Have recent declines in the value of your Thrift Savings Plan account got you worried about your retirement plan? If so, don’t blame the TSP funds or the markets, blame your plan.

The markets are doing what markets do – go down from time to time. This is an inevitable part of investing in risky assets, like company stock. Why would something that is predictable drive you to react with worry? Many investors nearing or already in retirement worry because they have failed to plan properly.

Planning should start by identifying, quantifying and timing your life and financial goals. This can be timeconsuming and, in some cases, difficult. The objective is to determine what cash flows will be demanded from your TSP account and when they will be needed. Once you have some idea of where you want to be, you can identify the investment strategy – aggressive, conservative or something in between – that is most likely to get you there.

If you’re losing sleep over whether you can afford to retire every time the stock market goes down by 5 percent, 10 percent or even 20 percent, something is wrong with your retirement plan or investment strategy. Either your plan has not adequately accounted for the expected behavior of your investment strategy or your investment strategy was not configured to work with your plan.

In the old days, when computing power was insufficient to make good planning techniques widely available to planners, the problem was usually that the plan didn’t accommodate the real-world results produced by the investment strategy. Planners routinely assumed that a particular strategy – say, investing 60 percent in stocks and 40 percent in bonds and rebalancing annually – would produce a given rate of return – say, 9 percent per year – in the future. They usually based this expectation on a sample of historical data for a similar mix of investments.

The planner would create a model – probably just a spreadsheet – in which a hypothetical retirement would be simulated. Each hypothetical year, withdrawals would be taken from the portfolio to support retirement spending, and a return – in this case, 9 percent of the previous year’s ending balance – would be added to the portfolio.

This is where the problem occurred. Even the most complex spreadsheet was useless because of the false assumption about the investment portfolio’s behavior – 9 percent return every year, like clockwork.

Even attempts to be conservative by reducing the expected annual rate of return to 8 percent or 7 percent, or lower, failed to solve the problem. Investors who are expecting 7 percent, instead of 9 percent, are hardly going to be comfortable when their portfolios produce a 10 percent loss during a year in which they are in need of reliable retirement income. These concerns are well founded given that a coincidence of bad investment performance with substantial withdrawals can cripple a retirement plan.

In other cases, investors are either unaware of, or simply ignore, the downside risk inherent in a particular investment strategy. Investment strategies are sometimes purchased like lottery tickets – for what might happen rather than what probably will happen. You know you’ll need a significant stream of income from your TSP account in retirement, so why not go for the strategy with the maximum upside potential? Because the strategy’s risks may make you broke before the potential payoff arrives, that’s why.

When it comes to managing retirement investment portfolio, risk should always come before reward. First, identify the maximum amount of downside risk that your retirement plan can tolerate, without failing, and then consider only strategies with no more than that amount of risk.

If a 10 percent loss in your TSP accounts value in a year means your retirement plan is in trouble, you shouldn’t have been invested entirely in the C, S and I funds.

Riskier investments can bring with them the potential for greater returns. Invest in the S Fund, and you should expect a greater rate of return than you would from the F Fund. But, you should also expect more frequent and larger losses, from time to time.

The recent action in the TSP’s equity funds isn’t unusual, it’s exactly what you, and your retirement plan, should expect.

Written by Mike Miles
For the Federal Times
Publication May 5, 2008