A Framework for Personal Finance

Here’s how to retire: save up 25x your annual expenses, dump it into an investment account with lots of stocks and maybe a handful of bonds, and hit the fuckin’ bricks. Easy peasy lemon squeezy, right?

This is usually called “The 4% Rule” and it just might be the golden rule of the personal finance communities. The rule comes from an academic paper, now informally referred to as “The Trinity Study” (Cooley et al, 1998, Trinity University).

Specifically, the authors of the study conclude that with a portfolio of 75% stocks and 25% bonds, a retiree can pretty safely withdraw 3–4% of the starting balance per year for a payout period of 30 years, each year adjusting for inflation. So to cover your annual expenses with 4% withdrawals, your starting balance would need to be 25x your expenses (1/25 = 0.04).

But what exactly is meant by pretty safe? The evaluation of risk is essential to any serious discussion of retirement planning, and The Trinity Study offers us an intuitive and useful approach in this regard. The authors wrote a computer program to simulate various strategies (varying withdraw rate, payout period, and asset allocation) on several spans of real historical data, and then reported the portfolio success rate for each strategy—the percentage of historical spans in which the portfolio did not run out despite regular annual withdrawals. So in the particular scenario given above, pretty safe means upwards of 98% success rate.

the approach: specify a retirement strategy, simulate carrying that strategy out in a variety of market conditions, evaluate the risk according to the success rate

While the 4% Rule has been enormously influential and useful to the world of personal finance, focusing on it alone is sort of missing the forest for one tree (albeit quite a fruitful one). Any rule-of-thumb is bound to fall short of the full utility of the more generalized approach. The scenarios examined in the study are, by necessity, highly simplified compared to more realistic retirement strategies. Two simplifications pointed out by the authors are tax considerations and transaction costs. The good news is that the approach extends very naturally to more sophisticated retirement strategies.

Taking full advantage of the Trinity Study approach

There are two components to capturing the value the 4% Rule is leaving on the table:

1. the means to create a very detailed financial plan

2. a ridiculously good simulation engine for carrying out that plan

In order for a rule-of-thumb to be useful to a wide audience, a lot of simplifying assumptions must be made. With a personalized plan this is no longer a constraint. This means one can encode information about their salary, expenses, debt, investment contributions, etc and any anticipated changes to these values over time, for example, increasing investment contributions after paying off debt.

While it’s perfectly possible to sit down at the kitchen table with a pen and a paper and write out a plan like the one above, it’s very difficult to say with any confidence how sound this plan is. With a simulator, one can put their plan to the test and get an idea of how it is likely to perform and how risky it is. Perhaps the critical feature of a good simulator is that it can carry out the plan in lots of potential market conditions and provide a measurement of risk, such as reporting the portfolio success rate.

With these two components, a framework for personal finance starts to take shape.

the framework: make a detailed plan, carry it out in the simulator, evaluate the outcome including risk

This should sound familiar because it’s basically the same as the approach highlighted above, but now with sophisticated tools in the hands of the to-be-retiree. With this generalized framework, two things become possible:

1. quickly iterating on a plan to hone in on specific goals (such as minimizing retirement age or maximizing annual spending allowance)

2. comparing two plans with a single critical difference (such as buying a home vs. renting, paying off debt vs. investing, or contributing to a pre-tax vs. post-tax retirement account)

This is much more powerful than simply relying on the 4% Rule.

The idea that the Trinity Study approach can be extended to uncover more generally applicable financial insight is the motivation (and inspiration) behind Syrplus. We are building a high-fidelity simulation tool that allows to-be-retirees to run their own highly tailored and much more sophisticated version of the Trinity Study.

To get early access to the tool, sign up here!

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