In my Aug. 8 column, I suggested Thrift Savings Plan participants consider their life expectancies, rather than the date they expect to begin making withdrawals, as the time horizon by which they choose one of TSP’s new L Funds. This strategy can produce superior withdrawal rates during retirement if, for example, it leads a new retiree with 30 or more years of life expectancy to select the most aggressive L Fund allocation instead of the most conservative.

This week, I’ll conduct additional analysis to determine whether the most aggressive L Fund allocation, which includes some fixed-income securities, is aggressive enough to meet the needs of every participant.

The L Fund’s most aggressive offering is currently its 2040 portfolio, which is intended for participants who will not begin withdrawing their money for at least 30 years. It is allocated most heavily in the TSP’s three stock funds with 42 percent to the C Fund, 18 percent to the S Fund and 25 percent to the I Fund; and the remainder in fixed-income funds, with 5 percent in the G Fund and 10 percent in the F Fund. For those of us who like to keep track of such things, that’s a split of 85 percent investment in equities and 15 percent in fixed-income funds. Further, a little more than 29 percent of the equity investment is allocated to the stocks of developed foreign countries.

According to data from the Center for Research in Securities Prices, the median compound average annual rate of return for taxable bonds during any consecutive 30-year period from 1926 to 2003 was 3.91 percent. The same statistic for large-cap domestic stocks was 10.82 percent; and for small-cap domestic stocks, 14.62 percent. So, based on this sample, the expected return for stocks is about three or four times greater than for bonds. It’s also interesting to note that the lowest 30-year rate of return in the sample for stocks was 8.47 percent, which means that a fully diversified portfolio of stocks, invested during any 30-year period since 1926 did not lose money. In fact, it almost certainly earned significantly more than its less risky all-bond counterpart.

A rational investor who does not plan to withdraw any money for 30 years or more will find it hard to justify holding a significant quantity of fixed-income securities, if any, in their portfolios. Based on the numbers presented above, a $100 investment in bonds can be expected to produce a terminal value, before taxes, of about $316 in 30 years. The same $100 invested in large-cap stocks can be expected to return about $2,180 over the same period. This difference explains why young investors should generally favor stocks over bonds in their retirement portfolios.

Even a difference in the compounded rate of return of one percentage point over the course of 30 years will have the effect of increasing the resulting account value by over 30 percent. This advantage is achievable by moving from the L Fund 2040’s asset allocation to one composed entirely of the C, S and I funds, without any investment in the G Fund or F Fund.

What about allocating your money once you are near or actually in the retirement withdrawal period? Is the L Fund’s most aggressive mix too conservative? I think that the answer should depend upon your time horizon at this point, as well. If you, as in the example above, are beginning the withdrawal phase of your TSP account’s life with the potential for 20, 30 or more years ahead of you, you should be careful not to adopt an overly conservative investment strategy. However, once withdrawals begin, the investor’s emphasis usually shifts from maximizing the account’s value to determining the amount that can be safely withdrawn from the account during the participant’s or a spouse’s lifetime. In this case, the benefit of trying to improve upon the L Fund’s most aggressive asset allocation is likely to be marginal and not worth the time and effort it would require to develop and maintain such a strategy.

Written by Mike Miles
For the Federal Times
Publication August 22, 2005