Trinity study
Encyclopedia
In finance, investment advising, and retirement planning, the Trinity study is an informal name used to refer to an influential 1998 paper by three professors of finance at Trinity University
. It is one of a category of studies that attempt to determine "safe withdrawal rates" from retirement portfolios that contain stocks
and thus grow (or shrink) irregularly over time.
Its conclusions are often encapsulated in a "4% safe withdrawal rate rule-of-thumb." It refers to one of the scenarios examined by the authors. The context is one of annual withdrawals from a retirement portfolio containing a mix of stocks
and bonds
. The 4% refers to the portion of the portfolio withdrawn during the first year; it's assumed that the portion withdrawn in subsequent years will increase with the CPI index to keep pace with the cost of living. The withdrawals may exceed the income earned by the portfolio, and the total value of the portfolio may well shrink during periods when the stock market performs poorly. It's assumed that the portfolio needs to last thirty years. The withdrawal regime is deemed to have failed if the portfolio is exhausted in less than thirty years and to have succeeded if there are unspent assets at the end of the period.
The authors backtested a number of stock/bond mixes and withdrawal rates against market data compiled by Ibbotson Associates covering the period from 1925 to 1995. They examined payout periods from 15 to 30 years, and withdrawals that stayed level or increased with inflation. For level payouts, they stated that "If history is any guide for the future, then withdrawal rates of 3% and 4% are extremely unlikely to exhaust any portfolio of stocks and bonds during any of the payout periods shown in Table 1. In those cases, portfolio success seems close to being assured." For payouts increasing to keep pace with inflation, they stated that "withdrawal rates of 3% to 4% continue to produce high portfolio success rates for stock-dominated portfolios."
The authors make this qualification:
Other authors have made similar studies using backtested and simulated market data, and other withdrawal systems and strategies.
The Trinity study and others of its kind have been sharply criticized, e.g. by Scott et al. (2008), not on their data or conclusions, but on what they see as an irrational and economically inefficient withdrawal strategy: "This rule and its variants finance a constant, non-volatile spending plan using a risky, volatile investment strategy. As a result, retirees accumulate unspent surpluses when markets outperform and face spending shortfalls when markets underperform."
Laurence Kotlikoff
, advocate of the consumption smoothing
theory of retirement planning, is even less kind to the 4% rule, saying that it "has no connection to economics.... economic theory says you need to adjust your spending based on the portfolio of assets you're holding. If you invest aggressively, you need to spend defensively. Notice that the 4 percent rule has no connection to the other rule—to target 85 percent of your preretirement income. The whole thing is made up out of the blue."
Ironically, the 4% rule of thumb would, in many instances, mandate a more frugal level of retirement expenditures than a portfolio that was fully invested in government inflation-indexed bonds, such as U.S. Treasury Inflation Protected Securities (TIPS). As of mid-October 2008, Treasury Inflation Protected Securities (TIPS) boasted real yields of approximately 3%. A laddered, 100%-TIPS portfolio yielding 3% real would sustain a 5% safe withdrawal rate over a 30-year period. A 100%-TIPS portfolio yielding 3% real would not only be less volatile than a diversified, part-stock portfolio, but also safely sustain a much more generous level—25% more generous, in fact—of retirement expenditures than a diversified portfolio to which the "4% rule" was applied. While a 3% real TIPS yield is well above historical averages for TIPS yield, even a TIPS portfolio that yielded only 1.3% real would sustain a 4%, inflation-adjusted, safe withdrawal rate over a 30-year period.
The original Trinity study was based on data through 1995. An update of their results using data through 2009 is provided in Pfau (2010). Shortly afterwards, the original authors of the Trinity Study published an updated study, also using data through 2009
.
The procedure for determining a safe withdrawal rate from a retirement portfolio in these studies considers only the uncertainty arising from the future returns to be earned on the investment. Another major uncertainty is the amount of spending that will be required each period to provide a given standard of living. For instance, there is a small chance each period of an emergency arising that will require a large extra withdrawal that may be comparable in size to the loss from a financial bear market. An example is major repairs to a home not covered by insurance caused by water incursion. The effects of such possible emergencies in addition to uncertain investment returns are considered in Pye (2010). Under conditions where a 4 percent withdrawal might otherwise be reasonably sustainable, reasonable assumptions about the chances for an emergency each year and its cost reduce the withdrawal from 4 to about 3 percent.
This latter analysis also differs by using the Retrenchment Rule to determine the value of the withdrawal each period. This rule is discussed in Pye (2010) and also Pye (2011). When using the Retrenchment Rule the default withdrawal each period is the prior withdrawal adjusted for inflation as in the earlier studies. There are conditions, however, when this default withdrawal is not applicable. In particular, the initial withdrawal is related to the prior standard of living of the retiree, not just the withdrawal that is reasonably sustainable. Also, the withdrawal for a period is reduced when a test indicates that such retrenchment is necessary. This occurs when the risk of running out of funds before the end of a plan has become too high given the size of the then current withdrawal and the funds that remain.
Trinity University (Texas)
Trinity University is a private, independent, primarily undergraduate, university in San Antonio, Texas. Its campus is located in the Monte Vista Historic District and adjacent to Brackenridge Park....
. It is one of a category of studies that attempt to determine "safe withdrawal rates" from retirement portfolios that contain stocks
Stocks
Stocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...
and thus grow (or shrink) irregularly over time.
Its conclusions are often encapsulated in a "4% safe withdrawal rate rule-of-thumb." It refers to one of the scenarios examined by the authors. The context is one of annual withdrawals from a retirement portfolio containing a mix of stocks
Stocks
Stocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...
and bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
. The 4% refers to the portion of the portfolio withdrawn during the first year; it's assumed that the portion withdrawn in subsequent years will increase with the CPI index to keep pace with the cost of living. The withdrawals may exceed the income earned by the portfolio, and the total value of the portfolio may well shrink during periods when the stock market performs poorly. It's assumed that the portfolio needs to last thirty years. The withdrawal regime is deemed to have failed if the portfolio is exhausted in less than thirty years and to have succeeded if there are unspent assets at the end of the period.
The authors backtested a number of stock/bond mixes and withdrawal rates against market data compiled by Ibbotson Associates covering the period from 1925 to 1995. They examined payout periods from 15 to 30 years, and withdrawals that stayed level or increased with inflation. For level payouts, they stated that "If history is any guide for the future, then withdrawal rates of 3% and 4% are extremely unlikely to exhaust any portfolio of stocks and bonds during any of the payout periods shown in Table 1. In those cases, portfolio success seems close to being assured." For payouts increasing to keep pace with inflation, they stated that "withdrawal rates of 3% to 4% continue to produce high portfolio success rates for stock-dominated portfolios."
The authors make this qualification:
Other authors have made similar studies using backtested and simulated market data, and other withdrawal systems and strategies.
The Trinity study and others of its kind have been sharply criticized, e.g. by Scott et al. (2008), not on their data or conclusions, but on what they see as an irrational and economically inefficient withdrawal strategy: "This rule and its variants finance a constant, non-volatile spending plan using a risky, volatile investment strategy. As a result, retirees accumulate unspent surpluses when markets outperform and face spending shortfalls when markets underperform."
Laurence Kotlikoff
Laurence Kotlikoff
Laurence Jacob Kotlikoff is a William Warren FairField Professor at Boston University, a Professor of Economics at Boston University, a Fellow of the American Academy of Arts and Sciences, a Research Associate of the National Bureau of Economic Research, a Fellow of the Econometric Society, a...
, advocate of the consumption smoothing
Consumption smoothing
Consumption smoothing is the economic concept used to express the desire of people for having a stable path of consumption.Since Milton Friedman's permanent income theory and Modigliani and Brumberg life-cycle model, the idea that agents prefer a stable path of consumption has been widely accepted...
theory of retirement planning, is even less kind to the 4% rule, saying that it "has no connection to economics.... economic theory says you need to adjust your spending based on the portfolio of assets you're holding. If you invest aggressively, you need to spend defensively. Notice that the 4 percent rule has no connection to the other rule—to target 85 percent of your preretirement income. The whole thing is made up out of the blue."
Ironically, the 4% rule of thumb would, in many instances, mandate a more frugal level of retirement expenditures than a portfolio that was fully invested in government inflation-indexed bonds, such as U.S. Treasury Inflation Protected Securities (TIPS). As of mid-October 2008, Treasury Inflation Protected Securities (TIPS) boasted real yields of approximately 3%. A laddered, 100%-TIPS portfolio yielding 3% real would sustain a 5% safe withdrawal rate over a 30-year period. A 100%-TIPS portfolio yielding 3% real would not only be less volatile than a diversified, part-stock portfolio, but also safely sustain a much more generous level—25% more generous, in fact—of retirement expenditures than a diversified portfolio to which the "4% rule" was applied. While a 3% real TIPS yield is well above historical averages for TIPS yield, even a TIPS portfolio that yielded only 1.3% real would sustain a 4%, inflation-adjusted, safe withdrawal rate over a 30-year period.
The original Trinity study was based on data through 1995. An update of their results using data through 2009 is provided in Pfau (2010). Shortly afterwards, the original authors of the Trinity Study published an updated study, also using data through 2009
.
The procedure for determining a safe withdrawal rate from a retirement portfolio in these studies considers only the uncertainty arising from the future returns to be earned on the investment. Another major uncertainty is the amount of spending that will be required each period to provide a given standard of living. For instance, there is a small chance each period of an emergency arising that will require a large extra withdrawal that may be comparable in size to the loss from a financial bear market. An example is major repairs to a home not covered by insurance caused by water incursion. The effects of such possible emergencies in addition to uncertain investment returns are considered in Pye (2010). Under conditions where a 4 percent withdrawal might otherwise be reasonably sustainable, reasonable assumptions about the chances for an emergency each year and its cost reduce the withdrawal from 4 to about 3 percent.
This latter analysis also differs by using the Retrenchment Rule to determine the value of the withdrawal each period. This rule is discussed in Pye (2010) and also Pye (2011). When using the Retrenchment Rule the default withdrawal each period is the prior withdrawal adjusted for inflation as in the earlier studies. There are conditions, however, when this default withdrawal is not applicable. In particular, the initial withdrawal is related to the prior standard of living of the retiree, not just the withdrawal that is reasonably sustainable. Also, the withdrawal for a period is reduced when a test indicates that such retrenchment is necessary. This occurs when the risk of running out of funds before the end of a plan has become too high given the size of the then current withdrawal and the funds that remain.