It seems appropriate, given the stock market’s – and hence, your Thrift Savings Plan balance’s – recent declines, to discuss one of the largely unrecognized realities of retirement planning. Every time a retirement plan is developed, refined and put into operation, risk is accepted. The risk is that the plan won’t work out as expected. Unfortunately, this risk is often overlooked and rarely dealt with by those accepting the risk or their advisers.
This risk comes from a number of sources, including some that are more or less under your control, like your goals, and others that are largely beyond your control, like an unexpected death or illness or problematic investment performance.
I’ll focus here on the risk inflicted on your retirement plan by your investment fund. This risk is unavoidable if you have invested assets that you’re relying on to provide income.
The investment industry and, therefore, most investors seem to focus exclusively on short-term price fluctuation, or volatility, when it comes to investing. Most investors consider a low-volatility investment strategy to be a low-risk strategy.
I encourage investors to instead define risk as the probability that an investment strategy will produce results that fail to support their goals. An all-too-common mistake, particularly after markets have fallen sharply, is to implement an investment strategy that will produce little volatility but is highly likely to fail to support the planned spending over a lifetime.
The problem, in this case, is that it is easy to see the short-term risk of volatility, but without the proper analysis, it is impossible to see the long-term risk of insufficient return.
Consider a 60-year-old woman retiring with a $100,000 TSP account balance. If she’s in average health, she can expect to live to around age 87, or another 27 years. Of course, she could live longer and has about a 20 percent chance of living at least to age 94, another 34 years.
According to my estimates, based on life expectancy data, if she invested her TSP account balance in the least volatile option, the G Fund, she could expect to withdraw about $4,300 per year, every year, adjusted for inflation, for as long as she lives. The expected value of the account at the end of her life would be about $41,000, in today’s dollars.
Alternately, she could invest her account in what I would call a growth allocation – 55 percent in the C Fund, 25 percent in the S Fund, 10 in the I Fund and 10 percent in the F Fund – rebalance it annually, and expect to withdraw $6,700 per year, every year, adjusted for inflation, for as long as she lives. In this case, the expected value of her account at the end of her life would be about $206,000, in today’s dollars.
The more aggressive growth allocation can be expected to support a higher withdrawal rate and produce a larger ending balance than the more predictable G Fund allocation. So, why wouldn’t this investor choose to go growth?
Well, she might, but she shouldn’t until she understands that, even though both plans have the same probability of success in the end, the plan based on the growth allocation carries a higher risk of needing to be changed in the future solely to compensate for worst-case investment performance.
In fact, the growth plan is about three times more likely to need adjustment – say a decrease in the withdrawal rate – during the first year than the G Fund plan. The actual odds that the plans will need adjustment: about one in five for the growth plan, and one in 15 for the G Fund plan.
These odds are useful in helping to select the right investment strategy for each investor.
They are also instructive in reminding us that every financial plan is only as good as the information we have at our disposal when it is prepared, and that it may need to be adjusted as the future unfolds.
While more aggressive investment strategies can produce higher withdrawal rates and portfolio values, their increased volatility also produces risk that should be considered as part of the planning process. Even the best-laid plans are subject to change.
Written by Mike Miles
For the Federal Times
Publication January 28, 2008