Pretty much everyone in the FIRE community has heard of the 4% rule.

It is the starting safe withdrawal rate number for a 30-year retirement horizon that was proposed a few decades ago by retirement researchers.

And it has attained near pop culture status in the FIRE community because it’s such a simple mental shortcut to answer the question: “how much can I safely withdraw from my portfolio each year in retirement and have high confidence that I’ll be financially secure for the rest of my life?”

This is easily the most important question for ANY retiree, and especially early retirees. So, it’s no wonder this topic is so intensely discussed in the FIRE community.

More than a few early retirees and FIRE bloggers swear by the 4% rule and have plunged into their own retirement using this withdrawal rate expecting that it will carry them through for the rest of their lives.

But when you ask the quants – the economists with the PhDs – there is broad agreement that the 4% rule no longer works most of the time.

But why not?

This week, I invited the renowned retirement economist Wade Pfau, PhD/CFA, who is Co-Director of the American College Center for Retirement Income, to share insight on why the 4% rule no longer works in today’s environment. He suggests an alternate safe withdrawal rate number that may be better suited for today’s retirees.

We discuss:

• Why Dr. Pfau thinks the 4% rule is flawed today + how the world has changed since the 4% rule was first proposed
• Pfau’s recommended safe withdrawal rate number for the current environment (including assumed asset allocation)
• How Pfau thinks safe withdrawal rate planning will differ for early retirees
• Pfau’s thoughts on asset allocation in the current environment of rising interest rates, high inflation, and high asset valuations
• What Pfau personally projects as his assumed real rate of return on stocks for his own portfolio
• How annuities can play a crucial role in your retirement portfolio depending on your investor risk profile and desired stock allocation
• Pfau’s framework of 4 retirement styles + optimal asset allocation for each

What do you think your safe withdrawal rate number is? And what asset allocation do you assume for that? Let me know by leaving a comment.

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Related links:

• Wade Pfau
• Retirement Researcher
• Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success
• Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement
• How Much Can I Spend in Retirement? A Guide to Investment-Based Retirement Income Strategies
• Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement
• The shockingly un-simple math behind retirement safe withdrawal rates – part 1 (HYW035)
• The shockingly un-simple math behind retirement safe withdrawal rates – part 2 (HYW036)
• Schedule a private 1:1 consultation with me
• HYW private Facebook community

Read this episode as a post:

Andrew Chen 01:22
My guest today is Wade Pfau.

Wade is kind of a big deal in the retirement and financial planning community. He’s one of the foremost thought leaders on retirement planning topics.

He’s a Professor of Retirement Income in the Financial and Retirement Planning program at The American College of Financial Services. He’s also the Co-Director of the College’s Center for Retirement Income.

And he writes widely on, among other topics, safe withdrawal rates, retirement income, and asset allocation. He’s published more than 60 peer-reviewed articles in academic and practitioner journals. And he is a contributing writer for Forbes, an Expert Panelist for the Wall Street Journal, and his research has been cited in The Economist, The New York Times, and The Wall Street Journal, among other publications.

Wade is also the author of several books (which I’ll link to in the show notes), and his latest book is the Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success.

Wade holds a doctorate in economics from Princeton and is a Chartered Financial Analyst.

…I am super excited and honored to have Wade on the podcast today to share insights on safe withdrawal rates and asset allocation, and why he thinks the 4% rule doesn’t work anymore. Let’s get to it!

Hey, how’s it going?

Wade Pfau 02:27
Good. How are you?

Andrew Chen 02:29
I’m doing well. Thank you so much for taking the time to chat with me. Are you based in Dallas, Texas?

Wade Pfau 02:34
Uh-huh.

Andrew Chen 02:35
I’m Texas born and bred. Not Dallas, but I grew up in Houston and went to college in Austin, so virtually all of my childhood was there. So, definitely a soft place in my heart for Texas.

I’d love to just start by learning a little bit more about your background. You’re an economist by training, but you’re most well-known as a key thought leader in retirement and financial planning research, you’re a professor at The American College of Financial Services, which is the degree and certification granting institution for financial advisers and planners, and in your work as the co-director of the Center for Retirement Income at the College.

I wanted to first start out just by learning a little bit more about how did you get into the field of retirement income and retirement planning, what was your path, and what got you interested as an economist in this area of research?

Wade Pfau 03:22
I initially just really wanted to be an economist. I knew before the end of high school that I was going to major in economics, and then I went to grad school in economics.

As a part of that, I started looking more at Social Security. Specifically, my dissertation was on Social Security reform. In the early 2000s, the president, George W. Bush, at that time, had a proposal to create personal retirement accounts, so I was testing how those would perform.

The idea was to carve a portion of Social Security payroll taxes and put them into individual accounts like 401(k)’s instead of keeping it all in the traditional trust fund for Social Security benefits. So, what I was doing to test that ultimately became what I do today in terms of doing simulations to test different types of retirement strategies, looking at accumulation and savings and then distributions in retirement.

Beyond that, it was really just a personal interest in terms of trying to look at my own financial planning and retirement planning, and thinking about those issues. After finishing grad school, I did spend 10 years in Japan, and I worked at a university for government officials mostly from emerging market countries.

While I was there, I looked more at national pension funds in different countries, but then wanting to move back to the U.S. and finding something marketable to do in the United States. That’s when I really started shifting more towards financial planning, given the CFA designation, learning more about investment theory.

And then, in doing that, I stumbled across this 4% rule for retirees, and I had a data set for 20 developed market countries. And really the whole starting point to get into financial planning specifically was looking at how that 4% rule performed with the other countries’ data, and finding that it’s really just an artifact of the United States and Canada, but in the other 18 countries, there’s no such thing as a 4% rule.

And I got such a positive reception from that article that I made the full switch away from traditional economics and into financial planning. It’s a new field in academics, so it’s exciting to be a part of that.

Andrew Chen 05:42
I’m not an economist by training, but it seems like it’s less common that academic economists are specializing in retirement income and planning, so it’s great to see that you’re a real pioneer in this area. How did you find your way to The American College, and what was the story for how you got eventually on the faculty with the College?

Wade Pfau 06:06
Economics, I think it’s a field where the difference between undergraduate economics and graduate economics is massive. I really liked the undergraduate economics, but the graduate level becomes so theoretical and so mathematical that I was always looking for outlets that were more applied and practical. And that’s where financial planning really is that applied version of economics to help manage household financial problems.

But I was still in Japan, and I knew I wanted to get back to the United States. I didn’t really know how to best go about doing that other than I contacted all the programs listed on the CFP board’s website for having financial planning programs to prepare for the CFP undergraduate degree programs.

The American College actually wasn’t even on that list because they don’t have an undergraduate program, but they caught wind that I had sent this letter to probably 80 different universities, and they reached out to me because they had an opening at the time. They were starting the RICP designation, which is the Retirement Income Certified Professional.

Also, at that time (this was about 2013), they were starting the PhD program in financial and retirement planning, so they had an opening for teaching and advising PhD students. So, that was a great opportunity, and that’s how I ultimately ended up with The American College.

Andrew Chen 07:30
What keeps the field exciting and interesting for you? I want to get to the substantive stuff as well, but I’m just so curious to learn a little bit more about your background. What keeps the field of retirement and financial planning exciting and interesting for you still after all these years?

Wade Pfau 07:48
Part of it will be, and I’m sure this will come up in the conversation, just with finances in general, we don’t know what the future will bring. We have different opinions about that, and there’s no clear framework for how to think through all that.

And with retirement planning being a new field, you can ask these basic questions and different people will give completely different answers, and they’ll believe there’s just one way to do things. And if anyone disagrees, they’ll think that person is conflicted or somehow just wrong or pigheaded.

So, that makes it interesting because we don’t know what the answers are, and we always need to look for new ideas, new approaches, better ways to build retirement strategies, and being able to test that, and writing the programs to simulate these different outcomes.

And it’s fun because there’s a lot of nonlinearities that have to be programmed in, whether it’s about something like a reverse mortgage or tax planning. They’re complicated problems, and just doing what I can to help find solutions keeps me motivated and active, always something to do.

Andrew Chen 08:54
Yeah, it’s a very dynamic field. So, the 4% rule, first introduced in the academic paper known as the “Trinity study” in 1998, has attained this pop culture awareness, especially in the FIRE community, which a lot of my audience is either pursuant of or already FIRE’d.

It basically suggests that if you calibrate your retirement withdrawals to start at 4% of your retirement date portfolio, and then simply just grow that spend by inflation each year, there’s an overwhelming chance you’ll outlive your portfolio, you’ll overcome the longevity risk over a 30-year retirement horizon, based on looking at historical returns since the mid-1920s and assuming a 50/50 stock-bond split.

And you’ve written and commented in recent years, you alluded to the paper that you wrote a moment ago, that the 4% rule is actually pretty flawed for modern times. I’d love to start just by understanding, what are the fundamental flaws that you see with the 4% rule, and how has the world changed since the 4% rule was first introduced that makes it not very helpful for would-be retirees today?

Wade Pfau 09:58
To be clear, though, the 4% rule provided a valuable contribution because people were making an even bigger mistake before that, which was I think the S&P 500 historically averages a compounded growth rate of 7% after inflation. So, I think to myself, “I can plug that into a spreadsheet.”

“Every year my portfolio grows 7%, I can take 7% out, I never run out of money. I never even dip into my principals. 7% is a safe withdrawal rate.”

And of course, that’s not true because there’s market volatility. So, what the 4% rule was originally looking to do was incorporate that market volatility into the planning process. It calls for an aggressive asset allocation, generally 50-75% stocks.

50% is a good baseline case study to look at, but usually not going much under 50% stocks. Because with bonds, we can really get into trouble, especially with today’s yield curve. The entire TIPS yield curve of inflation-adjusted real interest rates is negative right now, so there’s no such thing as a 4% rule with bonds.

But if you invest aggressively, you maintain that exposure to market growth and upside, then based on all the different rolling historical 30-year periods, you can expect that strategy to work. And that’s meant to bring in this idea of the market volatility and calibrating to say, in the worst-case scenario, which, with that 50/50 allocation, the years 1966-1995, you could have taken out 4%, sustain that with inflation growth, and run out of money precisely after 30 years.

But in any other of these historical scenarios, if you used 4%, you would have had a lot left over at the end. You could have spent more. I think about half of the time with the 4% rule in U.S. historical data, the real purchasing power of your wealth, if you started with $1 million, you’d have $1 million left at the end, in nominal terms, so forgetting about the inflation and just looking at $1 million.

Of course, $1 million in the 1990s is a lot different than $1 million in the 1960s, after all the inflation of the ‘70s and ‘80s, but almost 96% of the time, in almost all the historical scenarios, you would have kept your nominal wealth intact after 30 years.

So, for people who are comfortable with that rule, that’s the whole story. It worked historically. The historical data has a lot of volatility.

Of course, it might not work in the future. Past performance doesn’t guarantee future returns or future performance, but we’re comfortable with it as a good starting point. So, what really got me started with looking at that was just this idea of I had this data set and I was looking for uses for it, and I just tested.

Bill Bengen, who originally developed that 4% rule, and then the “Trinity study” later further amplified the concept. He was American. He was looking at U.S. historical market returns.

What if he was Italian, or what if he was German, or any number of these 20 countries with this data set going back to 1900? If I had invested in other countries’ stocks and bonds, would the 4% rule have worked? It worked in the U.S. and Canada; it did not work in the other 18 countries.

And there was a lot of variation. If you put all the data together, all 20 countries, the whole historical environment, with a 50/50 portfolio, the 4% rule worked about 68% of the time, historically. So, what we think of as a safe withdrawal rate that always works 100% of the time works about two-thirds of the time around the world.

And around the world, if you wanted a withdrawal rate that could have worked 90% of the time, you would have had to go down to 2.8%. So, I thought that was compelling.

The U.S. 20th century was a pretty unique century in world history, and Canada too. But that may be an anomaly. If you want to think about forward-looking returns for today’s retirees, I think it makes sense to draw from a more typical international experience and not just extrapolate the U.S. historical data.

That does become a philosophical question that some people just will reject that concept and say, “Who cares?” If you look at Italian data, the 4% rule worked 24% of the time.

But who cares? We’re not Italian. We’re not investing in Italian stocks and bonds.

We could have a globally diversified portfolio, but even with that, there was no 4% rule. It was more like 3.5% because the U.S. was effectively pulled down by other countries’ returns in a more diversified portfolio.

But who cares? If we invest in the U.S., that’s the only data we need to worry about.

So then I started looking at these other perspectives. And there’s all these issues, basic assumptions with the 4% rule that aren’t right or appropriate. Some of them you can actually use a higher withdrawal rate, but others a lower withdrawal rate.

The idea that it ignores investment fees; it just assumes investors are in the index market returns. They always rebalance every year. They never panic or sell after a market downturn or anything.

Thirty years is the right time horizon for them. Important as well, they don’t pay taxes, so they’re all coming out of a Roth account. Or if it’s out of an IRA, they’re paying taxes from the 4%.

But with a taxable account, you have to pay ongoing taxes on portfolio growth and interest and dividend. So, there’s no 4% rule with a taxable portfolio.

Most important is the low interest rates. It’s based on U.S. historical data, but interest rates are now lower than they ever were in the U.S. historical data. And that’s not a controversial issue: low bond yields means lower bond returns.

So, it’s fine to say the 4% rule worked historically, but if we’re now at a lower interest rate environment than we’ve ever experienced, that puts more strain on the 4% rule. And it’s not that I think it won’t work for someone retiring today. I just think that that 68% global success rate is probably more reflective of where we’re at with interest rates than assuming it’s going to have 100% success rate.

Andrew Chen 16:25
Yeah, you mean even in the U.S.?

Wade Pfau 16:27
Yeah, just for a U.S.-based investor.

Andrew Chen 16:30
Some of the European countries you mentioned (Italy, Germany, etc.), was the higher failure rate that you found in the data due to just lower or more volatile asset returns or lower interest rates or higher inflation, or a combination of all, case by case, depending on the country?

Wade Pfau 16:47
It’s a combination. Most countries had higher inflation rates, had lower average stock returns, plus higher stock volatility. I think Australia was the only country that actually had a higher average stock return than the U.S. and less volatility.

There might have been other countries that had higher average stock returns, but also with more volatility. And then all the rest of the countries, lower returns, higher volatility.

This is all nominal interest rates, so countries that had higher inflation experiences, and especially any country that experienced any sort of hyperinflation, really took a hit with the sustainable spending rate because the bonds would effectively become valueless, and you really then have to rely on the stocks to keep up with inflation over time.

Sometimes people dismiss that international experience, just saying if you lost a World War, it will affect your sustainable withdrawal rate, and so that affects Austria and Germany. Austria in World War I was one of the really bad scenarios, Germany with World War I and World War II, Japan after World War II.

But that’s not the whole story. There is also still plenty of countries where there’s nothing really wrong. Like the stagnation of the ‘70s, the U.S. was lucky to keep 4% in place, but in other countries like Australia and so forth, that sort of situation led them to 3% or less.

So, there’s no obvious reason why one country had 4% and then another had 3%, other than the luck of the draw in terms of how those returns materialized.

Andrew Chen 18:31
You’ve written in the past: what is mean reversion? That there is some higher mean that they can revert to. I was wondering if you could comment a little bit about what are some of the forces that caused interest rates, at least at a high level for the non-economist crowd, for why interest rates dropped from the highs of 70s, 80s, even 90s, to the rock bottom rates they are now.

There are definitely these macro forces that occurred, and why no one should take solace in the hope that they’re going to rise back to anywhere near those levels anytime soon. Because if you just look at a benchmark rate, like the Fed Funds rate, over a 70-80 year timeframe, and just squint and zoom out, it looks like an inverted V. It looked like it was low at first, and it went up really high, and then now, in modern times, low.

I was wondering if you could comment on some of the structural things that have happened that have caused that, and why you believe there’s no evidence that there will be mean reversion.

Wade Pfau 19:48
The best predictor of future bond returns is today’s interest rates. And whether the interest rate will go up or go down tomorrow is pretty much random. It’s really one of the best examples of a random walk.

There could be some mean reversion over the longer term. I think the U.S. data shows that. So, if you wanted to build into planning that interest rates may be higher 15-20 years from now, I think that’s appropriate.

But the whole idea of just assuming, in a couple of years, interest rates are going to be higher, we’ve had that experience now for almost 10 years, where it’s always been interest rates start getting lower, but they’re definitely going to go back up. And that remains to be seen for the most part.

And it’s really a supply and demand issue. Going back to when I was a student in economics, the textbooks would usually talk about the real natural interest rate, 2% real plus whatever inflation is, thinking that that’s a reasonable number. And for a long time, that was the real interest rate.

Like I mentioned earlier, now the entire TIPS yield curve is negative, real interest rates are negative. And I don’t think there’s any particular expectation that the real interest rate will necessarily get back up to 2%. And if it did, that could be great for savers, but it’s hard to know.

If there’s higher inflation, that will push up the nominal interest rate. But the real interest rate is really just driven by supply and demand factors. And if there’s a lot of savings, a lot of people wanting to purchase government debt, that increased demand is going to push up the price, which pushes down the yield for the new investor.

And that’s the primary issue: the demand is strong for owning government debt. Now there’s a large supply of government debt where they intersect with each other in terms of supply and demand. It’s still keeping high prices for debt, lower yields for the investors in debt.

Andrew Chen 21:47
In modern times, when I think about the big forces that cause this, just like China buys a lot of U.S. debt, what are the biggest sources of demand that have kept the interest rates low?

Wade Pfau 22:06
It’s all these factors. I don’t know a clear breakdown between people getting into their peak earnings years and also into retirement, so individual savers versus governments versus pension funds, which is part of the same process of we have a large number of people approaching retirement ages who have more assets and want to hold fixed income as a big part of that.

All those factors are at work, but I don’t have a good sense about the specific breakdowns of what may be most important.

Andrew Chen 22:41
Back when the pandemic was just getting going, in April 2020, you were quoted in the press saying, “The 4% rule is really more like maybe 2.4% rule.” And that’s if you’re taking a moderate amount of risk.

Is 2.4% still a safe withdrawal number that you think best applies right now, given how much has changed even since early 2020 in terms of stock valuations doubling from their low, inflation now reaching historical highs in some regard, and interest rates soon to be rising?

Wade Pfau 23:11
It might be a little bit higher than that now because that was primarily driven by interest rates. I have a retirement dashboard on my website that I update somewhat infrequently, but it’s really just then running a Monte Carlo simulation, looking at where the yield curve is, adding the historical risk premium to that, not even taking fees.

With risk premiums, are stocks going to maintain the same performance relative to bonds, or will they do even better, or will they do even worse? Sometimes people have a concern that the risk premium may go down because valuations are so high. I don’t even touch that.

I add the historical risk premium to the current yield curve to get an average stock return, apply historical volatility to the bonds but based on the current yield curve. And when the 10-year treasury was down at 0.6% or so back in April 2020, that’s the factor that was driving even lower numbers. That 2.4% could be more like 2.8% or somewhere in that ballpark if I were to rerun it today.

But it’s the same concept. That was with a 50/50 allocation and looking for a 90% chance for success.

And just small differences in returns have a huge impact on this. That’s where if you’re doing a Monte Carlo simulation, you’re looking at the probability of success, if you plug in historical average stock and bond returns, the 4% rule looks like it will work 95% of the time.

But if you account for the fact that interest rates are quite a bit lower than their historical averages, and you center your market performance based on the lower starting point today, that 95% success rate can drop into a 60-70% success rate. And that’s what’s driving that particular calculation.

Andrew Chen 25:07
And you mentioned, whether it was back then or now, 2.4% or 2.8%, whatever the number is, that’s if you’re taking a moderate amount of risk. What does moderate risk mean here? What kind of asset allocation?

Wade Pfau 25:20
That number specifically was linked to 50/50 stock/bonds.

Andrew Chen 25:28
Much of the retirement research is based on this traditional 30-year retirement and the risk that your portfolio runs out before then. So, heuristics like 2.4% or 2.8% safe withdrawal rate or, in literature, a 10-year sequence of returns risk horizon that gets you 80% out of the woods, or potentially utilizing rising equity glide path during the first decade of the sequence risk horizon. All these things are based on a traditional 30-year retirement horizon, as I understand.

But when it comes to early retirees who are maybe planning for up to two back-to-back 30-year retirements, I was wondering if you could talk a little bit about how do these heuristics change? How should early and would-be early retirees determine the safe withdrawal number that would get them through 60 years and not 30?

And how long of a sequence risk horizon would get them through 80% out of the woods? Because I’m assuming it’s going to be longer than 10 years. And how long they should spread out their rising equity glide path strategy to have the same impact on their portfolio as your traditional 30-year retiree.

Wade Pfau 26:38
Two points here: the first one about the time horizon. That does affect the safe withdrawal rate. Naturally, the longer the time horizon that you’re trying to plan for, the less you can spend because you have to stretch that money out for longer.

Now, the asymptote. At shorter horizons, the withdrawal rate can be quite a bit higher. As the time horizon gets longer, that withdrawal rate comes down.

So, if it’s crossing 4% at 30 years, as you go off into 40 or 50 years plus, it’s going to get somewhere in the ballpark of 3.5-3.33%, if 4% was the right number for 30 years. If something less than 4% is the right number for 30 years, accordingly, you’d have to adjust down.

But you’d have to take an additional haircut off. Not a dramatic haircut, but if you thought 4% was right for 30 years, for a more indefinite time horizon, something like 3.33% would get you the same sort of performance.

Now, with historical data, you’re eventually going to hit a constraint that you don’t have very many rolling historical 30-year periods since the 1920s. And also, going back long enough, the 1960s are where the worst-case scenarios came in. But if you start backtracking too far, with looking at longer time horizons, you’re going to miss having the 1960s be the starting points for retirements.

So, that would then push the withdrawal rate up, but it’s somewhat artificial because it’s taking you out of those worst-case scenarios. But the general answer to that point is you’ve got to look at making up for the haircut to the withdrawal rate to support that longer time horizon.

But the other important point for especially the early retirement community is: I talk about some of these artificial assumptions in the 4% rule, and so far, we’ve focused on issues that reduce the withdrawal rate. There’s a very important issue that can increase the withdrawal rate, and that is, the 4% rule assumes you never adjust your spending in response to the portfolio performance.

You always keep doing that same inflation-adjusted amount. The way you defined it was correct. It’s an initial withdrawal rate.

And then, with the spending you get from that, you always adjust it. You never make any sort of revision to your spending. And that actually creates the most sequence risk: trying to spend a constant amount from a volatile investment portfolio creates the most sequence risk.

Dirk Cotton at the Retirement Café Blog, who passed away last year, he was the first to note the opposite of the 4% rule, instead of 4% as the initial withdrawal rate, it would be every year I’ll spend 4% of the remaining account balance. In that case, my withdrawal rate is always the same, but my spending amount is going to jump all over the place.

That strategy has zero sequence risk. Just like if you invest a lump sum, the order of returns doesn’t matter. You’ll always have the same account balance at the end.

And if you use something like that, you can use a dramatically higher withdrawal rate because you don’t have sequence of returns risk. So, for the FIRE community, they really have to be thinking about just having more flexibility in their plan, and it’s really flexibility about the distribution from the investment portfolio.

So, whether that means being able to cut spending somewhat, if there’s a big market downturn, or whether that means having the flexibility to pick up some part-time work to reduce the distribution need during a market downturn, that would be two practical ways to help manage the sequence of returns risk and to still maintain a higher withdrawal rate…

But just with the caveat that you might have to make some cuts to that from time to time as you go through that longer retirement horizon.

Andrew Chen 30:34
That’s an interesting point. There’s definitely different levers that you can pull. Like you mentioned, maybe you can do some part-time work or consulting or something like that, or just link the withdrawal rate on a year-by-year basis.

For an early retiree who wants to truly retire without having to worry about going back to get a job, maybe their profession isn’t one that easily allows for transient in and out of the workforce, whatever the case, and they really just want to live off their portfolios. And in years when the return is negative, they don’t want it to be zero or contribute back to the portfolio, because linking a constant percentage wouldn’t allow for any withdrawal in those years.

And they also are convinced that the 4% rule is not as useful for modern times, it’s probably going to be lower. Are there tools, or how can a person like that calculate the 60-year horizon safe withdrawal number, maybe play around with their own simulations a little bit to get some confidence on what specific safe withdrawal rate number would actually work for them? Are there online tools exist for this?

Wade Pfau 32:06
And it’s still the safe withdrawal rate without any spending flexibility?

Andrew Chen 32:13
Maybe there’s a little bit of flexibility in that, but it has to be more than zero because you can’t live on nothing. You’ve talked about this in some interviews or articles you’ve written, where maybe it’s linked but there’s a floor and a ceiling. That might be possible, but it’s got to be positive every year because you got to eat, you got to live, etc.

Wade Pfau 32:34
This is an area where most of the commercial tools aren’t all that helpful because they don’t have the capacity to allow variable spending that responds to portfolio performance. I’ve written programs to do all that sort of analysis, but I don’t have any user interface for other people to be able to use it. It’s just code on my computer.

But I have something called the “pay rule.” If you have variable spending, you have to have a new way to measure downside risk that’s not just depleting the investment portfolio, because with some rules, you never technically deplete the investment portfolio.

Your spending might get very low. If you’re always spending 4% of what’s left, technically in the computer, you might have one penny left, you don’t ever hit zero, but for all practical terms, you’re not enjoying your lifestyle.

That’s how I do it on the retirement dashboard on my website. I have a few variable spending strategies, and I don’t define the results in terms of hitting zero at the end of the time horizon. It’s in terms of I’m willing to accept a 90% chance that my remaining wealth drops to 10% of its initial level in inflation-adjusted terms after 30 years.

And that lets you compare variable spending strategies with the same amount of downside risk to calibrate between them. So, that would be the kind of approach someone can take.

I don’t have any commercial tool about this, but that’s really how I started looking at this, and I’ve written about the variable spending strategies. You look at the distribution of how does the spending evolve in different market environments, how does remaining wealth evolve in different market environments, what is the downside risk, how low might spending go, how low might the wealth balance go?

And just judge from there what looks like an acceptable path for spending in terms of does it tend to rise over time, does it tend to go down over time, how much volatility is there on a year-to-year basis? You’ve got that flexibility to decide what sort of spending strategy looks the most favorable to you.

If you build in the constant inflation-adjusted spending, your withdrawal rate might be a lot lower than if you built in a variable spending strategy where, most of the time, it will offer more spending, but there could be some scenarios where the spending at some point might drop below what the constant inflation-adjusted spending strategy would provide.

Andrew Chen 35:14
For the constant inflation-adjusted spending strategy, is there an asymptote curve that folks can reference and say, “If I believe the number really is 2.8% for 30 years, then for 60 years, just looking at the table, it should be 2.2% or something like that”? Is there a heuristic that people can use if they were using the constant inflation-adjusted strategy?

Wade Pfau 35:40
Yeah, you can make up that heuristic. And I’ve plotted things like that before. This is going back, on my blog, probably 2011 or 2012, and those might not even be available anymore.

But then also, in my second book, “How Much Can I Spend in Retirement?” I know I at least plotted that curve for the historical data going to either 40 or 50 years. But I know I’ve done that. I specifically remember making that kind of curve with Monte Carlo simulations for at least 60 years.

So, I can’t speak to the specific numbers of it, and it would also depend on what you’re assuming about the market returns and volatilities. But you definitely do see that asymptotic effect of whatever it was at 30 years, it’s going to just have to be a little bit less than that as the time horizon gets longer.

I’m sorry. It depends on the assumptions about market returns too, so there’s not just one answer for it.

Andrew Chen 36:37
Of course. I don’t mean to put you on the spot. If you happen to have any quick tips on this, that was mostly the gist of it.

This is the other side of the same coin a little bit, but I think both you’ve written about this and I’ve also read about this elsewhere, around the sequence risk horizon. On a traditional 30-year retirement being about 10 years to get you 80% confident that you won’t run out, how should early retirees who are potentially planning for up to two back-to-back 30-year retirements be thinking about calibrating that 10-year mental shortcut number to a 60-year horizon?

Are there heuristics that investors can use to make that calibration, or is it the details matter and modeling matters?

Wade Pfau 37:41
That’s right, I’ve done simulations where if you’re planning for 30 years, the cumulative market performance in the first 10 years explains 80% of the final outcome, so you really have a sense of whether you’re going to be able to spend at a higher level or a lower level with what happens in the first 10 years.

Now, I’ve never run that same calculation for longer time horizons, but because a longer time horizon requires a lower withdrawal rate, that’s another way to get less sequence risk.

With a lower withdrawal rate, you’re less likely to get into these death spirals where a market downturn pushes that current withdrawal rate that much higher, which gets you in that much worse shape, where it becomes harder and harder to overcome that hurdle, and that leads you on the spiral down to zero.

So, with the longer time horizon, you now have a lower withdrawal rate, then you have less sequence risk. I think that 80% number would come down for the longer time horizon for that reason. Not significantly down, but at least it’s not going to be greater; it’s going to be less to some extent.

Andrew Chen 38:52
So, the intuition is that because your safe withdrawal rate number would come down, then the horizon might not actually extend beyond 10 years. It might actually be the same. It might even have more explanatory power, is that correct?

Wade Pfau 39:12
Yeah, there’s going to be an offsetting factor that now that you have more and more years, because you have a lower withdrawal rate, it’s easier for a market gain after 10 years to have a more positive impact on your sustainability. So, the first 10 years would be less important.

And then back to this whole issue of that’s assuming the constant inflation-adjusted spending. If you’re flexible with your spending, and if you can make cuts after the market downturns, there’s less sequence risk, so the first 10 years would not be as important.

Where, to the extreme, with the constant percentage strategy, there is no sequence risk at all, so the first 10 years of a 30-year retirement would explain, because it’s 33% of the length, it’s 33% of the outcome.

Andrew Chen 40:06
I wanted to talk a little bit about what we’re seeing in the market currently. Stock valuations have doubled since their early pandemic lows.

CAPE ratio is really high right now. I think it’s around 40. That means the inverse CAPE is about 2.5%.

Do you worry that asset prices are overvalued right now? If so, are there asset allocation changes that you think investors should consider given current macro trends, including the inflation that’s going on and the trajectory of near-zero interest rates that are poised to now start rising?

Wade Pfau 40:40
That’s an interesting question, and when I started doing this type of retirement planning research with historical data, that was something I looked into. In the historical data up until this really all started to fall apart in the mid-1990s, when Robert Shiller wrote his article about this (I think it was published in 1997), that more or less corresponds to where what I’m about to say stopped working.

But in the past, high valuation levels linked pretty clearly to lower subsequent stock market returns, and lower valuation levels linked to higher subsequent stock market returns. So, if you just play around with the historical data, you can see a strategy that would lower your stock allocation when market valuations are high, or increase your stock allocation when market valuation are low, would give you a better outcome than keeping the same fixed asset allocation throughout.

But again, all that sort of stuff would be telling you to have a low stock allocation since 1996 or 1997, with a brief exception in 2009 as part of the financial crisis. You temporarily got the CAPE ratio into a more historical normal range where you could have had your normal stock allocation. Otherwise, you spent the last 25 years with a lower stock allocation.

So, I don’t want to use that kind of approach to impact my asset allocation anymore. I just think of it more in terms of, to be safe, when market valuations are high, you should expect a lower future stock market return.

It always makes me nervous when people are assuming their portfolios are going to give them 8-12% returns. The 12% number was never correct because that’s a simple arithmetic average on the S&P 500, not a compounded growth rate, which is what matters to a long-term investor. But the S&P 500 compounded historically, it may be 8-10%.

I would be incredibly nervous about using such an aggressive number in this high valuation environment. It’s not that I would change my asset allocation, but I would just not be comfortable retiring or feeling that I’m financially independent unless my plan worked with a lower assumed market return than that sort of historical number.

Andrew Chen 43:04
What would be a better market return assumption presently in your view?

Wade Pfau 43:14
This is my personal number and not necessarily advice or recommendations for anyone else, but I’m assuming a real return of 2.25%. I still have inflation at 2%.

That doesn’t make as big a difference other than impacting things like Social Security taxation and so forth. So, basically, with 2% inflation, 2.25% real returns, I’m assuming 4.25%.

The inflation would increase that number. But again, it’s the real return and real interest rate that matters the most. And that’s because I still have a longer time horizon where I’m not going to have to be withdrawing from my portfolio.

If I was closer to really being dependent on my portfolio to sustain my standard of living, I would not be comfortable with a 2.25% real return right now. I’d want to be getting that closer to zero, which is still higher than the risk-free rate with TIPS, but at some point, those numbers get so low that it’s very discouraging.

The number is more like 0-2.5% real return. That’s all I’d really be comfortable discussing.

Andrew Chen 44:29
Is this for what type of weighting between stocks and bonds, or is this all stock?

Wade Pfau 44:35
That’s pretty aggressive in stock. I’m primarily thinking in terms of stocks.

With bonds, it’s not so difficult. You just look at the yield curve. If I had all my money in bonds, I’d look at the TIPS yield curve or the treasury yield curve, and that would be 2% for a 30-year treasury, or I don’t remember exactly where we are right now, but negative something for 30-year TIPS yield.

Andrew Chen 45:01
Yeah, because right now, it does feel like there’s this kind of asset allocation dilemma. It’s risky to invest in stocks because valuations are sky high. It’s risky to invest in bonds because interest rates are near-zero and are clearly going to start rising this year, and anyway, the only direction they can go is up.

It feels risky to invest in real estate, at least residential, right now because home prices have soared to truly staggering levels over the last couple of years because of pandemic buying and rock bottom interest rates. And it’s risky to hold cash because inflation is burning it up.

So, where can the investor turn, given the seeming dangers at every turn? It sounds like what you’re saying is that, given that no one can predict the future, perhaps the best assumption is just to expect persistently lower risk-adjusted returns going forward. Is that fair?

Wade Pfau 45:54
Yeah, that’s really the approach I take, at least with my own personal planning. Make sure your plan can work with all these buffers built in, and having a lower than average assumed return.

It’s not that I’m so weird with these low numbers. If you’re using any sort of Monte Carlo-based financial plan, if you’re targeting a success rate higher than 50%, the software doesn’t report this to you, but you’re effectively assuming a much lower than average fixed return as well.

Because there is a fixed return that corresponds to the success rate you’re targeting. If you want a 90% success rate for your plan, you might also be assuming a 3% or 4% overall fixed rate of return. So, it may not be all that different.

Andrew Chen 46:52
I wanted to talk a little bit about annuities briefly. You’ve written before about how you can purchase an annuity to supplement retirement income, which can then also help you perhaps more confidently shift your asset allocation to be stock heavier, if you were so risk-inclined.

I found the strategy pretty interesting, and I was curious if there’s an annuity type that you feel like suits the needs of most investors for this purpose, like a simple fixed annuity. Or is it really highly individual-specific based on individual needs? There’s no general suitable annuity type that you’d recommend for the masses?

Wade Pfau 47:33
Yeah, it really is individual-specific. Some of the research I’ve done recently is about retirement income styles and identifying four different styles: total returns investing, time segmentation, income protection (which is more like simple income annuities), and then risk wrap (which would be more like a deferred variable annuity with a lifetime income benefit).

And I think all four styles are legitimate. I’m agnostic about what people find most appropriate. I think everyone is going to have a style that will resonate best with them.

I do notice that a lot of the online community, especially the FIRE community, as well as other online discussion boards about finance, are very heavily tilted towards the total returns strategy, which is like the 4% rule style: 50-75% stocks and just spending sustainably from an investment portfolio. And they really view that as the superior strategy for everyone in that you don’t need annuities because they’re too expensive or whatever the reasons are.

But I disagree with that point. I think total returns is a viable strategy, but also strategies that may incorporate risk pooling are also viable strategies. And what I think is really commonly misunderstood is the power of risk pooling through an annuity is actually quite competitive with the stock market.

If you think about there’s three basic ways you could fund retirement, the starting point is you could just use bonds. And then you can’t spend very much, but you at least could build out a laddered bond portfolio to cover your spending needs each year. Then you have two options to spend more than that.

One is the diversified investment portfolio, and then you keep your fingers crossed that you get risk premium, that stocks will outperform bonds, and that you can spend at a higher level.

The other approach is you can use risk pooling through an annuity. You get an underlying bond-like return through the insurance company’s general account, and then if you happen to be longer-lived, you receive these credits or subsidies from the risk pool. Those who don’t live as long, some of their premiums subsidize those who live longer, which, in hindsight, you only want to be part of that if you live longer.

But since you don’t know, everyone in that risk pool can spend at a higher level than they could with bonds alone. And I think a lot of these total returns advocates just believe stocks are ultimately giving you more outperformance than annuity risk pooling. And I disagree with that statement.

I think that the risk pooling from annuities is a viable way to also sustain a retirement spending goal. And whether that involves using a simple income annuity, like a single premium immediate annuity, whether it’s a fixed index annuity with a lifetime income benefit, or whether it’s a variable annuity or the registered index-linked annuities with lifetime income benefits, any of those are options, and it’s really what’s best for the individual.

My own personal style is more risk wrap, which is, I’m comfortable with stock market growth, I’m comfortable investing in the market, but I somehow am not comfortable sticking my entire retirement outcome on the stock market. I’d like to have some sort of backdrop or guardrail or protection on that.

That’s what a variable annuity with a living benefit can do. You can still invest for upside in the market, but you have downside protection so that you’re spending far below a particular level.

Now, that downside spending level is probably lower than you get with a single premium immediate annuity or a deferred income annuity. So, if your style is more income protection, you’re not as comfortable with the stock market, so you might appreciate more the simple income annuity. But at the end of the day, it really depends more on what’s your style, how would you allocate the assets.

And your question also brought up, and I didn’t really mention yet, as much as possible, I want to think about protected income streams from annuities as being part of your bond allocation. So, to the extent you can draw from bonds to use the annuities.

And that’s another point where the crowd that says annuities are always bad, they’re always implicitly comparing stocks to annuities. And that’s not really how I’m thinking about it.

It’s whatever your stock-bond mix is, draw some of your bonds into the annuity and then use a higher stock allocation with what’s left, so that your overall stock holdings as a percentage of your household balance sheet, not just the percentage of the investment portfolio, that stays the same.

You still have the same dollar value in stocks. It’s just it might look like you have a higher stock allocation because part of your bonds were sent over to the annuity. That doesn’t show up on the portfolio statement.

And to the extent you can do that, I think risk pooling is a powerful way to help support a retirement spending stream as well.

Andrew Chen 52:35
So, taken to the extreme, if you wanted to have a 100% stock allocation in just your non-annuity investment portfolio, then if I’m hearing correctly, it sounds like you would just convert your entire bond holdings into annuities, and then you could go wild. If you really want to have 100% stocks, you can do that and still benefit from the downside protection from doing that. Is that right?

Wade Pfau 53:05
Yeah. And that goes back to I wrote an article about the efficient frontier for retirement income, where I just looked at all these combinations as stocks and bonds and income annuities and so forth.

When it comes to a spending goal, you may hold bonds for an emergency fund, but when it comes specifically to “I want to spend $40,000 every year for the rest of my life. What should I do to achieve that?” I find that the efficient frontier for retirement income was stocks and income annuities instead of stocks and bonds.

And then what’s the mix? It’s really just a matter of how much do you want to spend, allocate that portion to the simple income annuity, and then keep the remainder in stocks. And that gave you better protection to meet spending needs throughout retirement while also giving you a larger average legacy, especially if you live beyond your life expectancy, compared to a stock-bond portfolio.

Andrew Chen 54:04
That’s super interesting. I don’t know if this is going to open up a can of worms or if this would be a good question to close on, but you mentioned these retirement income styles, and I was wondering if you could give us the overview or just the brief explainer on what the four are and how they differ. We got a little bit of it just in the discussion, but I was wondering if you could explain in a bit more detail.

Wade Pfau 54:35
This was based on research I did with Alex Murguia, and also just based on I’ve been writing for a long time about how there’s two schools of thought for retirement, and I call them probability-based and safety first.

And they disagree with all these different issues about “Is there a safe withdrawal rate? Do stocks become less risky as you hold on to them for longer? Is there a rule for annuities?” and so forth.

And just extending that, we read all this material about retirement planning, whether it’s written for households or written for financial advisers, whatever we could find, and we were looking for things that seem to be distinct factors that might help explain how you think about or approach retirement. And then we came up with eight different factors.

The original research was with my Retirement Researcher website, where we had 1500 participants help us evaluate the questions, and then actually take the questionnaire. And then we did something called exploratory factor analysis, which just lets the data speak in terms of trying to understand: Are there questions that provide distinct factors?

And from that, we found two factors seem to be really important, there are four more supporting factors that could help tell the story, and then the other two really don’t seem to be all that worthwhile to look at further. But with those two primary factors, we could create a matrix that is really interesting how it explains basic retirement styles.

What these two primary factors are: One of them we did name the probability-based versus safety first. Probability-based is I’m comfortable relying on market growth, I’m comfortable with the risk premium, with the idea that stocks will outperform bonds, and I can reasonably sustain spending with that in my retirement.

Versus if I’m safety first, I really want some sort of contractual protection. There’s nothing that’s 100% truly safe, but at least if I have a contractual protection for my income, I feel more comfortable than if I’m having to rely on the stock market to provide that funding. So, that’s probability-based and safety first.

The other is optionality versus commitment, which is not necessarily one we would have picked thinking that’s going to be what’s important, but the data just told us it was important. So, if you have more of an optionality orientation, there’s the sense you really want to keep your options open as much as possible. You don’t want to commit to any sort of strategy, you want to have flexibility, you want to make changes, you want to respond to new circumstances, and so forth.

Versus if you have a commitment orientation, you’re comfortable committing to a strategy that you know will work for you, that you know is going to solve your lifetime income need. It may give you less flexibility to make changes and to respond to new circumstances, but at the same time, you can really check this off your to-do list to some extent. You’ve committed to a strategy that you know will work.

So, that gives us now, you plot probability-based versus safety first, you plot optionality versus commitment, we then have four combinations and those become the four styles.

Total returns investing, that’s the 4% rule, the systematic withdrawals, comfortable with the stock market. That’s somebody who is probability-based, comfortable relying on market growth, and optionality-oriented, wants to keep their options open. So, that sort of systematic spending strategy from an investment portfolio makes sense for those individuals.

There’s a natural correlation as well. People who are more optionality-oriented are also more probability-based on average.

Conversely, the opposite of that is income protection. People who are more safety first want contractual protections and more commitment-oriented. Those two factors tend to correlate together.

That’s income protection. That’s the idea of building a floor so that my essential spending needs are covered by lifetime income protections, like with simple income annuities. I first build a floor of lifetime income, and then I invest the rest for upside beyond that.

That’s the income protection strategy. It gives you the contractual protections, you’re committing to a strategy, and you’re off on your way.

Now, the other two quadrants, what’s really interesting about this is both of those strategies are relatively new, at least since the 1980s, and they’ve been described more in behavioral terms. Here’s a way to meet behavioral preferences for people who don’t have the natural correlations.

The first of these would be if you’re safety first, you want contractual protections, but you’re also optionality-oriented. You want to keep your options open.

Those are a little bit contradictory. With a contract, you don’t always have options, or at least there’s some limits there.

But that’s where time segmentation or bucketing does. There’s this idea of I use bonds and holding individual bonds to maturity to cover my short-term expenses. I get my contractual protections that way.

But then I have this growth portfolio or growth bucket for longer-term expenses, and that’s where I get my optionality. And that might make me feel comfortable with this strategy on a behavioral basis.

And then the other one, it’s this world of these deferred annuities, the variable annuities, some indexed annuities, and so forth, but with lifetime income protections, which have also been described behaviorally for people who aren’t comfortable with an income annuity that takes away the liquidity and doesn’t give you any upside potential.

Andrew Chen 1:00:12
And that’s the willing to commit but want probability-based outcomes?

Wade Pfau 1:00:16
Yeah, you’re probability-based, you’re comfortable with market growth, but you want to commit to a strategy.

And then with these secondary factors as well, if you’re either income protection or risk wrap (that’s the name for this deferred annuity world), you have more of a back loading preference. You’re more worried about outliving your money. You want to protect your future self.

Versus if you are more of a total returns or time segmentation style, you actually have a front loading preference. You’d rather enjoy your retirement in the short term because you know you’re healthy and alive, and you don’t know what the future will bring. And you feel okay about having to make cuts later on, if necessary, to get the most satisfaction out of your retirement.

So, back to risk wrap, you’re commitment-oriented, but you are probability-based. You’re comfortable relying on market growth, but you also have this back loading preference.

And that helps to explain the behavioral aspect of a variable annuity, which is, you still get the liquidity for the contract. You don’t have to annuitize it and give it up. You can still invest for some upside growth, not as much as with an unprotected portfolio, but at the same time, you have a lifetime income protection, so that you know if markets do really bad, your spending can only fall so low before you have that guarantee in place to protect you.

Andrew Chen 1:01:45
That’s a super helpful framework, and it sounds like the FIRE community, you have found, gravitates toward total return. It sounds like you ran a survey and collected data from the investing public. What are the distributions in the quadrants?

Wade Pfau 1:02:06
We did it with the Retirement Researcher, my website, first, and then now with a nationally representative sample of the country. And even within the Retirement Researcher community, there’s more of a tilt towards total returns. It actually somewhat balances out: upper 30% in the total returns, lower 30% in the income protection, and then the time segmentation and the risk wrap each had 15-16%.

So, there was a tilt toward total returns. But I think if you gave this to some of the other online communities, you’d get an even stronger tilt towards total returns. And then what we found with the U.S. population as a whole, there’s actually more of a tilt towards income protection, that it’s more like the upper 30% for income protection, lower 30% for total returns, and then still the same 15-16% range for the time segmentation and the risk wrap strategies.

Andrew Chen 1:03:10
Wade, this has been super insightful, very interesting conversation. I’ve really enjoyed our discussion. Where can folks find out more about you, your research, what you’re up to, all that good stuff?

Wade Pfau 1:03:23
It was my pleasure as well to talk to you. My life work was published in September: the “Retirement Planning Guidebook.”

It’s the fourth book I’ve written, but it’s actually the book I was always trying to write, and the books that came out before it were really chapters for that book. That’s so long, but I spun them off as independent books.

So, the Retirement Planning Guidebook, it’s available on Amazon or other leading retailers. Beyond that, my personal website is retirementresearcher.com. You can sign up there and get on the weekly email list every Saturday morning.

If you’re interested in taking the RISA (retirement income style awareness), there’s a link to it on Page 15 of the book, the Retirement Planning Guidebook. Otherwise, you’re not going to find a link there yet, but you can go to risaprofile.com to learn more about the retirement income style awareness.

We just had the research article published in the Retirement Management Journal in December, so we’re excited about that. Otherwise, Retirement Researcher, and then I’m also a professor at The American College of Financial Services to educate financial advisers.

That may not be less relevant, or you may have a mix of listeners between financial services. I am the RICP program director. That’s our Retirement Income Certified Professional designation.

Andrew Chen 1:04:45
We’ll definitely link to all that stuff in the show notes, and look forward to sharing this with the audience. I think it will be a really insightful episode. Thanks so much for coming on the podcast, and best of luck with everything.

Wade Pfau 1:04:56
Thank you. It’s my pleasure.

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