Thrift Spending Plan
Many articles, websites, and newsletters focus their efforts on helping you learn more about how to grow your TSP prior to utilizing it in retirement to supplement your fixed income. Many of these resources provide a plethora of knowledge to help you understand the different TSP funds, to track their performance, and even monitor your TSP account to quickly communicate market downturns… but the way these resources are often interpreted, it leaves readers with the impression that if they can ‘hit their number’ prior to retirement then they will simply have enough money to ‘coast’ through their golden years. As a result, there are still far too many feds around the country that view retirement as the financial finish line… which couldn’t be farther from the truth.
While retirement may represent the ‘finish line’ of the TSP’s Accumulation Phase, it is simply the starting line for the ‘Distribution Phase’ of your life. When we separate from services, there is no ‘portfolio auto-pilot’ that we get to engage and far too many of the pre-retirees that we speak with are unaware of the fundamental differences between investing your TSP during your career (the ‘Accumulation Phase’) and investing your TSP in retirement to generate the income needed to maintain your lifestyle (the ‘Distribution Phase’). To learn more about the differences between these two phases, especially in respect to ‘Sequence of Returns Risk’ read here, here and here. In designing your very own Thrifty Spending Plan, the – often overlooked – key focus is on managing the pace of the withdrawals from your account through changing markets, interest rate environments, and through the changing financial needs of a 20-30 year long retirement.
So, you’ve made it out the door to retirement with your nest egg intact – great! Now how do you know how much you can sustainably spend? How much money can you afford to enjoy? How much is too much?
Well, there are 2 primary methodologies that attempt to answer that question – Systematic Withdrawals and The Bucket Strategy. These two approaches both work to guide retirees on how much money they can afford to withdraw each year as well as providing insight as to where to pull it from.
This planning approach identifies a percentage of your portfolio to withdraw each year (often adjusting for inflation) and is commonly used because of its simplicity to understand, implement, and follow. In this approach you invest across a broad spectrum of assets and asset classes (for diversity) and then look to withdraw an amount each month proportionately from each underlying account. This is the school of thought upon which the (now considered outdated) ‘4% Rule’ was built.
In years when the portfolio gains more than the 4% needed for income, the withdrawals came purely from earnings, leaving the principal completely intact to continue growing. Conversely, in times when the portfolio’s return is less than 4%, this methodology is forced to spend down the account principal – reducing the funds available to earn interest later in your retirement. In years where the portfolio has a negative return, those losses are compounded by your cash-flow needs, further reducing the principal left in your account to generate future income.
Since this approach treats all of a retiree’s broadly invested assets exactly alike, it requires regular rebalancing to maintain its diversity through varying market conditions. Unfortunately, because the portfolio is viewed in aggregate (as a whole), this strategy causes many users a lot of anxiety and concern when the market experiences a sharp downturn or correction – which makes it difficult to maintain a long-term ‘Thrifty Spending Plan’ whenever the market doesn’t play nice. When this method was popularized, a 50/50 portfolio following the 4% rule had a 94% chance of success, whereas at today’s interest rates researchers say it only provides a 69% chance of success.
So, how can we design a spending plan that we, as emotional investors, are perhaps better equipped to stick to? Is there an alternate methodology that may allow retirees to sleep easier during times of market volatility?
The Bucket Strategy
In this approach, we look to segment your assets into different ‘Buckets’ that are aligned to fund different periods of your retirement – bringing a chronological consideration to when each asset class gets utilized. Why can it be helpful to outline the order in which you plan to spend your assets? So that we can use that information to help us determine how much risk would be appropriate for each bucket based on how far in the future that particular segment of funds needs to be available to pay the bills.
Generally, our short-term buckets are positioned to ensure the funds within are both safe and available, regardless of market condition. Buckets with the longest time before their intended utilization contain the asset classes that can justify the most risk (market exposure) – because, if this bucket experienced major losses in the market today, it still would have plenty of time to recover before it is intended to supplement the monthly budget. Could you see how segmenting your portfolio in this way could help you understand where market risk is appropriate and where safety needs to be prioritized? Could you see how understanding the timeline before an asset’s intended utilization helps folks ‘stay the course’ through bear markets and volatile economies?
A hypothetical set of buckets may look something like:
Emergency Fund Bucket – (Cash) this segment emphasizes safety and liquidity and is intended to be used on short notice. There is little to no long-term growth expectation but the fact that it is intended to be used soon means that we are not worried about this segment needing to outpace inflation over the course of your retirement.
Lifestyle Bucket – (Low Risk Investments) segment that still prioritizes safety but also looks for growth, albeit on a conservative basis, to provide supplemental retirement income starting in the early part of retirement. This is where the TSP Annuity (or other income-generating strategies) are often utilized to supplement your pension and social security on a guaranteed* basis in order to fully cover your cash-flow needs through the first decade or so of your retirement.
Long-Term Bucket – (Higher Risk Investments) segment that is not intended to supplement the budget for numerous years, which, in turn, allows us the freedom to invest with more market exposure in hopes of this segment experiencing significant growth. This segment is invested with the eventual intention of using it to offset the erosive effects of inflation during the latter years of retirement.
Legacy/Tax Advantaged Bucket – (Tax-Preferred Investments) segment that is comprised of Roth accounts and other Tax-Advantaged investments, such as life insurance, that is invested with the long-term intention of growing an after-tax or tax-free account balance. This segment is meant to continue growing until a time when income taxes are increased. If that never happens, then it is this asset segment that provides the most tax-efficient legacy to your loved ones. Don’t overlook the critical importance of tax-diversity, especially while taxes are ‘on-sale’, as it is a key component of portfolio diversity!
Both approaches have their merits, utilizing Systematic Withdrawals is the simplest approach to implement in your Thrifty Spending Plan and the Bucket Strategy is the easiest to stick with through scary market environments. If you would like to learn more about either approach to generating retirement income or if you would like some professional assistance in coordinating any/all of the components of your very own, personalized ‘Thrifty Spending Plan’ – contact a Federally Focused Retirement Planner today!
*Guarantees based on the claims paying ability of the issuing company