have to be getting it from stocks. But even the real return expected on stocks is not going to be 4% anymore, as it has been historically, so you have a problem doing it. So here's the thing, I've done some Monte Carlo simulations on this, where people have used the 4% rule, but then they had bad investment returns. By bad I mean, their returns track the fifth percentile mark every year.

And you might say, "Well, that's not going to happen," but yes, it can happen, and by definition, it's going to happen one time in 20. And if that ends up happening, then you're going to find that your money will run out by applying the 4% rule. It isn't actually a safe rule to be following, at least not blindly. You'll have to actually start curtailing your spending, if you find that your actual investment returns have been nowhere close to what you thought they were going to be. So I don't actually endorse the 4% rule. If you're going to use any rule at all, I would simply do the minimum withdrawals required under the RRIF rules.

Cameron Passmore: Okay. So Fred alluded to an important concept that the 4% rule doesn't address, which was Bengen's research was based on these constant inflation-adjusted withdrawals, which may not make a whole lot of sense. So of course, for those who listened to that episode, we talked to Moshe Milevsky, about the importance of having flexibility in retirement spending. I think it was one of the most perhaps challenging times that we've ever had in an interview.

Ben Felix: Moshe was tough. And for anybody wondering, yes, I did feel like a child when Professor Milevsky was questioning me about the 4% rule.

Cameron Passmore: He was so good. So pointed on that point, this is such a great part of that interview.

Cameron Passmore: Can you talk about how important it is that retirees have some sort of dynamic or flexible spending strategy?

Moshe Milevsky: To me, it's almost tautological. I'm surprised to have to explain to people how important flexibility is like, "You should be flexible." "No, really? I shouldn't just tie myself to the mass test and just go..." Of course, you need flexibility. So the idea of a spending rule, and I want to be very careful here, the idea of picking a spending rate at the age of 65, and sticking to that spending rate for the rest of your life no matter what happens, I mean, it is ridiculous. It should sound ridiculous once it's properly explained. So obviously, you have to be flexible and you have to adapt to what's happening in the market.

So the intelligent approach to spending is, "My portfolio is down 10%, how much should I adjust my spending?" That's the intelligent approach. "The markets have been up very strongly, I'm thinking I can probably withdraw a bit more. How do I adjust my spending? Markets are up 30%, can I adjust my spending 30%?" "No, no, no. You need to reserve." Vice versa in the other direction. "Markets are down 20%, should I reduce my spending 20%?" "No, you don't have to because there should be a reserve built in there." So obviously, you have to adjust and it has to be dynamic.

But to stick to a particular percentage and say, "Well, no matter what, we're going to continue to withdraw that percentage for the rest of my life as long as I live." I don't even know why we continue to push back against it. But to answer your question, Cameron, absolutely flexibility is important.

Ben Felix: When you say that in the book, you're comparing something like that with the rules of thumb in financial planning, is that things like the 4% rule?

Moshe Milevsky: Never heard of it. What's the 4%? rule?

Ben Felix: Okay. Perfect.

Moshe Milevsky: Explain to me what the 4% rule is, because everybody has their own version of it. It's like in the eye of the beholder. What's your version of the 4% rule?

Ben Felix: Okay. As I understand the genesis of the 4% rule, it came from a guy named William Bengen, and I think in a 1992 or 1994 paper, where he showed that you could have sustainably spent in the worst 30-year period in US market history, you could have sustainably spent 4% portfolio of US stocks and bonds without running out of money. Now, to be clear, this is a rule that Cameron and I have bashed, picked apart, explained why it doesn't make a whole lot of sense many times in the podcast. Hearing your thoughts. I guess we kind of already heard them, but if you have any specific commentary to my definition of the 4% rule, that would be-

Moshe Milevsky: Benjamin, to be honest, you didn't really describe the 4% rule. So let me break it down. So I come to you with a million dollars, and I say, "Hey, Benjamin. I've heard of this thing called the 4% rule, what does it mean? How much can I spend this year?"

Ben Felix: Yeah. So it's 4% of the million, probably broken up into monthly-

Moshe Milevsky: How much would that be this year?

Ben Felix: We're starting with $40,000 in the first year, 4% of a million.

Moshe Milevsky: Okay. What do I do next year, Benjamin? I want to follow this thing called the 4% rule. What should I do next year?

Ben Felix: So based on Bill Bengen's definition, we're going to increase that amount by inflation, that dollar amount, that 40,000 by inflation or deflation the following year, and then follow that.

Moshe Milevsky: And then what do I do in two years from now?

Ben Felix: The same procedure, and rinse and repeat.

Moshe Milevsky: Okay. And what if the market doubles in the next year, what do I do?

Ben Felix: This is one of the issues, we maintain the same path.

Moshe Milevsky: And if the market goes down 50%, what do I do?

Ben Felix: Same thing.

Moshe Milevsky: See, and I find that when you sort of break it down like that, you don't have to have a deep conversation about the 4% rule. People nod and say, "Yeah, that really does sound stupid."

Ben Felix: I would tend to agree with you. I like the way that you picked it apart though.

Moshe Milevsky: I got to be honest. So I've been doing this for a while now, I've been teaching for quite a while. And I remember when this thing caught on, and I'm like, "Man, that doesn't have legs. They're going to forget about that faster than yesterday's newspaper." And here we are 25 years later, and it's like a tsunami. I mean, it's crushed me. Anywhere I go, "We use the 4% rule." So what I've done is, I actually have implemented into my curriculum in the MBA program at the Schulich School. I teach a course on retirement income models, and I have an entire week, I mean, that's three hours of a 12 week course, dedicated to the 4% rule. "I want you to quantify the risks of the 4%, and does it make sense to you? And would any economist advocate for it? And what are the problems?" And they got to write an essay on it. So hopefully, the 40 students that graduate from my class will just shake their head and say, "There's no damn way I'm ever doing that thing," but who knows?

Cameron Passmore: Well, that was certainly clear from Moshe, wasn't it?

Ben Felix: He definitely knows how to get his point across. Now on variable spending strategies, that is one of the things that we spoke extensively to Michael Kitces about. So we're going to go to a clip with him where he talks about some of the other strategies other than constant inflation-adjusted spending that retirees may want to consider.

Ben Felix: One of the ways that people can deal with that is with variable spending, as opposed to spending a straight line, including when markets are down, obviously. Can you talk about some of your favorite variable spending rules?

Michael Kitces: Yeah. So it's interesting when you think about the ways that you can deal with this, is I kind of overgeneralize a little. There's sort of two/three ways that we can deal with this. The first, and we may talk about it more later, it's like, I can change stuff in the portfolio. I can risk manage, make adjustments, maybe buy and invest in different things, maybe invest more tactically, as I'm going like, "I can change the portfolio in response to the markets to try to manage this." Option two is, I can change what I'm spending in the first place to deal with this. It's sort of the proverbial like, "When times get tough, we'll tighten our belts a little bit."

Now, what we find from the variable spending and in particular, is that there really are a couple of different ways that you can go about this, and even find some of the sort of rules of thumb that people think about as a way to deal with this aren't actually good ways to deal with this. So the most straightforward way to do this frankly, is we just spend really conservatively. We spend so conservatively that even if something bad happens, we'll weather the storm. And at the worst case scenarios, if bad stuff happens, I'll call you in a couple of years and tell you, "You can spend more." Which for some people like, "Great. Spending cut, bad. Spending raise, good. So just tell me how far I got to ratchet down to be at a safe baseline level, and we'll figure out how to ratchet up later if and when the markets deal that to us."

And broadly speaking, that's a whole body of research called safe withdrawal rates. We generally find this number around 4% of the starting balance, so like $20,000 per every half million, $40,000 per every million. You take that number, you adjust it for inflation. And even when crazy stuff happens, markets tends to average out in enough time that you have enough left for when the recovery finally shows up. So option one is sort of, it's not really a variable spending rule but so like, "Be so conservative, you won't have to vary at least the downside, and you only have to make upside decisions when you get there." And you can even create sort of straightforward safety margin rules. I call these ratcheting rules.

Like look, "If your portfolio ever gets up 50% from where you started, you have built enough of a margin that even if there's a pullback, you're still so far ahead, you can have a race." So if you get up 50%, from where you started, take a 10% raise, every three years we'll check in, if you're still that far ahead, keep taking raises as long as you've got your safety margin. So one version is spend conservatively, ratchet higher as we go, but try to keep it conservative enough that if bad stuff happens, I don't have to cut my lifestyle because I don't like to cut my lifestyle.

The second version of this are what I call guard rails. Some people also call these decision rule approaches. Think kind of in, if this, then that approach to how we're going to handle it. I like to explain this to people as, because I've got little kids, think bumper lanes at the bowling alley. We have them in the US, I'm presuming this is a phenomenon in Canada as well. I've got three little ones, and so when we take them bowling, these little like bumpers come up on the lanes so that the ball can't go into the gutter. When I was young, they actually had like giant inflatable tubes they put in there, now it's all electronics, these like little gate barriers come up and block off the gutters. And then the bumpers go down when the adults go, unless the adults want to be conservative, and then you get the bumpers on the adult lanes as well.

So when my daughter goes to bowl the ball on a bumper lane, one of two things happens. She either rolls the ball fairly straight down the line. It rolls all the way down, it hits the pin, she gets all excited, does her little victory dance. Or she rolls the ball slightly askew, it drifts off to the side, heads towards the gutter, hits the bumper, bounces off the bumper, goes back into the middle lane, hits the pins. She is equally happy because she got the outcome that was desired, couldn't care less that it happened to bounce off a bumper. All that matters is we got to the end the way that we wanted to get to the end.

And so you can do the same kind of approach with a spending rule approach in retirement. So it says, "Look, maybe I'm going to start by spending a little higher because if there are bumpers, I could start a little higher, I just might hit a bad bumper that makes me caught. So maybe I'll start by spending, at say 5% of my portfolio. If things go really well, and my portfolio outgrows my spending, my withdrawal rate will get lower." Because the balance is going up more than the money that's coming out. It's like I might start at five, then it goes to 4.8, 4.5, 4.2. So if it drifts under four, I hit the conservative bumper which says, I get a raise. It's like if you start at five, but it drifts down to four, you get a 10% raise in just real dollars effective today. You're $50,000 withdrawal goes to 55.

Now we can put a bumper on the other end as well. So if your spending outpaces your portfolio, you have a big market decline, so suddenly your spending is a bigger chunk of your portfolio, if your spending starts going up from five to 5.2 to 5.5 to 5.8, you're still within the bumpers. But if your spending rate goes over six, you have hit the bad bumper. The bad bumper requires a 10% cut. So your $60,000 spending, it's chopped down to 54. So I can't tell you which bumpers you're going to hit. I do not unfortunately have a fully functioning crystal ball to tell you which bumpers we're going to hit in the future. But I can in the most literal sense give you a plan, a set of variable spending rules that says, "If you hit the 4% bumper you get a raise, if you hit the 6% bumper you take a cut. If you stay in the four to six range, you are in the lane and you can roll the ball straight to the end. If you're like that, you don't need a bumper."

And so I don't know which bumpers you're going to hit, I don't know if you're going to do it like my little boy and try to like curve it off a bumper and wing it into a bumper and make it bounce a couple of times there, to each their own, but what I can tell you is that we put bumpers in place, so there's no gutter balls here. Where you're not going to spend so far off the tracks that you're going to run out of money. At worst, you'll hit a bad bumper more than once and have to take more than one cut. But eventually your spending will come down. But we don't have to quite do it at the extreme of like, "Okay. The market was up 6% this year, so you get a 6% raise. The market is down 12% next year, you get a 12% cut."

Because if you just immediately translate all market changes into spending changes for most of us, just it's a level of spending volatility we can't really manage. I can't say like, "Cameron, I know I told you two years ago that you could buy that dream retirement home, but the market is down so much with the pandemic that you'll have to sell it." And then I call you back two years later, I'm like, "Market recovered, you can buy the house back." And you go, "Well, I can't. I sold it to someone and they like living there now. I can't go get it back after a two year temporary spending cut, I need a little bit more stability."

And so the idea of guardrail strategies or doing bumper lanes is not just that we're setting where the bumpers are so that we don't veer too far off course, it's also actually so that we set the bumpers wide enough that we don't have to constantly be changing our lives and our lifestyles. We only make the adjustments when the magnitude is big enough that it actually matters. The third adjustment I'd give quickly as another way to think about variable spending. One of the things that we see most commonly, just I'm part of an advisory firm as well, I've sat across from clients for a long time, one of the things that we commonly see with people is I think of it's like the tighten your belt phenomenon. "Times are tough right now, markets are down, I'm going to cut 10% or 20% out of my budget for the next two years until these things bounce back, and then we'll try to get back on track again."

And I certainly can appreciate that. I think it's an instinctive response for a lot of us when times were tough, we tighten our belts. The irony though, is that when you actually look at the retirement research, it doesn't help very much. When we're only spending 4% or 5% of our portfolio in the first place, and you cut your spending by 10% of that, you're talking about a spending cut that might be 0.4% of your portfolio. So if you do that for the next two years, and you shave off 0.8% of your spending, like you can make that up in one good day in the markets. The irony is it's very impactful for us personally, and actually does almost nothing to get the portfolio back on track, because it's not actually high enough impact over a long period of time.

The alternative that we find, that actually works better, so I call those large but temporary cuts. "We're going to take a big cut, down 20% out, but we're only going to do it temporarily." What we find actually works better is not large temporary cuts, but small, permanent ones. So think instead of, I'm going to cut my spending by 10% or 20% for the next two years, and revert it back again, I'm going to just give up my inflation adjustment over the next year. So I normally my spending goes up by 2% or 3% a year, I'm going to give up my 2% or 3% year raise.

Now in general, we don't think much of that. I mean, in practice working with clients, we've never had someone that's like, "Hey, we live a great lifestyle with $10,000 a month, but inflation just came out and it's 2.7% a year, so please change my monthly distribution to $10,270." We don't really do that. We spend what's in our bank account. Now if we work with our clients and say, "We're going to adjust your spending every year for inflation." If I increase their spending distributions, that's going to their accounts, because that's our plan, they spend the money that's in their account. And if we don't increase the distribution, we spend the money that's in our accounts. It's pretty straightforward.

But when I look at this over time, if I just trim like a 3% inflation-adjustment out, not only does it mean you don't lift your spending this year, it means your baseline spending is now ever so slightly lower for every future year as well. If I lift your spending up, that compounds. If I don't lift your spending up, that compounds. And so if I just take out 3% inflation adjustment writ large over 30 years, the impact of that is actually five to 10 times more beneficial for your long-term retirement than doing that small but permanent cut for two years. And so the irony is it's both five to 10 times better for the longevity of your portfolio and hurts far less, like we barely even notice the inflation adjustment that doesn't happen. 10% or 20% cut for my spending for two years, like I'm going to notice that. That's a lifestyle change.

And so the third way, I think just to think about this overall, like number one is we can set it so conservatively, that we're just only going to ratchet higher with good news because I don't like cuts. Option two is guard rails, like you got to be prepared for the bad guard rail and the good guard rail. But like we can put guard rails in. I don't know which ones you're going to hit, but I know we can't veer too far off track because we got the guard rails. And option three is more of a, we'll try to lift up our spending when times are good, but we're going to trim out inflation adjustments, or more generally, we're going to make small but permanent adjustments when times are difficult, because those actually have far more benefit than the large but temporary anyways, and they're easier to manage.

Cameron Passmore: So I think the idea of bumpers is super interesting, and I thought that was a great analogy from Michael. But the interesting thing about this, and we talk about this a lot with clients approaching or in retirement, is that you need to have a very refined awareness of what you need monthly for cash flow to make ends meet. A lot of people just don't have that awareness. And to have that awareness, then how much margin around that would you want to spend if you do have great returns in your portfolio? But part of the spending that is irregular are things in your, how to keep your house, perhaps, or a new vehicle.

So you really have to be aware of, if you're at the lower end of your spending amount because the bumper put you that way, what when things return to normal or your portfolio improves, do you need to allocate for the new roof on your house or your new furnace, as opposed to other discretionary type spending. So I think it's an interesting need for people to understand exactly what spending needs they have.

Ben Felix: Right. All right, so we've picked apart the 4% rule, we've kind of explained what it is, knocked it down, stripped it apart from a few different angles. And we've offered up variable spending strategies, which as Professor Milevsky pointed out, are probably more sensible than trying to find a single number safe withdrawal rate. Now, to be fair to the Financial Independence, Retire Early community who tend to sort of champion this rule, we spoke to Scott Rieckens who, I mean, I think speaks at least to an extent for the early retirement community. He certainly created an excellent movie about it. So he talked to us about how he thinks the 4% rule should be used and how it is used in practice.

BenFelix: One of the foundations, at least from my somewhat outside perspective, although maybe a little bit more inside after talking to you but still outside, one of the foundations of the FIRE movement is the 4% rule, which is this super simple idea and powerful idea that you can spend 4% of a portfolio of assets, and you won't run out of money. But there are caveats and a lot of them you mentioned on your website that the Trinity study, which is based on 30 years of historical US data, and we've talked about this in the podcast, and I've done a YouTube video on it as well. When you take a different data set, so keep 30 years but go international data, choose different countries, the only countries where 4% works historically is Canada and the US. It doesn't work anywhere else.

And then you extend the time period past 30 years and it's like, it doesn't work anywhere, 4%. So when we're talking about, like I read on your blog or in another interview that your FI date, even if you're not fixated on it, is around age 44 for you and Taylor. Obviously if you get there, 30 years isn't enough runway. So that being such an important piece of the FIRE discussion, how do you think about that?

Scott Rieckens: Yeah. So if you're a listener and you're a beginner, and you're having your epiphany, stop listening to this, fast forward like three minutes, however long it takes for us to talk about this, because it doesn't matter. It really doesn't matter, that's my number one answer. If you are aware of all this and really excited to hear what I have to say, then you're delusional and... No, I think there's a lot of validity to being incredibly skeptical of all hard and fast rules, especially when they come with caveats. And I think it's something that everyone should be thinking about. And I think the 4% rule is really more of a 4% guideline. Rule is probably the wrong word. I think it's an amazing way to frame how to plan for something like retirement, in this case retirement, I should say. And Big Ern, have you heard of Big Ern?

Ben Felix: Yeah.

Scott Rieckens: Yeah. I mean, I think he's doing like savant level work on these things and he's incredible, and he's also a wonderful human being. And I think right now he's got a PEG around 3.25 or 3.5, somewhere in that range. That's probably the safest way to go at this point, where you don't have to work so long to let's say get to like a 2% or something, that the early retirement part of this just goes by the wayside. But 3.25, 3.5% or somewhere in that range is going to be so safe that you just don't really have to worry. For me, look, it goes like this, one, we're not just going to invest in stocks, we're going to diversify that a bit. We're going to look at some real estate, so we have some passive income or fairly passive income coming in, that can help sort of buffer in times of need.

We're investing in businesses, so that even though we're "retired" from mandatory labor, we can still enjoy. I'm still going to want to tinker and play with ideas, and build things and stuff. So making that in the form of a business that can create a side income, it's going to be important to us. And it is a safety precautionary measure kind of thing, mixed with the reality of knowing ourselves and knowing that that's going to be okay with us. So what I'm really saying is, early retirement is not really the goal for us, financial independence is the goal for us. And in some cases we already sort of feel financially independent in some ways. It's not independent of mandatory labor yet, but our decisions are independent of finances quite often, and that's a wonderful thing. We feel more freedom because we have such a buffer.

Now with a bit of an emergency fund, and our net worth growing and an understanding of how all this works, we feel so much more empowered. Sorry, to get back to your question about the 4% rule, I think it's not a hard and fast rule, I think it's a guideline. I think none of us know how long we have on this planet but... And there's really no perfect plan with any of this, as you guys would contest. Like any time you invest your money, there is an inherent risk in that, even with the stock market, even over 30 years because something could happen that's a black swan event of a magnitude we've never seen before. That is possible, but it's going to happen to everyone. So that's something to consider is that like if something that apocalyptic happens, everyone's going to be feeling that because we are a global world now.

And so we'll assess at a later date and understand what it's going to take the best life we possibly can, if something like that were to happen. In the meantime, people who are really excited about math and geeking out about percentage points and how all that works, can go right ahead and do all that work for me. And I'll take a peek at it, I'll adjust my decision-making around those assessments.

Ben Felix: I mean, it's like a totally reasonable way to answer the question. I agree. Like the 4% rule is not useless, it's a tool that can help you start making decisions and given the right path. But like you say, it's a guideline.

Scott Rieckens: Yeah. And I would say too, I watched your YouTube video on the 4% rule, I thought it was wonderful. It was a great analysis, and it raised some questions for me and made me think about it a little bit more. And I would say to anyone having an epiphany today listening to this right now, who didn't fast forward too fast, go check it out. You're doing some great work on there. I'm really impressed by it, and yeah. And it's being validated by the views and the comments, and the likes and all that, so nice work.

Ben Felix: All right. So it's good to hear from somebody that's on the early retirement path, they're not using this as a rule, it's more of a guideline. That's reassuring to hear. From reading conversations online, I don't know if that's always well understood and that's definitely one of the points that we do want to get across. Now, we have picked apart the 4% rule. But we also did talk to Bill Bengen about longer withdrawal periods. We talked to him about non-US data, and we talked to him about other cases where in his opinion, the 4% rule may not hold. In these clips, Bill is going to refer to the 4.5% rule, which we'll address coming up in a clip further down.

Cameron Passmore: Do you think it's appropriate for someone who happens to be able to retire younger, say for a retirement horizon of more than 30 years, do you think it's appropriate for that kind of person to use the 4% rule in their planning?

Bill Bengen: The withdrawal rate is sensitive to the time horizon. So 30 years, you get four and a half percent. If you go to 40 years, I think it goes down to 4.2. And the longer you plan to live, the longer you plan to be depending on your portfolio, the lower it goes. Although 4% appears to be, for a tax-deferred portfolio, even if you live a couple of 100 years and the markets operate like this, I call that the Methuselah client, you're going to be okay, but you don't have too much less than 4%. That's my number. My colleague Ryan McLean, who owns a company that built a software that studies this issue, he recently published a study with even higher withdrawal rates than I've been able to generate, because he used a lot more asset classes. And he went from 4.2 to 5.0. So that's why I'm not a pessimist. I think if you have a well-diversified portfolio, four and a half percent is pretty cheap. I think 5%, 5.5% is doable even in this environment.

Ben Felix: You mentioned the rule being sensitive to the withdrawal period. If we hold that consonant and just say, "Let's talk about a 30-year period," are there scenarios where you would say, "You know what? Under these circumstances, I don't think the 4% rule does or the 4.5% rule does actually make sense anymore."?

Bill Bengen: Yeah. I've played around with scenarios. I wanted to see, what would it take to break the 4% rule or the four and a half percent rule, if we had it? And I came out with one scenario that the retiree encountered double digit inflation for the first 15 years of retirement, and that broke the 4% rule. That knocked it down to about 3.8. That's something we've never experienced, doesn't mean we won't. That's why I say that the 4% rule is not a rule of nature, it's just a rule of thumb, experiential rule. So it could change and it's changed in the past. In the past, in the '50s, it was not four and a half percent, it was 5%. And it came down because of that big inflationary burst in the '70s.

Ben Felix: Along similar lines, other researchers have since you published your research, they've looked at recreating the same analysis but in different countries. So I've seen it for up to 23 countries using the Dimson-Marsh-Staunton data going back to 1900. And the safe max, as you called it in your research originally of 4%, only holds in I think Canada and New Zealand and the United States. But every other country in the 23 country data set, the 4% rule does not work. And in some cases, it's really low, like 0.2% and stuff in Italy and Japan. Do you think people should take that survivorship bias into account when they're evaluating safe withdrawal rates?

Bill Bengen: Well, I guess it's country-sensitive. I mean, my research is kind of very narrow-focused. It's basically been focused on US investors, US investments, US bonds, US stocks, so I'm probably not very well-qualified to comment about what's happening outside our borders. But yeah, sure, I could see it could be different if they have different return profiles, different inflation profiles that we did historically.

Cameron Passmore: Can you talk about the impact of management fees on these numbers, management fees, like expense ratios?

Bill Bengen: My research assumes that you are using funds with extremely low cost, so essentially, they match their index. And obviously if you're investing in funds that are actively managed or have high fees, you're going to have to reduce your withdrawal rate accordingly. I think it's very important. In the context of my research too, it was very efficient investments that reproduced indices reliably, and don't have unnecessary costs.

Cameron Passmore: I'm so glad we got to ask Bill about the cost. This is something that ever since I heard for the first time the 4% rule, I wondered, "Are costs really included in that?" And so it's nice to get him on the record about the impact of costs on your success rate.

Ben Felix: Yeah, for sure. Now, Bill talked about the 4.5% rule there and some people's ears may have perked up because this episode is about the 4% rule. There are some interesting points that Bill makes around including other types of stocks. So in his original analysis, he was looking at US large caps, but later he extended that to include small caps, and it actually changed his findings.

Ben Felix: So after your '94 paper, you updated the 4% rule to a four and a half percent rule. Can you talk about what went into that update?

Bill Bengen: Yes, I threw in another asset class, excuse me, small cap stocks, US small cap stocks. I chose them as kind of a proxy for a lot of other asset classes, one, because they had a higher rate of return than large cap stocks by about 2% in return, and they didn't have a perfect correlation with large cap stocks. So there is some diversification value. And that worked out pretty well. It raised, I think, my early work indicator on 4.1, 4.2, and this brought it up to almost 4.5. So it was a pretty substantial increase perspective withdrawal rates with that change.

Ben Felix: Now, this concept of adding in small caps to market cap weights can be pushed even further, which is something that we've looked at and Bill's looked at too, we found in our analysis that a 50-year safe withdrawal rate using small cap value stocks, US small cap value stocks, was 3.6% compared to 3.1% for just US total stock market in historical data. We asked Bill about his findings and whether he would recommend that type of portfolio for a retiree.

Ben Felix: An extension of that idea of stocks from a safe withdrawal rate perspective being better than bonds came up in a 2016 paper that you did, or article that you did, where you actually showed that being 100% in small cap stocks gave better results over most time periods. Now, this is something within our podcast community that comes up a lot. We know what the evidence says about small cap value stocks, we know they have higher expected return, so a lot of the people in our community come to the logical conclusion that we should just all be in 100% small cap value stocks. You've done this research showing that small cap stocks give better safe withdrawal rates, why would retirees not go all in on small cap stocks?

Bill Bengen: For a couple of reasons. They are a very volatile asset class. I mean, we've had years and they've been down 65%, 70%, and years when they've been up 150. So there's an enormous range, and not everybody can tolerate that kind of volatility in a portfolio. A portfolio going up 50% rising, even if you know in the back of your mind it's going to work out over the long-term. That's true for clients, I think it's true for advisors too. I think it'd be very uncomfortable for advisors to sit there and explain to your clients that, "Your portfolio is down 50%, but don't worry about it." That's really a hard story to sell.

Also, small caps in general are a very small capitalization part of the market, and a whole lot of people have tried to adopt that strategy and try to invalidated it just like January effect. Everybody got in, and it's no longer there because you're going to lose that high return effect. There's too many people that are chasing those returns.

Ben Felix: That was another one of your more recent pieces of research that I read, and it was just fascinating.

Bill Bengen: Well, yeah. I find out that in this research that you just got to follow where the evidence leads, and not try to go ahead with preconceived notions about what I'm going to find. I had no idea what I'd find out when I started that crazy experiment with small cap stocks. I call it like the exports of investing it, so going 100%. But there are a lot of years when I've worked, 100% allocation to small cap stocks did work, and it generated an average withdrawal for the average investor, 13% was the average. And one lucky investor got 25%. It's hard to imagine withdrawing 25% of your portfolio, and you're still having less 30 years. But that's the nature of the beast.

Ben Felix: Well, listen, we did a podcast episode a few months back where we looked at safe withdrawal rates for a bunch of different equity asset classes, and we found something similar. We found that the best safe withdrawal rate came from US small cap value stocks in historical data. So it wasn't necessarily a surprise to us, but it is fascinating to think about. And it's hard to think about, because we just talked about the behavioral reasons why you wouldn't do it. But like you said, if you had stepped back from that and just think about it logically, it's not easy to say that you shouldn't be all in small cap value stocks. For the reasons that you described, I agree that people probably shouldn't do it and I wouldn't personally do it, but there's a bit of cognitive dissonance.

Bill Bengen: Well, for a retiree who is in real trouble with retirement plan and retirement with the right circumstances, maybe it's toward the end of the bear market and things are just trying to look up, and small caps with prospects, maybe that would be the panacea for that particular individual. You're just giving that extra kit to make them last 30 years or whatever he needs. So it's just a possibility, another arrow in the quiver.

Ben Felix: So it's possible that the 4% rule can be saved with a heavier loading to small cap value stocks. The other thing that Bill explained is that in his most recent research, he's sorted the US data by CAPE, by cyclically adjusted price-earnings, and inflation regimes to find safe withdrawal rates within those different regimes. So we've covered our thoughts on CAPE in past episodes of this podcast, and its lack of a real usefulness and making asset allocation and spending decisions. And the research that Bill is going to talk about does suffer from the same hindsight bias that we've talked about, because it sorts time periods by CAPE ranked relative to the full historical sample of historical CAPEs. It's a problem because we have no idea how that historical record compares to future CAPEs, which is what actually matters ex-ante. But nonetheless, the research that Bill did on this is absolutely fascinating.

Ben Felix: You did another research update very recently in December 2020, and this I found to be fascinating. So you wrote that despite prices being high as measured by the Shiller CAPE, which Michael Kitces found prior to this, tends to predict lower withdrawal rates when prices are high, so they're high now. But we also have low inflation expectations. And you've found in your most recent research that under those conditions, the withdrawal rate could actually be higher than 4.5%, which is contrary to what a lot of people, including me, have been saying because of how high prices are. Can you talk a little bit about that research?

Bill Bengen: Yeah. I know a lot of my colleagues who I respect have been saying, "Maybe it should be 3.8, maybe it should be 2.8, maybe it should be less than 1%." That four and a half percent withdrawal rate is the worst case scenario historically. It's based upon the investor who retired in October of '68. And within five years, he was hit with two huge bear markets, and then after that, he was hit with 10 years of high inflation, and inflation particularly damaging to investment portfolios, because it forced you to increase your withdrawals and it's a permanent increase. You can't get it back. You can't with markets.

So I don't think today's circumstances quite match the dire nature of things back in those late '60s, early '70s, even though prospective returns for assets are pretty low. In fact, if you look at the picture across time, four and a half percent is the worst case. The average investor was able to take out seven, if you just picked a random investor, and the maximum was actually 13%. One lucky investor with a couple of lucky investors want to do that. So the quoting of the 4% rule or four and a half percent rule, I think unnecessarily focused people on the worst case scenario. I think they can be probably more optimistic unless we get into a situation where PE is equal to 100, or inflation comes in a big way. That really concerns me, inflation more than anything else.

Ben Felix: The thing that I loved about this most recent research is that you grouped withdrawal experiences by CAPE ratios and inflation rates. And you'd found in the research that even when prices have been high like they are now, if it's been in a low inflation environment, withdrawal rates have actually not been so terrifyingly low. That to me was eye-opening. Looking at both of those components, prices and inflation, can yield materially different results. I just found that to be really insightful research.

Bill Bengen: Yeah, that kind of blew my mind too. That was a discovery I made this summer. It took me 27 years to find it out. And it's funny because that's really the front end of the withdrawal process, how to choose a withdraw rate. And up to that point, I didn't know how you could specify a withdrawal rate or take advantage of the very high withdrawal rates that occurred in the past. But for the first time, once you throw in place into a picture, as well as stock market valuation which Michael Kitces had developed, then you have a very, very close correlation between those two factors and what you can withdraw from your retirement portfolio.

So it opens up whole new doors. Like back in 2009 marks the market bottom using those tables I developed. 6.5%, 7% was doable. And if you look at that investor 10 or 11 years later, he's doing great. His portfolio is up substantially, despite the fact he's taking out much more than a 4.5% rate. So hopefully, there'll be opportunities for that in the future. We can go higher.

Ben Felix: So international data, longer time periods, killed the 4% rule, but we may be able to revive it using tilts towards small cap value, if you really want to get to that 4% number or get closer to it. Low expected returns might have killed the 4% rule, but at least in the US historical data, low inflation could more than offset that if we continue to have low inflation, which is a big question on a lot of people's minds.

Cameron Passmore: No kidding.

Ben Felix: But I think that even the bigger point that people should be thinking about is that we shouldn't really even be having this conversation about fixed withdrawal rates, because trying to withdraw a constant inflation-adjusted amount from a portfolio of risky volatile assets is kind of ridiculous. And again, Moshe made that point kind of at my expense.

Cameron Passmore: Well, he was practically speaking, he's dead on. You have to have that flexibility.

Ben Felix: Absolutely. Absolutely.

Cameron Passmore: That to me is the key takeaway from this whole discussion. I mean, the whole 4% rule, I remember when I first heard about it, in my experience back when I first heard about it, it got people to reduce how much they thought they could spend. Because a lot of people were thinking like, "It's been 5%, 8%, they weren't taking account how much you had to leave in the kitty for inflation. So I think the whole notion is a good thing and brought people to something that's more reasonable in terms of expectations. Most people back then weren't thinking about protecting for inflation, necessarily, and weren't really appreciating the randomness. That's the good part about the 4% rule.

Ben Felix: And it's interesting if it takes people down from 8%, then yeah, I agree. I agree with what you said. And we heard Scott Rieckens talk about this too, that if this is something that anchors people and allows them to think long-term and make decisions and reduce their spending and put money into savings, because it's easy to think about, that's awesome. If it's being used as a guideline like that, I still think that the number deserves careful thought. It's probably not possible to narrow it down to a single number to use in real financial planning, but if you're going to use a number to help make decisions, sort of as a heuristic, I think it's probably lower than 4% unless you're really juicing up the small cap value. But as we heard Bill talk about, that's probably not sensible for most people to do.

Cameron Passmore: You got to have good behavior and stay committed to your factors.

Ben Felix: And it's probably higher than 2% probably. Like when I've run this in Monte Carlo, which gives us a different type of insight than using historical analysis, using current relatively low expected returns, I've found around that 2% number even for long, like very long retirement periods. But you could also argue that's low because relative to the historical data, the Monte Carlo completely ignores any mean reversion, although we probably shouldn't bet on mean reversion happening again in the future. Anyway, I think somewhere between higher than two probably, and lower than 4% if somebody is going to be using a safe withdrawal estimate. And of course, it depends on other things like taxes and time horizon and asset allocation.

Cameron Passmore: It's also spending, right? Like a lot of people that we work with that are retired, they don't go and take out the whatever 2% increase every year. Often they've set it at pick a dollar amount, 5000 a month, and here we are five or 10 years later, it's still $5,000 a month they're taking. So I don't know if they're like Michael Kitces is talked about eliminating permanent spending on certain items. Could be that going on? Could be just their spending pattern drifts down over time, which is what Fred Vettese talked about in our interview with him, just a natural spending pattern that combats inflation as you get older.

Ben Felix: Yeah. There's so many different ways to slice it and think about this retirement income problem. And this hasn't even spoken to different product allocations, like using annuities later on.

Cameron Passmore: Good point.

Ben Felix: Yeah. I mean, there's so many things that goes into it. So to summarize, I think as a guideline, like we've mentioned, if using something like this is going to help somebody who doesn't have access to sophisticated financial planning software, make quick decisions or long-term decisions, I think that's great. I'd maybe be using something lower than 4%, though. But anyway, we hope that this consolidation of portions of interviews with experts on this topic has helped define what the 4% rule is, and provide context around when it is maybe useful, when it maybe isn't useful, how it should maybe be adjusted, and maybe even more broadly, how people should be thinking about retirement spending.

Cameron Passmore: Agree. And with that, thanks for listening.

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