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A Deep Dive Into Retirement Planning
The Trinity Study
To understand the Safe Withdrawal Rate, we must first understand the Trinity Study.
The Trinity Study is the informal name given to a 1998 paper by three professors of finance at Trinity University. By analyzing data from 1925 to 1995, it was concluded that a retirement account Safe Withdrawal Rate of 4% per year could be established with a very high rate of success; remaining funds would continue to grow enough to match or exceed the 4% drawn.
A powerful effect of the study is to point retirement back at spending instead of pre-retirement income. This underscores a fundamental aspect of the FIRE movement - frugality.
Determining the Safe Withdrawal Rate
The first step in planning for retirement is understanding how we will need in retirement. The closer you are to stepping away from the 9-5, the easier this will likely be. I'm on a longer track, so instead I have to make assumptions based on the information I have right now. As the information changes, so does my plan.
So what do I know now with a great deal of certainty? I know how much I spent last year (and last quarter, last month, and any other time frame for the last ten years) thanks products such as Personal Capital and Mint.
I also know how to notice trends. The electricity budget rises in the summer months for us, whereas the gas budget is higher in the winter. I can even see how much, on average, these costs have increased over the last several years.
Based on this, I can predict how budgets are likely to change into the future. Is this 100% accurate? Not until I'm looking at it through the rear-view mirror, but at least I have a point of reference.
Combine tracking tools, the spreadsheet for future predictions, and calculations on debt pay-offs, and I can get a sense of how much will be needed in retirement - around $30,000 per year. In fact, this number is potentially high considering many of the expenses should drop post-retirement (e.g. gasoline cannot possibly cost the same as it did when I drove to work each day).
Solving for X
Now that we know expected spending during retirement, let's see how the Trinity Study applies. $30,000 / year represents our living expenses, which should equal 4% of our total retirement accounts if we are viewing it as the Safe Withdrawal Rate. Setting up the equation:
Therefore, when our retirement accounts reach $750,000, we are likely to be able to withdraw $30,000 each year for the rest of our lives! Is this a sure thing? No, of course not, but this represents reasonable expectations given the last hundred years of market data.
Even more importantly, this $30,000 per year does not assume cutting back on expenses in retirement. Each year we have a vacation budgeted (made easier by travel rewards cards), entertainment, dining out, and other items for a relatively luxurious life.
Building a Buffer
Rather than basing estimations on $30,000 annually, we actually use $40,000. Why? That extra $10,000 per year acts as a cushion for living a dream life. Maybe we decide we want to travel more often than currently planned, for instance.
And even if we don't necessarily spend more than we do now on discretionary spending, what if I have grossly underestimated the cost of medical expenses? The extra $10,000 per year covers the cost of my ignorance. It is the price of peace of mind.
As we get closer to retirement, this margin of error will likely shrink.
How does this change our retirement account calculations?
To review, $1 million in retirement accounts gives us a reasonable expectation of pulling $40,000 out each year in perpetuity. Since we only need $30,000, this setup offers a higher level of protection.
There's even more benefit to this setup. Remember that I actually only need $30,000 according to my calculations. If I am correct in my planning, I don't have to withdraw $40,000.
I can play things a bit more lean in one year, reducing the strain on my retirement accounts (the 4% rule becomes the 3% practice). Or if we need more in another year due to unforeseen expenses, the money will more likely be there.
One of the great things about the Trinity Study is that numbers are inflation-adjusted. Expected market returns and the Safe Withdrawal Rate both take inflation into account
As an additional confidence-builder, I model retirement account growth at 5% annually. Long-term economic growth is typically considered at 7% to 10% or more. Using 5% is conservative and would represent a worse-case scenario.
The Trinity Study sets up the concept of a Safe Withdrawal Rate, which points retirement planning back to the spending-side of the equation.
With a few tools and conservative planning, it is possible to estimate how much will be needed before retirement.
What do you think about this logic for retirement planning? How do you plan for your number - do you use a similar method or base it off income? Is early retirement on the table for you? Let me know in the comment section!