Are you getting closer to retirement? How should you modify your TSP investments until then, and afterwards? What about other accounts? Should you change the allocation if the market performs poorly? Are you taking on too much or too little risk? Will your investments give you enough to live on in retirement?
There are many things to consider when determining an appropriate asset allocation for your TSP and other investment accounts. One of the most important factors is your ability to stick with the plan you have made, even in the face of turbulent markets. That is not easy to do, but can be made much easier if your allocation is based on an understandable “tiered” strategy.
The Tiered Strategy
A retirement investment account that is invested in a broadly diversified portfolio of stocks and bonds may be entirely appropriate for an individual, but not necessarily easy for that person to maintain through volatile investment returns. Rather than a single allocation mix, the tiered approach is constructed in different “tiers” that are each intended to be used in a different time frame. The basic idea is that it is easier to live with possible short or medium term negative returns in a particular tier if you know that the money was not intended to be used for many years. There are many different variations on the concept, and what is most appropriate for a given individual will depend on many factors. A qualified financial advisor familiar with the process can assist in the final overall design. For this article, we will discuss a generic 3-tier plan to demonstrate the process.
This is the money that is set aside for emergencies, such as unexpected home repairs, medical expenses, or being laid off from a job. These funds should be in a readily accessible savings account, taking on no additional investment risk and not striving for any particular return beyond basic interest. The level that should be set aside here will vary, but three month’s salary is a good starting point. This type of account is appropriate regardless of the overall strategy for the remainder of the portfolio.
Tier #1: Short Term
The short term tier is money that is needed for income in the next 1-3 years. This is particularly important just prior to and during retirement, since this money will be needed soon and minimal risk should be taken in the investments. While in TSP, this would typically consist primarily of G fund or L Income fund investments. Individuals with higher risk tolerances could also consider including the F Fund.
Tier #2: Medium Term
The medium term tier would be used for money needed in years 3-10. There can be a little more risk taken, but not so much that there might not be time to recover from a down market. In the TSP, this would primarily consist of the F fund, but could also include portions of any of the others, depending on risk tolerance.
Tier #3: Long Term
The long term tier is for money that won’t be needed in the next ten years. That allows for more risk to be taken with it, due to the much longer time horizon. These investments would consist primarily of the C, S, and I funds, though that could vary depending on an individual’s risk tolerance. L funds might also serve this purpose, with the L 2030, L2040, and L2050 funds being possible growth accounts with varying degrees of investment risk.
Identifying the Tiers
One of the keys to the tiered strategy is to clearly define each tier and have an understanding of its purpose. That typically means using separate accounts for each tier (when the investments are held outside of TSP) that can be tracked independently. The TSP doesn’t offer an option for different accounts, so the simplest way of accomplishing the same thing is to utilize only one fund for each tier. For example, you may use the G fund for Tier #1, the F fund for Tier #2, and the L2050 fund for Tier #3. By using this understanding of the allocation, a drop in the L2050 fund for the long-term tier would seem less troublesome if you saw your balance in the G and F funds (that were enough to cover 10 years of expenses) maintain their value. Depending on your risk tolerance and financial situation, it may also be appropriate to use other fund combinations, including all of the various L funds. The important thing is to clearly identify which fund or combination of funds represents each tier and keep them segregated.
Withdrawals and Transfers
The tiered framework is particularly important as it relates to the withdrawal of funds to support retirement. Withdrawals all come from the first tier, since it holds the first three years’ worth of income. As those withdrawals are made, though, the first tier no longer has enough money to last three years. Transfers made over time will drain each tier into the one before it, eventually filling the first tier back up. The strategy is based on flexibility of timing for those transfers. It may not make sense to take funds out of the growth tier (#3) at a time when the market was down significantly and thereby lock in those losses. That’s the reason to have so many years in the first two tiers, so that with patience a better decision can be made about reallocating funds to the more immediate tiers as advantageous opportunities arise. Again, it is important that actual withdrawals only come from the first tier to keep the philosophy intact.
The tiered strategy will still work for those whose retirement is a long way off, but it should be applied differently. There is still a need for the emergency savings, but there is no need for income during the timeframe of the first two tiers. In that instance, it is appropriate to allocate your entire portfolio to the growth tier. The investment allocations themselves will still be based on risk tolerance, however. As retirement gets within ten years, the process begins to fill the earlier tiers.
An individual’s risk tolerance is an important consideration when deciding on the investments within each tier. Every person has their own limits on how much volatility they can take, and the fund selection should take that into account. The tiered approach can, however, frame the decision process more clearly and hopefully allow for a better understanding of the potential effects, particularly in the longer-term tier.
Implementing a tiered strategy first requires projecting expected income needs from investments in the coming years. That cannot be done until a budget is established and all of the other sources of income are factored in. For a federal employee, that includes the CSRS or FERS annuity, FERS supplement, social security, spousal pensions or annuities, disability payments, military retirement, and others. The first year in retirement is the most important, since the lower interim payments from the federal government (could last up to a year) can create a cash-flow problem if not accounted for. It is imperative that a comprehensive retirement income plan be put together before calculating the income needs in retirement and building a portfolio accordingly. It also helps verify retirement preparedness, and may possibly affect timing decisions. A financial professional well versed in the nuances of the federal benefit system will be invaluable in helping to craft this plan.
Implementing the Strategy
The actual implementation of the tiered strategy, particularly in the withdrawal phase, can be a little tricky within the TSP. The TSP program is an excellent and cost-effective way to save for retirement, but is more difficult when it comes to distribution. Here are a few key things to keep in mind:
- Fund Availability: The funds within the TSP are available immediately after normal retirement, and not subject to the typical penalty for withdrawals prior to age 59 ½ that most outside qualified accounts have. Regardless of your overall strategy, enough funds should be kept in TSP to cover the years until age 59 ½ to avoid the penalty.
- Withdrawal Options: The TSP program limits your available withdrawal options to the following, and any withdrawal program will need to factor that in:
- One partial withdrawal of any amount over your lifetime, including while employed
- Regular monthly withdrawals, either pre-determined annually or set by IRS life expectancy tables
- Annuity purchase from MetLife
- Payout of the entire amount, either directly to the participant or rolled over to an IRA
- Withdrawal Sources: Any withdrawal made from TSP will be deducted proportionally from all investment funds. That means that a withdrawal intended to be from Tier #1, invested in the G Fund, would actually come partially from all other invested funds as well. In order to return the overall portfolio to the desired philosophy, transfers will need to be made to the other funds to return them to the amounts they should have maintained. Only two transfers are allowed per month.
- Roth Accounts: Similar to the different investment accounts, withdrawals made will be deducted proportionally from the standard account balance and the Roth balance. There is no way to make transfers between those two types, so tax management strategies that rely on varying the amounts taken from the Roth and standard accounts are not possible.
- Investment Options: The TSP is limited to the five basic investment fund options (G, F, C, S & I), and the L series of combination funds. All risk-based portfolio decisions will need to be made from among these options
Putting It All Together
The tiered strategy for retirement income is another way of looking at an overall portfolio, and can help keep everything in perspective as markets vary over time. It can be implemented within TSP, in outside accounts, or combinations of both. Once an overall income plan is put together, the tiered approach can be just the key that is needed to stick with it and successfully enjoy a comfortable retirement.