Editor’s note: This is part 2 of a 3-part series on TSP investing.
The first article in this series covered TSP contribution strategies. For most federal employees, the TSP is one of their most valuable assets. It is also the one they have the most control over. A federal annuity is based on a specific formula and the value of a home depends on the real estate market, neither of which most people have any control over. The TSP, however, can be greatly affected by the investment allocation decisions an employee makes. There are several factors that should be considered before deciding on this allocation:
There are many “rules of thumb” and strategies for determining the right portfolio allocation for any particular situation. They might depend on income, savings, age, and retirement date, among other factors. One key factor that is missing in any universally applied recommendation, though, is personal risk tolerance. Risk tolerance is a measure of the amount of risk you as an individual are willing to comfortably take. There are some people early in their career who ideally should be investing aggressively, but can’t stomach the thought of their balance dropping by 10%. Conversely, there are also people who have been retired for 10 years and are still comfortable having almost all of their funds in the riskier C, S, and I funds. Where you fall on that scale will be up to you to determine, and will affect how you implement your desired investment strategy.
Many factors can affect a retirement plan, including balances, returns, and withdrawal rates. One of the most profound considerations, though often overlooked, is the effect of inflation. Inflation can be overwhelming when the withdrawals necessary to maintain a standard of living begin to increase significantly, depleting an account balance faster than anticipated. Once that starts to happen, it is a snowball effect as the next withdrawal amount becomes even higher and there is less of a balance with which to earn an offsetting return.
As people live longer, this detrimental effect takes an even bigger toll as it has even longer to compound. For that reason, it is usually recommended to maintain at least some exposure to investments that typically rise with inflation, such as higher risk equity investments.
The concept of diversification is a basic one for investing, and simply means that all of your eggs shouldn’t be in one basket. The five primary TSP funds are all well diversified for their target markets, so there usually isn’t a need for other funds of a similar class. Despite that, it usually makes sense to ensure you have some level of diversification among the different TSP options as well. That could mean including all five in your overall allocation, though the amounts would depend on your risk tolerance and overall plan.
When considering your investment strategy for TSP, it is important not to overlook the value of the other portions of your retirement, particularly the federal annuity. Once you have an estimate of your expected annuity payment, you can then begin to estimate the value of that benefit as if you had it in cash up front. The multiplier will vary based on your age, but for estimating purposes you can figure the present value of your annuity is approximately 25-30 times the yearly payout. For many FERS employees, that can be from $500,000 to over $1,000,000. If you consider that this amount is guaranteed, it can change how you look at the rest of your investment portfolio and how much risk you are willing to take with it.
Getting Closer to Retirement
Early in your career, while you are regularly contributing to TSP, dips in the market are not desired but are much more manageable than later in life. You have time to ride them out, and continue to increase your balances through additional contributions. You also have the option of continuing to work longer if you find it necessary.
As you near retirement (and while actually retired), your ability to add contributions is gone, and your timeframe for riding out market upheaval is much more restrictive. It is for that reason that most people move to a more conservative allocation over time.
Another consideration when nearing retirement is your actual preparedness itself. If you have a solid retirement income plan put together that is comfortable while only requiring modest investment returns, you can enjoy your retirement in relative peace without having to take on much additional risk. In essence, once you’ve won the game, you can stop playing. If your plan is not as secure, though, making it work may require some additional returns that may not be achievable with an overly conservative portfolio. In that instance, some additional risk may be necessary to have a better chance at success.
Many people understand that their TSP savings is an important part of their future retirement, but do not have the knowledge, experience, or desire to spend any time considering their investment options. Fortunately, the TSP does offer a sort of “default” mechanism using the L funds. The simplest method is to pick the L fund with the date that corresponds most closely to your expected retirement date. Over time, the fund will gradually become more conservative, and therefore reduce the need to continuously re-evaluate your portfolio. If you have a higher or lower risk tolerance than typical for your age group, the adjustment can be made by moving the L fund to one with a closer date if you are more risk-averse, and to one with a farther out date to be more aggressive.
Even if you don’t intend to use this simplified method, it is usually worth looking at the TSP website to see what the L fund internal allocation is for the fund for your expected retirement date. If nothing else, their “recommendation” can give you a place to start.
Building Your Own Portfolio
For those that desire to put forth the effort to construct their own portfolio allocation within TSP, there is no shortage of advice available if you are looking for it. Most of the discussion centers around whether you should pick an allocation and leave it alone (buy and hold), or constantly monitor and adjust what you are invested in (active management). The two transfers per month limitation has restricted some ability to do active management, but there are still many people who prefer to do what they can despite the restriction. A description and the case for each style will be saved for a future article.
You may be disappointed with the lack of any outright recommendation presented here, but that is not possible, since every person will have their own set of circumstances that dictate what is most appropriate for them. If you have questions on your own situation, you should contact someone familiar with the options and retirement planning in general.