One of the questions I hear most frequently from Thrift Savings Plan participants is: “Should I be contributing the maximum amount to my TSP account?”

The answer depends upon each individual’s circumstances, resources and expectations. For example, your age, health, marital status and number and age of dependents will have an impact on the answer. So will the amount you already have saved, including your investments, pension and other assets. The age at which you plan to retire, the amount of money you expect to be able to earn, save and inherit, rates of inflation, the amount of money you expect to receive from pensions and the lifestyle you plan to enjoy in retirement are also critical to the decision. In short, to answer intelligently, the retirement savings question can require a fair amount of complex analysis weighing many factors.

It is also important to note that it is usually preferable to err on the conservative side when making your estimates. Running out of money too soon, for most people, is the most unacceptable result of the planning process. Your approach to the retirement savings decision should also be influenced by the time you have remaining until retirement. Younger people are subject to greater risk of error since they are forced to predict events farther into the future, and should carry a greater bias toward saving more money — just in case.

One of the best ways to plan for retirement is to use something called Monte Carlo simulation. This is a type of scenario analysis that repeatedly simulates many individual lifetimes — usually thousands — while varying life expectancies and annual investment returns during each simulation. This allows you to ask, “What if?” over and over to see what circumstances must occur to cause your plan to fail. Not all Monte Carlo simulation software is the same. The results can vary widely with the assumptions about investment performance that are used. You may want to seek professional help before you make a decision based on Monte Carlo simulation.

In the absence of a thorough retirement savings analysis, you may want to use a rule of thumb to help you decide how much to save in your TSP account. You can work backwards with one widely accepted rule of thumb that says the maximum withdrawal rate from a diversified, balanced investment account should not exceed 5 percent per year.

To figure out how large your TSP account should be to make possible the withdrawals you expect to take, follow these steps:

  1. Estimate how much annual income you will need in retirement.
  2. Subtract from that any income you expect to receive from annuities and sources other than your TSP account. The remainder will be the amount you will need to withdraw annually from TSP in retirement.
  3. Divide the TSP annual withdrawal figure by 5 percent, the maximum withdrawal rate recommended in the rule of thumb above. The result of the division shows the balance you will need in your TSP account at retirement to make it possible for you to withdraw the amount you need at a level that does not exceed 5 percent of your total. The 5 percent figure factors in the effects of inflation, investment returns and depletion of the account.
  4. Estimate the rate of savings required to accumulate the TSP balance you need. For example, to accumulate savings of $100,000, I recommend saving $7,600 per year if you have 10 years to save; $2,900 per year if you have 20 years; $1,400 per year if you have 30 years; and $800 per year if you have 40 years. These figures assume that savings deposits are made at the beginning of each year, accumulate tax-deferred and earn an average annual real rate of return (nominal rate minus the rate of inflation) of 5 percent.

So, for example, if you currently earn $50,000 per year, would like to enjoy 80 percent of this income in retirement, have 30 years until you plan on retiring, and expect to receive about half of your employment income from pension income, the calculation would be as follows:

  • $50,000 times 0.8 equals $40,000 per year — the amount of retirement income you expect to need.
  • $40,000 minus $25,000 pension income equals $15,000 — the amount you will need to withdraw from TSP annually to meet your income needs.
  • $15,000 divided by 0.05 equals $300,000 — the balance you will need in your TSP account at retirement to make it possible for you to withdraw $15,000 per year at a rate of 5 percent of your account balance.
  • If saving $1,400 per year over 30 years amounts to $100,000, then three times $1,400, or $4,200, would be the annual savings required to accumulate $300,000 over 30 years.
  • $4,200 per year is about 8.4 percent of your current income.

The 5 percent withdrawal rate, to be sustainable over 30 years, leaves little room for error or deviation from the plan, and may be a bit optimistic for all but the most aggressive personalities. You may wish to try the calculations to estimate the savings required for a 3 percent or 4 percent withdrawal rate.

Written by Mike Miles
For the Federal Times
Publication January 17, 2005