Afford Anything - How Much Can I Spend in Retirement? - with Dr. Wade Pfau

Episode Date: September 23, 2019

#216: It’s September! If you’ve been listening to the show for the past few months, then you know that I’m on what I’ve dubbed my September Sabbatical, in which I’m taking a break from podcast production and traveling the globe. In light of that, we’re digging through the archives and airing some of my favorite interviews on the show, in between airing interviews I’ve done on other podcasts.  Welcome to another episode from our archives! This one was recorded in March 2018, and Dr. Wade Pfau had a ton of insight into the four percent rule that so many of us are concerned with. First, here’s a brief history of how the four percent rule came to be.  In 1994, William Bengen decided to look at 30-year timespans throughout U.S. History, beginning with the year 1926.  He worked under the assumption that a retiree held 50 percent stocks (in the form of S&P 500 Index), and 50 percent bonds (intermediate-term government bonds).  He looked at two things: the worst-case scenario, and how much an investor could sustainably withdraw from their portfolio under that worst-case scenario.  The year 1966 ended up being one of the worst to retire during, and an investor could withdraw 4.15 percent during the first year, and 4.15 percent, adjusted for inflation, every subsequent year.  That is how the 4 percent rule came to be.  Dr. Wade Pfau, a Professor of Retirement Income at The American College of Financial Services, argues that the 4 percent rule may not be the end-all-be-all we think it is. He voices his hesitations and explains how you can determine how much you can afford to spend in retirement on this episode.  Enjoy! P.S. - We’ll return to our regular podcast production schedule in October!  For more information, visit the show notes at http://affordanything.com/216  Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything but not everything. Every decision that you make is a trade-off against something else, and that doesn't just apply to your money. It applies to your time, your focus, your energy, your attention, anything in your life that's a scarce or limited resource. And that leads to two questions. Number one, what matters most to you? And number two, how do you align your daily decisions in accordance?

Answering these two questions is a lifetime practice. And that is what this podcast is here to explore. My name is Paula Pan. I am recording this right now from Tokyo, Japan. It is the month of September 2019, and I am taking this month off to go travel. So today, you are going to hear an interview that we originally aired in July of 2018, a little over a year ago. This is an interview with Dr. Wade Fow.

He's a professor of retirement income at the American College of Financial Services in Bryn Maw, Pennsylvania. He's one of the most cited researchers in the nascent field of retirement income and retirement planning. He's received awards from the Journal of Financial Planning and the Retirement Management Journal, and he was named an innovator by Investment News. He's also a chartered financial analyst, and he holds a doctorate in economics from Princeton. Today, he joins us to discuss how much money a person can spend in retirement, and he introduces some counterintuitive ideas.

We talk about the four Ls of retirement planning, we talk about a U-shaped asset allocation, and we talk about two frameworks for thinking about your approach to retirement planning, the probability framework versus the safety-first framework. Before we dive into today's interview, I would like to let you know that our course on rental property investing, which is called Your First Rental Property, opens for enrollment today. So today, Monday, September 23rd, the release date for today's episode. We are opening the doors for enrollment for our course. We only open enrollment twice a year once in the fall and once in the spring. So we have a fall semester and a spring semester. Enrollment opens today. Enrollment closes on Monday, September 30th, 2019. So it's a fall in the fall semester. So it's a fall semester. So we have a fall semester. So we have a fall semester. Inrollment opens today. Enrollment closes on Monday. So we're in the fall semester. So If you want to sign up to be a student in our fall semester, you have to sign up this week. The first day of class begins on October 1st. So hopefully I'll see you there.

If you want to learn more about it, you can go to afford anything.com slash enroll, where you will get all of the details. Again, afford anything.com slash enroll to get all the details. Now, with that being said, here's our interview with Dr. Wade Fow on how much money you need for retirement. Hi, Wade. Hi, thanks for having me today. So I would like to talk about, I mean, there's so much ground to cover, but your research and your book on retirement planning is excellent. One of the first things that captivated me is what you refer to as the four L's of retirement planning. Can you discuss that?

Sure. Yeah. And I think what really makes retirement planning different from the traditional investment management or wealth management is this idea that you have to meet goals in retirement and goals have expenses connected to them. And so you have to use your assets to meet those expenses. And so the four Ls are the financial goals of retirement, essentially. It's lifestyle, longevity, liquidity, and legacy. Lifestyle and longevity are really the kind of base retirement spending on an annual basis. Your budget and retirement, how much are you seeking to spend on a year-by-year basis? For some people, lifestyle and longevity might not really be all that different from each other. And they may really then just have three Ls.

But if there's a distinction there, it's that longevity are really these core fixed, more essential types of expenses that people want to make sure they can cover no matter how long they live and not really have to jeopardize, not being able to make those longevity expenses. So not necessarily wanting to use assets that have potential risks, like not having the stock market cover longevity expenses. And then lifestyle, if it's different from longevity, is going to be more. more discretionary. How could you enhance your lifestyle and enjoy a better retirement beyond just the basics, some more discretionary types of things where there's more flexibility. You might be more willing to invest for upside growth to enjoy an even better lifestyle with the understanding that if things don't go well in the markets, you may have to cut back and not have as nice of discretionary lifestyle component.

So that's the basic retirement budget, the lifestyle and longevity. And then liquidity and legacy. Legacy is real simple. It's just the kind of legacy goal you wish to leave behind. And liquidity, that's the more complex one. That's having liquid assets available to cover the unexpected, suspending shocks, things outside the baseline retirement budget, something like a health care expense or a long-term care expense,

or different things that can happen that aren't part of the basic budget. For some people, they may ultimately not cost them anything because they don't have any major unexpected expenses. But for others, they do run into some issue where they have to draw from assets. And to really be liquidity, it can't just be a liquid asset in the sense that your investment portfolio is liquid. It really has to be an asset that's not yearmarked for one of the other else. If you're using something like a 4% rule of thumb for your spending in retirement and you're trying to be an asset. and you're trying to spend $40,000 from a million dollar liquid investment portfolio, well, that million dollars is really earmarked to cover your $40,000 spending on a year-by-year basis.

It's not really liquid in the sense that you could use it for something else without potentially jeopardizing your ability to meet the other else. So by liquidity, I really mean assets that are not earmarked for another purpose that really are available for these types of unexpected spending shocks in retirement. Right. And that's the distinction between technical liquidity versus true liquidity, yes? Yeah, yeah, because an investment portfolio technically is liquid. But if I'm trying to spend $40,000 from a million dollars and I believe in the 4% rule, then in a true sense, I don't have liquidity because that entire $1 million is earmarked to cover the $40,000 spending goal.

True liquidity is only when you have assets that are not earmarked for another purpose and that are truly available for whatever may come up. And one mistake that you often see people make is double counting money. Certain money is earmarked for X and then it's also double counted as earmarked for Y. Right, right. It's part of the same concept that if I'm using that million dollars to fund a $40,000 spending goal, then I'm really double counting if I try to say that this is a liquid portfolio that I can use if I have a big spending shock that requires additional expenses, because I could use it for something else, but then I'm directly trading off my ability to meet my future baseline retirement spending budget.

So you really have to be careful not to double count assets when you're trying to build this framework for retirement where you're matching assets to your spending liabilities. Now, when it comes to the risks of a retirement portfolio, I mean, you've named longevity, an unknown time frame, market volatility, inflation spending shocks. How, this is a very big question. How would a person manage this risk? That's probably too large of a question. That's really the question of retirement income planning. And yeah, that's definitely a very broad question. Ultimately, it's around clarifying what your goals are. relation to those four Ls, and then combining available tools using your assets in different ways.

The assets are the tools to meet your spending goals and trying to just put together your assets in such a way that you're able to meet the goals while managing this changing nature of risk in retirement, managing the longevity risk, not knowing how long you live, managing market risk and the amplified impact of market risk through the amplified sequence of returns risk you experience when you're taking distributions from assets and also having the liquidity for those spending shocks and just trying to use assets in the most efficient possible way to be able to meet those goals and to manage the risks. And in that regard, I think it's really a matter of assets can fall into three general categories, reliable income assets, the diversions,

diversified investment portfolio and then reserve assets that are available for the liquidity. Cover that again, reliable reserve and then one other that you said. And diversified portfolio. So the distinction there, the diversified portfolio could have capital gains and capital losses. And with reliable income where you're trying to meet your core longevity expenses, not necessarily wanting that exposed to the stock market, whether it could be losses or to say, long maturity bond funds where there could be capital losses, but having some sort of contractual protections. So of course, things like social security benefits and traditional pensions, but also

holding individual bonds to maturity, or using different types of insurance, different types of annuities that provide risk pooling as a way to help fund longevity. If you end up living longer than expected you have assets that specifically come into play to support spending particularly well in those scenarios. Can you talk a bit about the framework between a probability-based retirement approach and a safety first retirement approach? Because I thought this was fascinating. I had never distinguished between the two, but when I read it, it made intuitive sense.

Sure, sure. And that's where retirement income is still a relatively new field. and people look at it in a completely different way. And there's a number of basic questions you can ask that these two different schools of thought will give completely different answers about them. So the probability-based school, it's really more of an investment-based approach.

It's the whole idea of using the investment portfolio to fund your retirement, taking distributions from investments, relying on the idea that over the long run stocks will outperform bonds. And so if you use them more aggressive, investment portfolio and retirement, you'll get enough upside growth from the stock market that you can fund a higher standard of living than the bond market could otherwise support.

And being comfortable with that as a way to guide your retirement. And then the way you manage risk in that framework, longevity risk and market risk, is you just try to either make sure your spending's low enough that you're not going to run out of money if you do live a long life and do get a bad sequence of market returns, or just being flexible with your spending so that you will cut your spending after a market downturn as a way to help avoid selling assets at a loss. And that's really the probability-based approach. The safety-first approach would come more from the insurance side of the financial services world,

and that's trying to look more at using risk pooling through lifetime income guarantees as a way to more cheaply and efficiently meet retirement expenses, to then free up more of the assets to just be invested for upside growth, but to not have core retirement spending dependent upon upside growth from the stock market, to have contractual protections to support the basic retirement spending needs. And that sort of risk pooling is something that an investment portfolio can't provide. It can only be done through insurance. And so it's a different way of relying more on risk pooling instead of the risk premium.

as a way to fund basic retirement expenses and then using the risk premium for the more discretionary types of goals. Between the two camps, do you lean to one side or the other, or do you prefer a hybrid approach between the two? Well, in some sense, I think the safety first approach really is a hybrid because it includes both insurance and investments. It's not insurance only versus investments only. It's more probability-based tends to be investments only. and then safety first tends to be combined insurance and investments. And I do tend to lean more towards a safety first approach just because a lot of the early research I did. I do come more from the investments world, but things like the 4% rule of thumb that are used on the investment side to define retirement strategies. They're really just based on 20th century U.S. financial market data.

and so when you look at broader potential market volatility experience more internationally, then those sorts of rules of thumb don't really work. And when you consider today interest rates are so low compared to most of the 20th century U.S. market data, stock market valuations are so high, I think there's a lot more concern that something like the 4% rule of thumb for retirement spending from investments is not as safe as people may have thought just based on an analysis on U.S. historical data. And in that regard, risk pooling is a very competitive source of returns to the stock market. The idea that how a basic income annuity works, that risk

is pooled together, those who end up not living as long, then help subsidize payments to those who live longer, which clearly benefits those who live longer because they're getting all these mortality credits. They're getting all these subsidies from those who didn't live as long. But even for those who didn't live as long, they, in a sense, benefiting as well because they're able to enjoy a higher standard of living than they would have otherwise been comfortable with using an investment portfolio. Because their spending is based on their life expectancy when they pull that risk versus if they're managing longevity risk with investments, then they have to worry that they're going to live well beyond their life expectancy and just spend less to try to stretch those assets out and make sure they don't run out of money. So I really do think that risk pooling is a very valuable source of returns. And in that regard, I made up those names, probability-based and safety first around 2012. And I really made a mistake in doing that.

Probability-based, the idea was the investment portfolio was supposed to provide you with the highest probability of success. But that's really not the case. Risk pooling is so powerful as a competitive source of returns to the stock market. that you're not necessarily maximizing your probability of success with investments. If I could start over with that today, I'd really just name them more investment-based and insurance-based schools of thought rather than probability-based and safety first. One of the interesting points that you made that I had never explicitly thought about is that self-management of those risks, i.e., if you are not risk pooling, requires you to assume lower

returns and assume a longer time horizon and therefore have a more frugal life than you otherwise would quote unquote need. Yeah, and in that regard, this is really a great lead-in to just mention what the 4% rule of thumb really is and what it does. It's Bill Bingen was a financial planner based out of California who in the early 1990s was looking at how much could you spend from an investment portfolio. So he was thinking in terms of a 65-year-old couple, And the way he managed longevity risk was he just said it's very unlikely that a member of a 65-year-old couple would live beyond age 95. So if we just plan for 30 years, it's very unlikely to outlive that. So that's a conservative planning horizon.

And then with the market volatility, he looked then at all the different 30-year periods in U.S. history since 1926 and calibrated it to the worst-case 30-year return sequence, which, for a 50-50 portfolio would have been 1966 to 1995. And basically the 4% rule of thumb, it survived that worst 30-year period in U.S. history with a 30-year period, with the idea that 30 years is well beyond life expectancy. So that's where it's doing what you indicated there. You're assuming you live well beyond life expectancy, and you are getting some poor market returns, however defined, in this case defined as the worst 30-year period in U.S. history. But then there's always a concern.

Well, what if 30 years isn't long enough? And especially for early retirees, 30 years may just be a drop in the bucket. Some early retirees may need to think about 60-year retirements or much more than 30 years, which just means the 4% rule was never meant to apply to them in the first place. And then with the worst-case scenario in U.S. history, Well, we've, if you look more broadly at the international experience and look at where interest rates are today, where stock market valuations are today. And also just consider this unrealistic assumption that the 4% rule of thumbs based on indexed market returns and assumes that investors

will get those returns net of any fees, investment management fees and so forth, then there's reasons to question whether 4% is low enough. But nonetheless, it's showing the logic there. It's meant to be low to deal with bad market returns and a long retirement. It's just there's still an open door, open window about, is it low enough? Could people live even longer than 30 years? And could market returns be worse than what was experienced in 1966 to 1995? Right. And that's the conflicting nature of, you know, when you consider the 4% withdrawal rule, on one hand,

4% represents the the worst case scenario. So the majority of those 30-year periods that William Benjian studied, 4% represents the worst case within all of that, which means that for the majority, a person could have spent even more than 4%. So you've kind of got that argument on one side of the table. But then, as you said, on the other side of the table, the data was never only looked at a 30-year retirement horizon. So it was never meant to, apply to people who, for example, retire at the age of 40 and may have a 60-year retirement. Right. It's specifically for 30 years and then specifically that U.S. worst case than the U.S. data, although just there's a lot of points that were close to 4%, so that a 5% withdrawal rate worked in about 70% of those 30-year U.S. periods. And then a 6.5% withdrawal rate would have been the sort of average withdrawal rate where half of the time the withdrawal rate was less than 6.5%. Half of the time it was more than 6.5%. We'll come back to this episode after this word from our sponsors.

Are you tired of getting nickel and dime to buy your bank and do you want to have a checking account that pays a really good interest rate? Check out Radius Bank. Radius Bank has something called the Radius Hybrid Checking account. It's called that because it combines the flexibility of a checking account with the interest earnings potential of a saving account, and so in a checking account, you can earn 1% APY on balances between 2,500 to 999,000. To put that in context, that is between 17 times to 20 times greater than the national average, according to data from the FDIC as of July 2019. You can also earn 1.2% APY on balances

of 100,000 and up. These are not flashy teaser introductory rates. They do not expire. And they come in the form of a checking account that gives you freedom from fees. There are no ATM fees. They will reimburse you the fee that other ATMs charge you. There are no monthly maintenance fees. Your first order of checks is free. So this is a bank that gives you freedom from fees and a great interest rate on your checking account. To open an account with them, go to radiusbank.com slash Paula. That's R-A-D-I-U-S-Bank.com slash Paula. P-A-U-L-A. Radiusbank.com slash Paula. Hiring can be a slow process. Let me tell you about Cafe Altura's chief operating officer Dylan Miskowitz.

He needed to hire a director of coffee for his organic coffee company, but he was having trouble finding qualified applicants, so he switched to ZipRecruiter. Now ZipRecruiter doesn't just depend on candidates finding you. It finds them for you. Its technology identifies people with the right experience and invites them to apply to your job, so you get qualified candidates fast.

Dylan posted his job on ZipRecruiter and said he was impressed by how quickly he had great candidate supply. He also used ZipRecruiter's candidate rating feature to filter his applicants so that he could focus on the most relevant ones. And that is how Dylan found his new director of coffee in just a few days. With results like that, it's no wonder four out of five employers who post on ZipRecruiter get a quality candidate within the first day. See why ZipRecruiter is effective for businesses of all sizes. Try ZipRecruiter for free at our web address, ziprecruiter.com slash afford. That's ziprecruiter.com slash aFF oRD. ZipRecruiter.com slash afford.

ZipRecruiter, the smartest way to hire. So what should a person do if an individual or a couple wants to retire early? I mean, would it be wise for them to consider the 4% withdrawal rate? within their planning? So there's a lot of assumptions that go into the 4% rule. Another one that I think's really also quite relevant for early retirees is the 4% rule assumes you're always going to increase your spending for inflation every year, like right on cue with whatever the consumer price index does. And a way to help manage that sequence risk, as I mentioned earlier, is to be flexible with spending. So I think early retirees really need to be vigilant about this idea of being.

flexible with spending or at least being open to the idea that with a poor sequence of market returns, they may have some potential to do some part-time work or something along those lines to help cover some of their expenses to reduce the stress on needing to take distributions from their investment portfolio. As soon as you, there's again, a lot of assumptions in the 4% rule. One that can help people is by being flexible with spending, you can use a higher initial spending rate if you're willing to cut spending in the event and cut portfolio distributions, either by just spending less or by doing some part-time work to reduce the stress on the portfolio. And that's a way to then use a higher initial spending rate. So I think really the only

way an early retiree could consider 4% is if they do have that flexibility. If they don't have that flexibility, then 4% really is aggressive in the low interest rate environment that we face now. And they should really seriously be thinking something more like 2.5% to 3% if they're using an investment portfolio and as a way to manage the potential risks around that. I've said to many people, you know, in the absolute worst case scenario, you could always get a job. Right. And to the extent that you can, then you have more risk capacity. Then your lifestyle's not as vulnerable to a downturn in the stock market. And so you can take advantage of that by being more aggressive in other ways. And one way you can be more aggressive is to spend at a higher than a safe

percentage. Now, you've mentioned the low interest rate environment a couple of times. It seems like you think that that is one of the major threats facing people who are retiring now. modern retirees. Yeah, yeah, there's no controversy there that low bond yields are very good predictors that bond returns will be lower. And then if returns are lower, then spending rates have to be lower. The 4% rule forgets about all that, that returns link to spending rates. And when interest rates are low, there's more stress. For much of U.S. history, a portfolio is generating off enough income that you could spend 4% without having to spend down principal. But today, you could build a 30-year ladder of treasury inflation protected securities

and not be able to use a 4% withdrawal rate because interest rates are too low. That's beyond what the bond yield curve can support. So if you're trying to spend 4% today, you're more exposed to sequence risk because you have to get capital gains. Your portfolio is not generating enough income to do that. And if you don't get the capital gains, you're going to more quickly enter into having to spend principle triggering losses, locking in losses on your assets, you're more exposed to that sequence

risk when interest rates are low. And that's really an important consideration for people retiring today. Speaking of sequence risk, first of all, actually, could you, for the people who are listening who are not familiar with sequence of returns risk, could you quickly define it? So sequence risk is the idea that it's, if I have a 30-year retirement, it's not just what's the average return to the markets over that 30 years. It's what, what's the specific order that those returns come. And if you get bad market returns early on when you have more wealth, that's going to have a bigger impact on your financial outcomes. There's no sequence risk if you put a dollar in the market and let it sit. And that's how

mutual funds calculate performance and so forth. It's a time-weighted return. But as soon as you have cash inflows or outflows, there is sequence risk. There is sequence risk prior to retirement if you're saving a percentage of your salary every year. And then it's market returns later on when you've added more contributions to your account. But then once you actually transition from adding new savings to taking distributions from your assets, that further amplifies the impact of sequence risk. And so those early returns, the returns you get in early retirement are going to really drive your retirement outcomes and define whether you can spend at a high level or a low level. in your retirement. And you and Michael Kitsis, who is also a previous guest on this podcast,

have been looking into a very novel approach to mitigate sequence risk, the U-shaped approach. Can you talk about that? Yeah. So sequence risk is really an inverted U-shape. You're most exposed to the market returns around your retirement date. When you're quite young, quite far from your retirement date, market returns don't have as much impact. And then later in retirement, market returns don't have as much impact. So in terms of your lifetime stock allocation, we talk about a use-shaped lifetime stock allocation where just like with target date or lifecycle funds, you have a higher stock allocation when you're young. Your stock allocation reduces as you get closer to retirement. But then the question

becomes, what do you do post-retirement? And most of the target date funds either keep you at a low stock allocation throughout retirement or further decrease your stock allocation through retirement. And what we found in doing simulations around this is the more effective way to manage sequence of returns risk is we agree with having the lower stock allocation at retirement, but then actually increasing your stock allocation throughout retirement rather than continuing to decrease it, that that works as a risk management technique because it helps to protect you in the scenarios where sequence risk does the more damage. Now, I mean, there's really four different

things that could happen in retirement. If you got bad market returns for your whole retirement, then no ask allocation strategy saves you. But the more realistic worst case scenario is you get bad market returns in early retirement. And then markets do better later on. That's what happened in that 1966 hypothetical case that triggered the 4% rule. Market returns for a rough about halfway through that retirement from 1966 until 1982. And then markets did great after 1982. So the second half of retirement was really good. And that would be the exact scenario that the use-shaped lifetime or the rising stock allocation glide path in retirement would help. Then if markets did good and early retirement, bad later in retirement, you're not going to run out of money. Either way,

you're going to leave a pretty large legacy at the end. We're talking about the U-shaped stock allocation as a risk management technique, so it's not helping you in that scenario. It means you're going to leave a smaller legacy, but you're still not running out of money in that scenario. And then same, if markets do great throughout your retirement, it's going to reduce your legacy relative to having a high stock allocation throughout your whole retirement.

But it's also not disrupting your retirement. it's really playing the role to help manage risk in worst case scenarios. And so it works as a risk management strategy to have, again, the lowest stock allocation around your retirement date and potentially a higher stock allocation when you're younger and then again when you're older. You mentioned there are four things that could happen during retirement. One is bad returns throughout, in which case you're kind of screwed. The second is bad returns at retirement, like at your retirement date. The third is that the markets could do great throughout. And then what was the fourth?

Well, just that markets do great early on and then do bad later on. And how would the U-shaped fare in that scenario? If markets do great early on, then your retirement will work out, even if they do great throughout retirement or if they do poorly later on. you're not going to run out of money if you get a good sequence of market returns in early retirement because it just your portfolio continues to grow, the distribution rate you need to meet your goal continues to decline, and you're just not going to run out of money in those scenarios. And the U-shaped glide path doesn't cause you to run out of money or anything.

It just means you're not going to leave as big of legacy at the end as you might have if you kept an aggressive stock allocation throughout. Now, when I think about the U-shaped model, my initial knee-jerk reaction, I very much internalized the idea that your stock allocation should reflect your timeline. And so when I think about the U-shaped model, as a person is deep into retirement, their timeline is compressed. And so knee-jerk, it seems to me, that means that their stock allocation should also be lower, that their risk capacity. is lower as a result of the shortened time horizon. I suppose that's the part of the U-shaped model that I guess that makes it a little counterintuitive. Yeah, so well, risk capacity is really just how vulnerable is your lifestyle to a downturn in the stock market. If the stock market can crash

and that doesn't impact your lifestyle, then you have risk capacity. And so late in life, if you've had good market returns earlier on, you're getting to the point where you're not going to run out of money and your lifestyle's not vulnerable to those market downturns. I mean, I think there's a bigger concern as well. It's just behaviorally, it's difficult to increase your stock allocation as you get older and older. At the end of the day, I'm not, the media really enjoyed this use-shaped glide path discussion, but I'm not going out there on a day-to-day basis trying to advocate that people, use this. It's really, it works mathematically as a risk management strategy, but I think there are a lot of psychological reasons against using it. And also, I view it more as, I think the safety first approach is really a better way to approach things. And I'd want people to consider the power of risk pooling as well. And this use shape glide path is more something that, well, if you're not going to consider risk pooling and insurance as part of your retirement plan and you're only going to use investments to cover your retirement, then what should you do? And then at that point,

I would argue that this U-shaped glide path helps to manage risks. Another thing we didn't mention about the 4% rule of thumb is it assumes an aggressive stock allocation. Bingen had said, use 50 to 75% stocks in retirement, but as close to 75% stocks as possible. And that's something that always shows up in all the subsequent research because as soon as you want to spend more than bonds will support, bonds aren't going to get you there. Stocks, in an investment's only context, stocks are the only thing that can do it. So you have to use high stock allocations. And not everyone's comfortable with that. That's not really conventional wisdom that you have a high stock allocation in retirement. So we're just saying, well, you can start retirement with a lower

stock allocation, if you're willing to increase it later on, you can't keep the low stock allocation forever. Well, it depends on market scenarios and so forth. But this really, it's just, it's a risk management technique that works mathematically, but doesn't necessarily work in the real world when you consider behavioral implications and psychological implications of increasing your stock allocation as you age. We'll return to the show in just a moment. Let me tell you about a useful life hack for absorbing information from more books in less time. So one of the ways that you can do that is by listening to summaries of books, because the thing is it's hard to find the time to sit down to read and learn more.

When you can, it's great, but when you don't have free time, it's hard to read or work on personal development, but there's an app that solves this problem that I recommend. It's called Blinkist, and Blinkist is just really unique. It works on your phone, your tablet, your web browser. Blinkist takes the best key takeaways that need to know information from thousands of nonfiction books and it condenses them down into just 15 minutes that you can either read or listen to. Successful people, business leaders, are known for reading a lot of books.

And Blinkist is made for busy people like you who want to get to the main points of the book quickly so that you can start using that information right away. It has an audio feature which makes it easy to finish a book during your commute or on your lunch break. I typically listen to Blinkist. if I'm going on, like let's say I'm going from my home to the grocery store, right? So 15-minute trip, that's not enough time to get into an audiobook or to even really get into a podcast, but that 15 minutes is enough time to listen to one blink.

So I can listen to the best key takeaways from a particular book. They've got a huge selection of books. You can check out great books like Start with Why by Simon Seneck or Factfulness or The Power of Habit or Getting Things Done. Those are all super popular books that are in their library. Now with Blinkist, you get unlimited access to read or listen to a massive library of condensed nonfiction books. All the books you want and all for one low price. Right now, for a limited time, Blinkist has a special offer just for our audience. Go to Blinkist.com slash Paula, try it free for seven days, and save 25% off your new subscription.

That's Blinkist, spelled B-L-I-N-K-I-S-T. Blinkist.com slash Paula to start your free seven-day trial, and you'll also save 25% percent off, but only when you sign up at blinkist.com slash paula. That's b-l-n-k-I-S-T-com slash Paula, P-A-U-L-A. One thing that I think we can all agree on is that doctors, dentists, nurses, people who work in the medical and health care fields are awesome. I think most of us can think about a time when a medical professional has helped us or helped a family member. So if you are looking to give a gift to somebody in that field, you can get a gift card for figs. Now, figs creates high.

quality scrubs, high quality medical apparel, so that medical professionals can look good, feel good. Every set of figs is antimicrobial. They're made with yoga waistbands. They come in a variety of styles. And figs is an ethical company. Every time that you shop at figs, they give a pair of scrubs to healthcare providers in need around the world through their Threads for Threads initiative. They have donated hundreds of thousands of sets of scrubs in over 35 countries. So if you're looking to give a gift to somebody who you know, you can feel really good about this because you can not only give a gift to someone, but you also know that by shopping at Figgs, they're going to donate a set of scrubs to a health care provider around the world. They gave me a set of scrubs that I gave

to a friend of mine who's a PA, and she loved it. She said that they were comfortable. She loves the scrubs that I gave her. So it's a great gift. It makes somebody smile. And they also give back. So whether you're one of the awesome humans that works in healthcare or someone who wants to say thanks to these deserving folks, Figgs is going to make that easy by providing you with 15% off your first purchase by using my code, Paula. Get ready to live. love your scrubs, head to wearfigs.com, W-E-A-R-F-I-G-S dot com, and enter my code Paula at checkout. That's wearfigs.com and enter Paula at checkout for 15% off your first purchase. In the studies that have been done, Benjian study, the Trinity study, and all those

studies about stock allocation with regards to a retirement portfolio, do these studies assume that your stock allocation is only exposed to U.S. equities? Or do they assume an international component as well? Right. Yeah, that's a great question. So most of the basic studies out there generally stick to two asset classes you've got. And it's generally large-cap U.S. stocks like the S&P 500 and then some bond index. Now, I know the Trinity study authors did have one case where they looked at international as well. But for the most part, you're looking at the two asset classes.

I wrote an article in 2012 to try to give people a framework to deal with this problem and that all of this discussions included in my book as well on this topic of what asset classes do you want to use? And then if you're willing to choose a list of asset classes and willing to choose your assumptions about them, returns, volatility, correlations, then I provide a framework for thinking about, well, with your assumptions, what's the sustainable spending rate for a given probability of success and so forth. Because it's really a matter of if you use international diversification, what impact does that have on returns and on

volatilities. Now, in historical data, because the U.S. did so amazing in the 20th century, international diversification hurt. I did do a study about the international data and a GDP-weighted portfolio from the perspective of a U.S. investor, the historical safe withdrawal, rate was 3.5% instead of 4%. But that on a forward-looking basis, I'm a big advocate of international diversification as a way to not necessarily increase returns, but at least to reduce volatility. And as you look at the trade-off between return and volatility, I definitely think you can, with reasonable assumptions model that international diversification can support a higher sustainable spending rate in retirement. What about commodities, reits, all of those other assets?

classes? Yeah, so as long as you're willing to make assumptions, for each asset class you want to consider, you need the kind of expected return, what we'll do on average, the volatility, how much fluctuation is there around that return, and then how is that asset class correlated with other asset classes? And also, it should be an asset class that its returns follow a kind of bell-shaped normal distribution if financial derivatives and things don't necessarily work that way, but commodities and real estate should work that way. So then, yeah, you can include those in the portfolio and the framework I described can be used to calculate withdrawal rates for that. If a person going into retirement has outside sources of recurring or passive income, such as

royalties from something that they've created or rental income from properties that they own. How should they factor that into their personal retirement analysis? Well, so it's a matter of first figuring out what's your budget in retirement, how much do you want to spend, and then starting to apply assets to that. And that's where you may get into some questions. I think about this with book royalties. Like, how much of that is reliable income? What's a reliable level that I might be able to expect on an ongoing basis? And that I could treat as a reliable income source to help cover my longevity expenses. But if there's some uncertainty and the royalties may go down in the future, you don't want to get too aggressive about assuming too high

of a number to cover your core retirement expenses. So you might want to treat that more as a way to help fund more discretionary types of expenses. But it's just matching assets to liabilities, either on the asset basis or on the cash flow basis. If I want to spend $2,000,000, $1,000 a month, and I can reasonably rely on $1,000 a month in some sort of cash flow of that nature. Then I've just got another $1,000 gap, and that might be partly funded if I do get higher royalties than I expect, or I just need to be ready to use other resources, whether it's portfolio distributions or something else to make up that difference. within the probability versus safety first framework, where would that class, the class of passive income or recurring income, where would that fall within the framework? Would it be more analogous to having an annuity or is that not an apt analogy because it's not truly guaranteed?

Yeah. So I think it's a question of do you want to classify it as a reliable income source? And it's not that there's a contractual guarantee behind it, but it's just how reliable. is that income? Or do you want to treat it? Does that income behave more like a bond or more like a stock? And this could be like rental income too if somebody owns like an apartment complex. How much of that is really a reliable income that they can count on and how much of it will be more variable because it may depend on occupancy rates and so forth. And you may divide it out. I may say that you know, a thousand dollars of it is reliable income and I really can treat it that way. But I might be able to get more than $1,000 is that cash flow. But the rest I want to treat more as a variable component of income that I don't want to

rely too much on it. I want to. Just like with the stock market, I don't want to rely too much on getting the stock market growth to cover my expenses. I may not want to rely on that full income value to cover my retirement expenses. I think that's really just the way you have to approach it. is it more like a stock or a bond, and how much of it is really reliable, how much of it is more variable in nature. And that's where be flexible accordingly that if you have some really good

years with that, you can spend more in those years. But if you've got some bad years with those passive sources of income, then if you can cut spending in those years as well, that's one way to manage it, or if you want to keep the higher spending level, that's where distributions from other assets will have to play a bigger role. When do you plan to retire? So for me, I think it may be more of a phased retirement. And in terms of financial independence, I got a little bit of a late start because I spent the first part of my career as a just purely a traditional professor with, but now I've got more variable income sources and things. So I'm hoping to become. financially independent by sometime between 45 or 50 at the latest. And then in terms of

retirement, I enjoy a lot of aspects of what I do. So I think it's going to be more of a gradual phase down of, I don't know, it's really hard to say what age I would get to the point where I can't cover my expenditures from new labor income. But yeah, I'm interested in this sort of financial independence, early retirement type of concept, although I'm not in a big race to retire as quick as I possibly can. I just would, it'd be nice to have financial independence at some point. If you don't mind me asking, you mentioned that you've pursued other variable income sources. What have you gone into? Well, the book writing and then doing public speaking, and then just in addition to being a professor, also working with a financial advisory firm,

and a financial planning software company. That's probably most of it. Where do you see the field of retirement planning going in the future? I mean, as you mentioned, it is a fairly new field. Historically, it has not been distinguished from overall investing, investment management. Yeah, well, there's still this very negative image about annuities, but I think they really do add value to retirement planning. I think in the future there will be more appreciation for not just using investments, not just

using annuities by themselves, but really integrating both of them together into a more comprehensive plan. And also just looking at ways of using available resources more efficiently so that you're not leaving money on the table or not making decisions that might be nice in the short run, but will be harmful in the long run if you do enjoy a long retirement. and where that longevity risk becomes an issue. So I think that would be increasing recognition that, like, so much of investing, it's these simple examples and they're based more on accumulation, and there'll be something like

if you assume you earn an 8% rate of return, and if you save $50 a month, you'll be a millionaire by age 65 or something like that. And just the recognition that in retirement, I don't know if assuming that 8% return was ever appropriate, but it's really not appropriate when you're not appropriate when you're you're taking distributions, that sequence of returns risk plays a much bigger role in driving volatility for those outcomes. And so you really can't get away with that type of simplified framework. And that's what really makes retirement different. It's along with this idea of matching assets to your liabilities. So I think there's going to be more and more recognition of this is what

makes retirement different and that you have to be more careful about your assumption. on the stock market, you can't assume an average stock market return because that only works 50% of the time and so on and so forth. You have to think more broadly and holistically. Great. Well, I don't think I have any other questions. Actually, I do have one, but it's way out of left field, if you don't mind me asking. There's speculation about what might happen. you know, might we be on the cusp of a human lifespan extending to 120, 130, even 150 years? Again, this is a very broad question, but what implications would that have for personal retirement planning, for social security? I mean, again, I know that's a very big question and purely speculative, but it's an interesting thought exercise.

Right. And so I'm not a demographer. And even then I think demographers don't know. Some do believe, you know, like the person that will live to 150s already been born. Some believe that actually life expectancies will get shorter because of obesity and poor health and so forth. And it might really be there's a divergence where already there's a huge divergence that people with a long-term focus that generally then earn more income, have more wealth and take better care of their health, live substantially long. than other people that don't have those characteristics and that divergence can continue to widen. So there are going to be some people that live substantially longer. The idea of living to 100 is not so rare anymore. It's the Society of Actuary's data that I like to use to represent kind of the people that are going to be listening to a podcast on these topics shows that there's a 10% chance now that a 65-year-old female will live to 100.

And again, that's not for the whole population, but that's for really a subset of the population that has a longer-term focus. And that does have implications. So Social Security is going to be stressed. Annuities are stressed if people live longer and you have this guaranteed income. Now, that's partly going to be offset by life insurance, where an insurance company, if their customers start living a lot longer, we'll pay fewer death benefits on the life insurance, but more payments on the annuity, guarantees. So there'll be some natural offset there, but that can be a stress. And I think just as people live longer, there might be more of a sense of, well, there's more reason to invest in

human capital because you may be working longer, so getting education and so forth. But people might want to go in and out of the workforce or try different careers or just be more flexible with the whole concept of retirement, maybe taking a sabbatical and then doing something different and staying active, that if people are staying healthy into their 80s and 90s increasingly, they may not be in such a rush to retire or to just really be more open to different sorts of lifetime patterns in terms of their work and their retirement and what they do with their time. But yeah, there's a lot of people that are speculating on the societal implications of extreme longevity and it certainly is a definite possibility. Thank you so much, Wade. Thank you for

joining us. Where can people find you if they would like to know more about you in your work? Oh, thanks. Yeah, so my website is Retirementresearcher.com. It's all one word and retirement researcher, like a person researcher, not just research.com. And I have a weekly email list that they can feel free to sign up for and get an email every Saturday. And you can also just find more about books and and other webinars and things that I do through the website. Thanks. Thank you. What a fantastic interview. Big thanks to Wade for coming on the show. What are some of the core takeaways that we got from this? Here are four that I came up with. Takeaway number one, flexibility is the only true security. In retirement, your ability to survive shocks, whether it's

a market crash or some big spending shock, your ability to get through those tough times. comes from your flexibility. And a perfect illustration of this is the fact that the 4% rule of thumb is based on the assumption that you withdraw exactly 4% in year one and then 4% adjusted for inflation every subsequent year, regardless of what's happening in the overall market. So there's a lot of assumptions that go into the 4% rule. Another one that I think is really also quite relevant for early retirees is the 4% rule assumes you're always going to increase you're spending for inflation every year, like right on cue with whatever the consumer price index does. But if you reframe your approach to the 4% rule such that if the markets are bad,

you don't adjust your spending for inflation for a year or two. Or you pick up extra part-time work. Or you just decide to live on less. You eat at restaurants less often. Or you Airbnb a room in your home temporarily just for six months or just for a year when the markets are particularly bad. or maybe you spend a year living in Bali or in Thailand or in Ecuador where the cost of living is a lot lower. Like if you do any of those things, well, then that is your security.

That will allow you to participate in the 4% rule of thumb without having to go down to a 3% rule or something more conservative. Because your ability to access that money comes from the fact that you are going to be able to be flexible when the markets are rough. So that is takeaway number one. Flexibility is true security. And in the world of investing or in the world of retirement or working or just in life, flexibility is their biggest asset. Takeaway number two, if you're retiring through rental income, then conceptualize your net cash flow,

that net cash flow that comes from your rental properties in two different buckets. You have the reliable bucket and then the extra bucket. And you may divide it out. I may say that, you know, $1,000 of it is reliable income. And I really can treat it that way. But I might be able to get more than $1,000 is that cash flow. But the rest I want to treat more as a variable component of income. All right. So here's an example. Let's say that you're retiring off of rental income. And for the last three years, your rental properties, let's say three years ago, your net rental income, annual net rental income, was $37,000. Two years ago, your annual net rental income was $42,000, and then last year it was $40,000, right? So the range in the last three years was between $37,000 to $42,000 in net passive cash flow after expenses. Let's say that you want to retire on this.

What you could do is pick that lowest number or maybe even go a little bit below it and say, you know what, $35,000 a year is what I can reliably count on. And then anything extra is a bonus. So that $35,000 a year will be the maximum amount of money that I spend on groceries, utilities, my own renter mortgage payments. You know, I'll keep my basic, basic cost of living to that. And then if I have a good year and I end up getting $45,000 in rental income instead of only $35, then awesome. I've got an extra $10 grand that I can use to spend skiing and kayaking and traveling and going to Fiji. You know, I've got. that extra money for all of these fun things, but if I don't have it, that's cool too, because I know I at least have enough to cover my basic, basic bills. So if you do retire on rental income, that's the way that you can conceptualize that income in two buckets, the needs bucket and the wants bucket. So that is chief takeaway number two from this conversation. And then takeaway number three, and this is closely related, is that no matter how you are

retiring, whether it's based on rental income or index funds, broadly speaking, think about your retirement in terms of the baseline income that you need. Wade refers to this as your longevity income, your cost of living income. So think about that in one bucket. And then in the other bucket, think about the extra money that you want. That's what Wade refers to as the lifestyle bucket. I think probably an easier way of saying this is your wants bucket and your needs bucket. So no matter how you're going to retire, conceptualize your sources of retirement income as falling into one of these two buckets. And then ask yourself how you want to fill each bucket.

So Wade, for example, Wade is a proponent of the safety first model. So he might suggest something like using an income annuity to cover your needs and then using stocks or market investments to cover your wants. I'm not a big annuities person. So, you know, a modified version of this, especially for an early retiree, might be that your rental income could cover your needs and your side hustle income could cover your wants. or another modified version of this could be that you create a bond ladder. That bond ladder covers your needs and then your returns that come from index funds cover your wants. So there are all kinds of modifications that you can make in which you have a group of assets that are a little bit more reliable and those cover your needs in retirement. And then you have a different group of assets that are less reliable.

They have more volatility, more variable income, but a potentially higher probability of return over. a long term, and those cover your wants because, you know, if they don't pan out for a year or two, that's fine. So that is takeaway numbers two and three, really, is put your retirement income into two different buckets and then choose the assets that are most appropriate for each bucket. Finally, takeaway number four is to consider a U-shaped model for your stock allocation, especially if you do retire early because, again, a sequence of returns risk is so, is going to to be such a major component of shaping your retirement that, sure, it makes sense to lower your stock allocation right at retirement, but there is an argument for, as counterintuitive as it may

sound, there is an argument for then increasing your stock allocation as you get away from your retirement date, because as Wade says, your risk capacity is not actually related to your timeline, your risk capacity is related to your ability to absorb volatility without it massively impacting your lifestyle. And so if you're flexible, then you have a higher risk capacity. And that means that you can have more stock exposure even as you are retired, even in your retirement. And so for all of those reasons, a U-shaped retirement model could actually be a pretty decent idea. So those are four takeaways that I got from this conversation with Wade Fow. Hey there, this is Paula Pan.

Recording from Tokyo, Japan, once again. I hope you enjoyed that interview with Dr. Wade Fow, which we originally aired in summer of 2018. Before we sign off, I just wanted to share one final reminder that we are reopening enrollment for our course, Your First Rental Property, this week only. So from September 23rd through September 30th, 2019, we're opening the doors for enrollment for the fall semester. We only open enrollment twice a year. We have spring semester and fall semester.

So if you want to join our fall semester cohort, this is the week that you can enroll. It's the only week that will allow enrollment. After this, we close our doors and we're not letting any new students join us until the spring of 2020. If you'd like to learn more, go to afford anything.com slash enroll. Now, this is for our course, your first rental property. As the name implies, actually as the name blatantly states, it's for people who want to buy their first rental property. So if you are a beginner rental property investor and you are looking for a step-by-step roadmap to guide you through this course, then this is the course for you.

This is the A to Z that can get you from novice to successful first-time rental property investor. Again, all the details are at Affordanithing.com slash enroll so you can go there to learn more about it. Affordanithingcom slash enroll. Thank you so much for tuning in. I'm coming to my last few days in Tokyo. If you want to check out some photos of my travels, read some travel stories, you can follow along on Instagram. I'm there at Paula P-A-U-L-A, P-A-N-T. Big thanks to our sponsors for today's episode, Radius Bank, ZipRecruiter, Blinkist, and Figs.

If you enjoyed today's episode, please share it with a friend or a family member. That's one of the best things that you can do to share the message of financial independence and to spread the word about the importance of retirement planning, which is a topic that improves people's lives. I mean, the difference between going into retirement prepared versus going into retirement anxious and unprepared, game changer. So share this with a friend or a family member, spread the word about the importance of setting yourself up so that future you will look back and be like, wow, I'm glad I did that. Thank you so much for tuning in.

Once again, my name's Paula Pant, recording from Tokyo. Make sure that you are subscribed to this podcast, and I will catch you next week. See ya.