Is the 4% rule too conservative?
Bill Bengen, who established the 4% safe maximum withdrawal rate (the rule on which most of financial planning relies), is a straight shooter, and his perspective on whether or not we’re currently in uncharted waters surprised me.
But fear not—there’s a little-discussed element of planning for early (as well as regular!) retirement that might be our saving grace. We’ll unpack that, too.
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Bill Bengen:I think your point is well taken. If you're an individual whose own personal inflation rate is lower than national, you probably will find that numbers I give are a little bit conservative, and that you're gonna end up with a lot of money when you're dead.
Katie:Which is like the worst time to have a lot of money, right?
Bill Bengen:Yeah, that's tough to spend.
Katie:Welcome back to this week's episode ofThe Money with Katie Show, Rich Family. I'm your host, Katie Gatti Tassin, and today I have averyspecial treat for you—and me, frankly. Because when we talk about our face-melting, calendar-liberating eventual retirements, it doesn't take long to shift from dreaming of endless European river cruises to waking up to the cold, hard reality of how many dollars we're going to need. Whether you're going to pursue what I like to call the evolved model of retirement—wherein your working life might be longer, but it's peppered with sabbaticals and periods of part-time work and other departures from a traditional career—or you're going for the tried and true “work for 40, rage for 20” strategy, financial bean counting is an inescapable part of the process.
The retirement math linchpin on which all of our fantasies of Tuesday afternoon naps and 2pm virgin margaritas rely is the 4% rule, introduced by Mr. Bill Bengen. It is the foundational theory on which almost everything pertaining to long-term financial planning is built. Devotees of the FI community wear T-shirts with Bill Bengen's face on them underneath all their clothes, because the 4% rule is the spell that makes early retirement magic possible. Like, really, every time I change my clothes I see this man's face in the mirror staring back at me. And boy, do I have some news for you today. And we'll be right back after a message from the sponsors of today's episode.
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Katie:So is this just another podcast about the 4% rule? Much digital ink has been spilled about this theory in the near 30 years since its inception. “It's dead!” Then “Never mind, no it's not!” The 4% rule posited that retirees could reasonably expect to be able to withdraw 4% of their portfolio value in their first year of retirement, and then adjust their withdrawal upward for inflation annually for 30 years without depleting their money.
It was revolutionary at the time, in 1994, because it was the first known attempt to gauge safe withdrawals based not on averages that can inadvertently smooth the bumps of real life, but on actual, historical time periods and the returns, yields, and inflation rates they actually experienced. In financial planning circles, it became an article of faith that the 4% rule worked 96% of the time. That in the dozens and dozens of overlapping 30-year historical periods that Bengen studied, it worked 96 out of a hundred times, and the retiree didn't run out of money.
This was a landmark discovery sussed out of historical data, because it answered the age-old question with a deeper level of certainty: How much money do I need to retire?
So my girlies who aced Algebra II may have picked up on the implications of the inverse of the rule, which is that if we know a portfolio can usually support 4% withdrawals each year, that means 4% of our portfolio value has to equal our annual spending in order for it to be enough. To figure out what portfolio value our annual spending represents 4% of, we can multiply our annual spending by 25. Hashtag #math. For example, if you spend $40,000 per year, your portfolio would need to be worth $1 million in order for 4% of it to be $40,000 per year. You with me?
So the 4% rule was a fascinating discovery because it accounted for both volatile periods in the stock and fixed income markets, and eras of abnormally high inflation. And critics who haven't bothered to explore the underlying research are quick to point out “But you know, we're going through this crazy inflation right now. What about inflation?” But don't worry, dear catastrophizer. Bill Bengen and those who duplicated his research at Trinity University accounted for that.
So that's the TL;DR. If you're not super familiar with the 4% rule and you want to learn more about it, we did a deep dive episode last year that we’ll link in the show notes. But in light of inflation hitting 40-year record highs over the last couple of years, I am excited to talk about it again today. And I have a very special surprise: that Bill Bengen himself is joining—the man, the myth, the legend who changed financial planning forever.
I asked him to weigh in on a few key misconceptions throughout this episode as I pontificate on one aspect of how I think the spreadsheet maps onto our real lives and why it actually might be more conservative than it needs to be. And yes, if you guessed that it pertains to inflation, you're right, because Bill is the OG freak in the sheets, but I don't wanna offend him with my bad Excel puns. He deserves the utmost title because he performs all of his analyses manually in Excel using historical data that he plugs in from a book.
Bill Bengen:I still, that's the approach I use. Very, very big spreadsheet by now. You know, after all these years with data going in, it's enormous and it runs a little slow. But yeah, I don't use modeling software. I don't use any Monte Carlo techniques as many other folks do. So that's perhaps why my results are a little different.
Katie:Oh my gosh. So you just go online, download the data of the real returns, and then do your thing?
Bill Bengen:Yeah, actually, I'm not that high techy. I order every year a manual that has the latest year's data, and I manually transfer into the spreadsheet.
Katie:Are you serious? Oh my gosh.
Bill Bengen:There isn't that much involved, but it's kinda fun. I like a hands-on feel.
Katie:When I tell you that my imposter syndrome literally evaporated when I realized that a key financial planning discovery was made by a curious CFP with a spreadsheet. Anything is possible if you have a giant brain and a little elbow grease. But since the longevity of the 4% rule has been such a hot topic of debate in recent years, thanks to high inflation and low bond yields, I wanted to explore something I haven't heard discussed widely. And I asked Bill if he thought that these times were truly unprecedented.
Bill Bengen:That's a great question. The 4% rule, if you wanna call it—I actually use 4.8% now as the worst-case scenario—is based on the individual retired in October of 1968, 'cause they ran into a buzz saw. They hit two bad, terrible bear markets back to back, and then they had years of inflation which forced them to raise their withdrawals. So they got hit from both sides. Terrible portfolio returns, very high withdrawals, and that's why their money ran out so early.
I'm concerned because there are two factors that in my research show historically affect withdrawal rates. One is how early in retirement you experience a really bad bear market, and the other one is what your inflation rate is. Both of these factors, you know, contribute to the depletion of your portfolio, and quite frankly, if you look at January 2022 with a Shiller PE ratio being around 40, inflation, you know, approaching 8% or higher, those are two numbers that have never occurred in the data in the US before together. And I think a lot of what happens will rely upon how quickly inflation is tamed. If the Fed can do it and knock it out in a few years, we may have a chance of having the so-called 4% or 4.8% rule survive. But if inflation continues or gets worse, we may be headed for a new worst case. I advise people, even if I recommend 4.8% historically, they start out with something less than that in this environment just to be safe, 'cause we don't know where it's going. We may be in a whole new regime.
Katie:Man, I really miss when things were precedented. That said, I feel like we have a saving grace; that is, large fixed costs like mortgage payments or car payments, and how they impact the 4% rule. My addendum to Bengen's theory comes down to the inflation side of the equation, because when we talk about projections for the future, we often talk about how you'll increase your spending parallel to inflation annually while you're drawing down your assets. That's how the analysis was conducted. If you spend $100,000 per year as a retiree in 2022 and inflation is 8%, you'll increase your spending for 2023 by 8% and you'll spend $108,000, and your portfolio over time, should history be an accurate guide, should be able to withstand such increases.
Bengen's research, which was originally published under the name “Determining Withdrawal Rates Using Historical Data”—very chic—was very careful to increase a hypothetical historical retiree’s withdrawals each year by that year's actual inflation rate, right? Not the average. There is another little-known fact about the actual numbers used in the analysis that sometimes surprises people. It turns out that the media really latched onto 4%, when in reality he originally stress-tested with 4.15%. In the historical data, you could withdraw slightly more than 4% about 96% of the time, and a flat 4% rate had a 100% success rate.
Bill Bengen:When I published my first paper back in '94, the number I got was 4.15%, and that actually generated a 100% success rate historically. So you could consider that safe, although, you know, I have to be careful using that word, because going forward, who knows? Conditions could be different. And yeah, I used that 4.15% rate and it's an annoying thing because you could round it down to 4.1%, round it up to 4.2%, but everyone else rounded it down to 4%, through no effort on my part. And that's where we were stuck for a long time until I did follow-up research, you know, in around 2006, and published a book and came up with a 4.5% rate for a 100% success rate, and updated it since then.
Katie:But, and here's the part that I'm suggesting we often gloss over: All of your spending isn't impacted by inflation equally. For example, most people's largest expenses are things like their mortgage and their vehicles, unless you're a Dave Ramsey acolyte, in which case you may own those things outright and your biggest expense is mutual fund fees. But anyway, what's true about mortgage payments and car payments? They are typically fixed costs. So to make this point a little more saliently, if you spend $100,000k per year, that breaks down to $8,333 per month. And if you're anything like the average American, your mortgage likely makes up roughly 30% of that total, give or take.
Since insurance and taxes are subject to change, let's just look at principal and interest alone. Assuming you've got one of those handy dandy 30-year fixed rate deals, call it $2,500 a month. Let's throw in a single car payment for good measure, say $500 per month. That's roughly in the same universe as the US average in 2021, and taken together, the fixed portion of our example $8,333 per month spend is roughly $3,000, or 36,000 per year, which represents—you guessed it—a full 36% of your annual spending. 36% of the spending in this example is fixed. It's not subject to inflationary factors.
This, of course, assumes that you don't already own these things outright when you retire, but I maintain that building this type of flexibility into your drawdown that would allow you to move and get another mortgage, or begin renting again if you needed to, or buy a different car, especially if you end up in a Cadillac arms race with your neighbors Jim and Pam once you've left work, that's important. You don't wanna retire only to find that you are stuck in the vehicle or the home that no longer works for you. The point is, there's often a substantial portion of your spending that is likely to be fixed. And because I had Bill and some of his time, I bounced my theory off of him and I asked him what he thought about it.
Bill Bengen:Yeah, I think your point is well taken. If you're an individual whose own personal inflation rate is lower than national, you probably will find that numbers I give are a little bit conservative and that you're gonna end up with a lot of money when you're dead.
Katie:Which is like the worst time to have a lot of money, right?
Bill Bengen:Yeah, that's tough to spend.
Katie:We'll be right back after a message from the sponsors of today's episode.
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Katie:So using fixed costs, let's flesh our fixed costs example out to the end, and then we'll circle back to what the 4% rule means for us in 2023. If we take our $100,000 per year spending example a step further, our spending would only increase from $100k to $105k instead of $108k in a year of 8% inflation. Now that doesn't seem like much of a break from $108,000, but much like our returns, it's gonna compound over time, for two reasons. The first reason is that your unspent $3,000 stays invested and it continues to compound. The second is that an 8% increase on a smaller number nets a smaller number. A $105k annual withdrawal turns into a $110,500 annual withdrawal after another year of 8% inflation, compared to what would have been $116,600, and so on, had the entire amount been adjusted upward.
So over time, that unspent money that represents your spending insulated from inflation will create quite a cushy compounding buffer for you. In Bill's original 1994 paper, he talks about the way in which there are a few different scenarios for retirees. He calls them the “black holes, the stars, and the asteroids.” Now, the black holes are the retirees who start their retirement during a crash, like those who retired in 1929, '37, '46, '69, '73, or '74. So the years of stock market events big and small that really rocked the boat for them. But he discovered something fascinating: At the precise time an investor would be most tempted to switch to bonds, for example during a huge crash when they're seeking safety, the best course of action that we now know in retrospect would've been to dial it up to 100% stocks.
It basically flies in the face of what your instincts would be. Someone who retired in 1929 with $500k would've seen it dwindle to less than $200,000 by 1932. But if at that time the retiree had switched to 100% stocks and held, by 1992—which is, granted, 60 years later; I don't know anyone that has a 60-year retirement. But the sub $200,000 balance would've grown to $42 million. This same pattern played out in the other black hole scenarios that he studied, illustrating that the moment your common sense is urging you to bail on stocks is often the exact time it makes the most sense to go all in.
Though realistically, most retirees probably wouldn't risk it, and maybe intelligently so, because as we've noted, we are in some weird times. I tell you the story of the black holes A, because it's just super cool, and B, because knowing the historical returns is one thing, how it played out in history, but actually investing through unprecedented times is another thing entirely. And I asked Bill about his black holes theory. How does he feel about it today? That the time it feels most like you should divest from stocks entirely has historically been the time it would've made sense to double down. And his response might surprise you, too.
Bill Bengen:There are only two things a retiree could control: what they spend, which is reflected, you know, in their withdrawal rate, and the other is how their portfolio is set up. I'm not a believer in buy-and-hold investing, particularly for retired folks. It may work well for folks who are saving for retirement, 'cause they have such a long-term horizon; they can afford to take those risks. But for a retiree facing a difficult situation, these are tough markets and they could go down further. We don't know. I myself actively manage my portfolio and the risk in it. I use a third-party subscription service to help me get the emotion outta that process. I would recommend that folks don't just sit there and let your retirement nest egg get beaten to death by a big bad bear. Take measures to protect it. You know, reduce your exposure with the help, perhaps, of a third party who knows what they're doing and helps you avoid the emotions that can go with buying and selling at difficult times.
Katie:Lowering your withdrawal amount, even a little bit, helps to bolster the success of your withdrawal rate over time, demonstrating the power of these fixed expenses remaining impervious to inflation. Your related expenses on the periphery will probably still go up over time, like your car insurance, your property taxes, your maintenance, but the bulk is relatively fixed. Remember how our original example created a difference in withdrawal of about $2,500 in year one and around $6,000 in year two? If you extend our example for 20 years, where all $100,000 is being increased by 8% inflation every year, versus only 64% of our initial $100,000 of spending being increased by inflation every year, and then the other 36% just remaining static, your withdrawals from the uniform inflation portfolio are up to $431,000, while your withdrawals from the partially fixed spending portfolio are only $312,000.
Now in both cases, these sound like a ton of money, because I'm pretending we'll have consistent 8% inflation for the next 20 years. But that's just to keep the example steady, though as you can see, it makes a really big difference over time, and these small differences early on can really change the trajectory. That sounds like a lot because I am using 8% inflation consistently over time just to keep our examples steady. But lord help us: Let's hope that we do not face consistent 8% inflation for 20 years.
So does this mean you should try to own your home outright by the time you retire? Not necessarily, but maybe. The home is an interesting security blanket in retirement. If you find the right one at the right place and you like living there, it is a good store of value once you're living on fixed income that you could cash in if need be.
I often hear people in the FI community say, “You should own your home outright when you retire.” But I don't necessarily agree. I think as long as the total cost of the home is well within your means, I think it's totally fine to still have a mortgage by the time you retire, or maybe even rent if the price to rent ratio in your area is totally unreasonable. And it's at this point that I should point out, you might find yourself spending your additional savings early on on major maintenance and repairs.
American Family Insurance has two different rules for capital expenditure budgeting around a home. There's the 1% rule or the $1 per square foot rule. I like the square footage rule more, as the 1% rule seems more susceptible to being skewed by location factors. I don't think a home in a more expensive zip code is more likely to require a roof repair than one in an inexpensive zip code, for example. And the square footage rule seems more impervious to that type of desirability variation in home pricing. So to put a finer point on this, a 2,500 square foot home would then generate about $2,500 per year in estimated upkeep costs, which is ironically almost exactly what our hypothetical retirees would save in year one from the inflation-protected portion of their spending. Though fortunately, as you saw when we extended it out over a long period of time, that gap really widens and should still provide a decent buffer as inflation is adjusting a smaller portion of your spending upward every year.
So housing considerations aside, inflation considerations aside, there is one other elephant in the room that I really wanted to talk to Bill about, because these theories are all based on historical data, and history cannot be extrapolated forward perfectly accurately. And critics are quick to point out that Bengen's research relied on the US stock market during a time of prolonged US economic dominance.
Bill Bengen:The original research just had two asset classes: intermediate-term US treasury bonds and US large cap stocks. That was it. Not exactly a diversified portfolio, but you know, had to start from somewhere.
Katie:That was true of his original research in 1994, but he reanalyzed in 2020 using a few more asset classes.
Bill Bengen:I wanted to expand my research because I knew that a two asset class portfolio is not representative of what most people have or what most investment advisors use. So I wanted to start approaching that. So I added small cap stocks, primarily because you get the most bank for the buck out of them. You know, they had a higher return than large cap stocks and the correlation was not too high. So as a result when you put them in there, you got a big jump from 4.15% to 4.5%. Even then I knew I didn't have…so a few years ago, I added a few more asset classes and raised it a little bit more, although I think we're starting to reach the points of diminishing returns.
Katie:What else did you add a few years ago?
Bill Bengen:2020 I looked at, instead of three asset classes, I used seven. So I added, in the equity area, microcap US stocks, midcap US stocks, international stocks, and also US Treasury Bills. Those four asset classes raised from about 4.5% to 4.8%. I added a lot more asset classes, but I didn't get that big a bump. And that's why I'm indicating to you that we're probably approaching some kind of a limit, you know, of 5%. We might get there if we use real estate and we use gold and other things, which unfortunately I don't have databases going back to 1926. That's one of the problems I had initially in my initial research. I couldn't find good databases that went that far back. Took awhile for those to be developed and publicized.
Katie:So while history isn't a perfect measure for the future, in the black box of retirement planning, it kind of is the closest thing that we have to accurate guidance. And I wanted to know how Bill felt about the US-heavy nature of the research moving forward, and whether or not we should expect lower growth in the future.
Bill Bengen:Good question. All my research was done essentially for my clients, and my clients were basically folks from down the street, you know, Jane and Joe Smith, who were American citizens like I was, planning for retirement. Therefore the work I did utilized investments that they would've access to, you know, through mutual funds, ETFs, individual stocks and bonds. And I admit it may not be applicable to folks in other countries. I have friends in other countries I speak to regularly, and some of 'em don't have access to those investments. And the ones that have, don't have the historical rate of return that many of the US investments have. This is a great place over the last a hundred years to invest compared to many other areas. So yeah, if you don't have access to US-based investments, you probably would not be able to utilize my research for that purpose.
Katie:There's a lot of talk right now…I don't know if you're familiar with the Ray Dalio thesis about how China is the burgeoning hegemonic power and that the US is kind of on the downswing. What do you make of that? Are you like, “No, I'm still pretty confident the US stock market is gonna continue, like you're gonna get similar results over the next hundred years”? Or do you feel like investors that are just starting right now, do they have cause to be wary? I know that no one has a crystal ball, but I guess I'm just curious, just like gut instinct, how you feel about that?
Bill Bengen:Great admirer of Ray Dalio and the work he's done, especially in the area of personal philosophy; I think it's fabulous. But also the history of economic cycles is fascinating to me. It's really hard for me to judge. I would rather rely on somebody like Warren Buffett who's a real genius, who says repeatedly that America's a great place to invest in and will be for a long time. If you look at our markets, even though they have difficulties—we've had a little trouble here the past few weeks with a few banks, I understand. Our markets are very well regulated, they're open, they're free, they're very flexible. They're enormous in size. I suspect that the US will still continue to do well, although our growth rates might slow down as time goes on. It's really hard for me to predict those things.
Katie:Of course, in the last recession, bond yields were so low that there was no alternative. But now things are a little different. There are CDs paying upward of 5%, which feels like a much safer bet than stocks if you are relying on your capital for cash flow.
Bill Bengen:My own investment portfolio, and I don't recommend to anybody, I'm not giving you advice, is 2% stocks right now and 3% gold and 90% CDs. And I don't think I've had a portfolio that weird in my lifetime. But when you can get 5% plus in federally insured CDs or treasury bills and the stock market has prospective returns over the next 10 years of zero to 1%, I mean, should you really be having a lot of your money in stocks at this point? Does that make sense? That's what investors have to ask themselves.
I'm enjoying this bear market because I'm getting good income, which I didn't. Remember, the last one was terrible. There was no alternative. That [inaudible] thing? My research is based upon buy and hold because it's an easy way to analyze things, but that doesn't mean investors have to follow that investing philosophy in their own portfolio.
Katie:Inflation is a fickle mistress, and I was surprised the extent to which Bill thinks how the Fed handles inflation will determine whether his now-adjusted 4.8% safe withdrawal rate will continue to work in the decades to come. As he said, it could be a new worst-case scenario, but we don't know. Nobody ever really knows. That's kind of the point.
After an extended period of low interest rates and low inflation, the last few years have been a rude awakening that oh yeah, sometimes the prices of things rise, and rise really quickly. But that's why it was important to me that we couched this broader discussion of the 4% rule in 2023 within the context of what youcancontrol: your personal inflation rate. And fortunately for you, you may have some fixed expenses working in your favor already. Of course we used a home and vehicle today, but your personal inflation rate may be lower for other reasons. As Bill highlighted, the amount of money you're withdrawing is one of the only things you can control when you're living off your assets. Great, another consideration for retirement planning, right? But at least this one can be used to justify a sick new retirement swagmobile.
At the end of the day, there are two truths that we can hold simultaneously. Looking back, we know the safe withdrawal rate for a well-diversified portfolio could be as high as 4.8% per year, based on historical returns and inflation. And number two, moving forward now, we are truly in unprecedented territory, and the Fed getting inflation under control could make a big difference for new retirees. Meaning a more conservative approach might be warranted to preserve your capital through the next few years.
All right, y'all, that is all for this week. I will see you next week, same time, same place, onThe Money with Katie Show. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer, and additional fact checking comes from Kate Brandt.