The 2% rule is a concept related to retirement spending. The 2% rule suggests that you should aim to spend 2% of your portfolio each year during retirement . This rule is more conservative compared to the commonly known 4% rule . The 4% rule suggests that you can safely spend 4% of your portfolio in the first year of retirement and adjust that dollar amount for inflation each year thereafter . However, the 2% rule is not as widely accepted as the 4% rule and may require a more conservative approach to retirement spending . It's important to note that these rules are based on historical data and may not account for all individual circumstances or market conditions . Flexibility and adjustment in retirement spending is advised .
(someone): So by bad, I mean their returns track the fifth percentile mark every year. You might say, well, that's not going to happen, but yes, it can happen. 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 RIF rules.
Cameron Passmore: Okay, so Fred alluded to an important concept that the 4% rule doesn't address, which was Bangen'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 Molesky about the importance of having flexibility in retirement spending. I think that was one of the most perhaps challenging times that we've ever had in an interview.
Ben Felix: Emotion was tough. For anybody wondering, yes, I did feel like a child when Professor Malewski 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. Can you talk about how important it is that retirees have some sort of dynamic or flexible spending strategy?
(someone): So by bad, I mean their returns track the fifth percentile mark every year. You might say, well, that's not going to happen, but yes, it can happen. 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 RIF rules.
Cameron Passmore: Okay, so Fred alluded to an important concept that the 4% rule doesn't address, which was Bangen'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 Molesky about the importance of having flexibility in retirement spending. I think that was one of the most perhaps challenging times that we've ever had in an interview.
Ben Felix: Emotion was tough. For anybody wondering, yes, I did feel like a child when Professor Malewski 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. Can you talk about how important it is that retirees have some sort of dynamic or flexible spending strategy?
Ben Felix: 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 – Benjamin, to be honest, you didn't really describe the 4% rule.
(someone): Let me break it down. 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. It's 4% of the million, probably broken up into months later.
(someone): How much would that be this year?
Ben Felix: We're starting with $40,000 in the first year, 4% of a million.
(someone): 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: 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.
(someone): Then what do I do in two years from now?
Ben Felix: The same procedure and rinse and repeat.
(someone): Okay. 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.
(someone): If the market goes down 50%, what do I do?
Ben Felix: Same. Same thing.
(someone): I find that when you 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: Nobody had done that before, which is crazy. In 1994, Anyway, I guess he came from a sufficiently computational background that he had the capability to run this and he ended up working in financial planning. It was just the right skills in the right field at the right time. Anyway, he did this analysis and it just totally flooded through the world of financial planning and it hasn't gone away, even though lots of economists detest, like Moshe Malevsky, for example, detests the 4% rule. What Bengen did is he took historical data for US stocks and intermediate term treasuries and he tested how long a portfolio of 50-50, 50% stocks and 50% bonds would be able to sustain various levels of withdrawals, stated as a starting percentage of the portfolio and adjusted for inflation, like I mentioned earlier. The result is a historically safe, constant inflation adjusted spending rate. That's the 4%. He tested withdrawals starting each calendar year starting in 1926 and he observed how long the portfolio lasted at each starting point. For a 30-year retirement period with the 50-50 portfolio, he found the 4% rule or the 4% figure, which he became the rule. Then there was another 1998 study with similar findings, retirement savings choosing a withdrawal rate that is sustainable and Between those two studies, we arrive at this 4% rule. Now as a tool, not a rule, I think safe withdrawal rates are useful. Absolutely. Right? You remember we talked to Scott Rickins about that? Yeah. In episode 95, where I kind of – he'd seen my video on the 4% rule and he kind of knew that I had rubbished it.
Ben Felix: 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. Bill Bengen, it's with great pleasure that we welcome you to the Rash Reminder Podcast.
(someone): Thanks. Appreciate the invitation. Great to be here.
Cameron Passmore: Yeah, we're so happy to have you. In 1994, your analysis in determining withdrawal rates using historical data, I think it's safe to say 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?
(someone): Yeah, your question, maybe go back and take a look at my original paper. And when I reread it, 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. If you're withdrawing during retirement from a tax deferred account, and you're expected to live for 30 years, and you want any 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 I was just using two asset classes. I was using large cap stocks and intermediate term treasuries. And the asset allocation that came out of that was about a 50-50. It turned out to be optimal for that.
Ben Felix: Anyway, so the 4% rule or any constant spending rule does not account for that, that you may be better off being flexible with your spending. They also don't account for taxes, which are going to be different for every investor. Then the other piece of this, and this is one of the common counter arguments when I say, well, no, the 4% rule doesn't make sense. People will say, well, you're not going to actually spend 4% the whole time because your government pensions are going to kick in. I think on one hand, that's valid. On the other hand, the 4% rule just tells you how much you can spend from your portfolio. It's somewhat irrelevant. But the reality is, at some point, most people will have some level of government pensions or otherwise types of pensions that kick in. Like in Canada, especially with the CPP expansion, that can end up being a pretty significant portion of expenses at age 65 or later. Now, those are general shortcomings for safe spending rates, but I think the 4% rule specifically and the way that it was arrived at has some big problems. The focus that we're going to have of those problems, the one that we're going to focus on today is that it was based on US data. There are two papers really, that I want to speak to. One is specifically on the U.S. experience and I find this paper fascinating. Then the other one is Scott Sederberg's paper on safe withdrawal rates, adjusting for success bias and survivorship bias. The U.S. stock market experience has been exceptional. This is fact. Everybody knows this.
(someone): Yeah, I played around with scenarios. I wanted to see what would it take to break the 4% rule, or 4.5% rule, whatever you have 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 a 4% rule is not a rule of nature. It's just a rule of thumb. Experience a rule. So it could change, and it's changed in the past. In the 50s, it was not 4.5%, 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. I've seen it for up to 23 countries using the Dimson-Marston data going back to 1900. 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. 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?
(someone): Well, I guess it's country sensitive. I mean, my research had a very narrow focus. It's basically been focused on U.S.
Cameron Passmore: Do you think it's appropriate for that kind of person to use the 4% rule in their planning?
(someone): The withdrawal rate is sensitive to the time horizon. So 30 years, you get 4.5%. 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, oh, well, 4% appears to be for a taxable portfolio. Even if you live a couple hundred years and the markets operate like this, I call out to Methuselah client, you're going to be OK. You don't have to do much less than 4%. That's my number. My colleague, Ryan McLean, who owns a company that built 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, 4.5% 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 constant 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?
(someone): Yeah, I played around with scenarios. I wanted to see what would it take to break the 4% rule, or 4.5% rule, whatever you have it.
Ben Felix: Okay. So have you heard of the 2.26% rule for retirement spending? Probably not unless you listened to our episode with Scott Sederberg because he did actually mention it during that conversation. Everybody has heard of the 4% rule, especially if they listen to our podcast because we've talked about it many times. The basis of the rule is that you can safely spend 4% of your portfolio in the first year of retirement and then adjust that dollar amount for inflation each year thereafter for the rest of your life and with very little risk of running out of money. It's like maybe a 5% failure rate depending on how you model it. We did that deep dive episode, the comprehensive overview in episode 164. We dug into this topic with a whole bunch of different guest perspectives. I thought that was a pretty cool exercise to go through. Now we've also in many past episodes discussed the flaws of With the 4% rule, which we also rehashed with that panel of guests in the comprehensive overview episode. To give a very quick overview, because I know at least regular listeners have heard this many times. Bill Behnken, who was a guest in episode 135, super nice guy. He wrote a paper in 1994 titled, Determining Withdrawal Rates Using Historical Data. This was like – We talked to him about this in the episode. It was fun talking to him about it. He didn't – Nobody knew this was going to be such a big deal, but it was the first fairly rigorous empirical approach to determining how much you can safely spend from a portfolio. Nobody had done that before, which is crazy. In 1994,
(someone): 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 and even something bad happens, we'll weather the storm. And if the worst case scenario is if bad stuff happens, I'll call you in a couple of years and tell you can spend more. Which for some people, like, great. You know, spending cut, bad. Spending raised, good. So just tell me how far I gotta 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 tend 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 it's a like, be so conservative you won't have to vary, at least to the downside. And you only have to make upside decisions when you get there. And you can even create, you know, sort of straightforward safety margin rules. I call these ratcheting rules. Like look,
(someone): The 4% rule is based on U.S. historical market returns, and I had global market returns for 20 different countries and looked at, did the 4% rule work in other countries? Just found that it worked in the U.S. 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 U.S. 20th century market returns when the U.S. 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 U.S. context, well, if we live and invest in the U.S., who cares about other country market returns? But then that just led to all these other issues, the low interest rate issue that we just discussed. It's going to lower returns, 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.
(someone): 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 raise. 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 livestock because I don't like cutting my livestock. The second version of this are what I call guardrails. Some people also call these decision rule approaches. Think kind of an 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. You know, 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 giant inflatable tubes they put in there. Now it's all electronics. These 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.
(someone): 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 we continue to push back against it. 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?
(someone): Never heard of it. What's the 4% rule?
Ben Felix: Okay, perfect.
(someone): 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 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% of a 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 – Benjamin, to be honest, you didn't really describe the 4% rule.