As a Thrift Savings Plan participant, you have a vested interest in your account’s ability to produce a reliable stream of income that will support your lifestyle in retirement. Unfortunately, TSP doesn’t guarantee a stream of income in exchange for your contributions.
What many TSP investors seek is a way to predict how much they can expect to receive in retirement for each dollar they invest today. Unfortunately, this value is impossible to accurately predict. The best you can do is to try to estimate it — which is, it turns out, a difficult task. The problem is there are a number of factors that have a big impact on the result and that can’t be known in advance. The key variables are your TSP contribution amounts and timing, your retirement date, the investment return amounts and timing, the inflation amounts and timing, and your lifespan.
All of these factors involve risk, but some are more within your control than others. You may feel comfortable about committing to a series of savings contributions and your retirement date, but how comfortable are you estimating the future rates of inflation, investment returns and your lifespan?
TSP provides calculators — at www.tsp.gov — to help you predict what your contributions and account management will buy you in retirement. Unfortunately, the result you get will be misleading.
The problem stems from the need to provide a simple solution to a complex problem. But in the case of TSP’s calculators, it’s kind of like offering someone with a brain tumor a rusty saw with an instruction manual. It’ll keep you busy — while your problem gets worse.
Let’s run through a couple of the calculators and I’ll point out the major problems.
If you’re still contributing to the TSP, you would need to start with the calculator called “How much will my savings grow?” I’ll enter the following information, for demonstration purposes: My retirement system is FERS and I plan to contribute 10 percent of my $50,000 annual pay for the next 20 years. I currently have $20,000 in my account, and I expect to earn 10 percent per year on my account. Based on this input, the calculator predicts that in 20 years, when I plan to retire, my account will contain $622,229. Good to know!
But, I also want to know the kind of lifetime retirement income I can expect from all of those contributions. For this, I have to switch to the “monthly payment calculator.” I choose the dollar amount, rather than the life expectancy, calculator since I want steady and predictable income. I enter the $622,229 result from the first calculator as the amount that will be used for monthly payments. I enter 5 percent as the expected annual rate of return my account will earn during my retirement and then I’m asked to enter a desired monthly payment amount. I’ve heard that 5 percent per year of my initial balance — $31,111 — would be pretty aggressive, so I enter 1/12 of that as the monthly amount: $2,593. I click calculate and, presto, I’m advised that my account will support this income stream for 177 years or, if I’m 60, until I’m 237 years old. Terrific!
Based on this prediction, I have all kinds of room to live a long life, spend more, save less or earn less on my TSP investment, right?
Not so fast.
There are many problems with this prediction, but I’ll point out the top three:
* First, the calculators ignore investment risk — the risk that you will fail to earn the expected rate of return over the long run and the risk that you will earn less than the expected rate of return in any period along the way. Both of these risks are huge and can have a tremendous impact on the results.
* Second, the calculators ignore inflation. That monthly payment in the second calculation isn’t going to buy in 20, 30 or 40 years what it will buy today. Adjusted for inflation, this payment may be worth only a small fraction of its predicted value when I receive it.
* Third, the calculators ignore longevity risk — the risk that your life won’t be the length you expect. Living a long life can mean running out of money unexpectedly, while living a shorter-than-expected life can mean sacrificing your standard of living unnecessarily.
To put the shortcomings of these into perspective, I conducted my own probability analysis, using my firm’s assumptions about inflation, investment returns and life expectancy, and found that rather than having lots of room for error, I would actually have about a 75 percent probability of running out of money while I was still alive. Not terrific at all!