You’ve worked hard for years, and now it’s time to ride into the sunset, but as retirement nears, you’re faced with the frightening challenge of turning your TSP into a monthly paycheck.
Sure, you have your FERS pension and Social Security (or the FERS Supplement), and while these benefits will keep you from ever becoming homeless, you’ll need your TSP to ensure you have the retirement you’ve envisioned.
So, how much can you afford to withdraw from your TSP without running out of money in retirement?
In comes the 4% rule, a common rule of thumb used to answer just that question. In fact, the 4% has become so popular that it is often referred to as the “safe withdrawal rate.“ So, this week we’re reviewing the rule and whether federal employees should use it when managing their TSP in retirement.
What Is the 4% Rule?
So, what exactly is the 4% rule? It’s a rule many utilize to determine their sustainable withdrawal rate (the amount you can withdraw throughout retirement without running out of money). The rule is relatively simple, which is likely why it’s so popular; first, you add up all your retirement savings and withdraw 4% of that total during your first year of retirement.
For example, say you have $500,000 in TSP savings, and your spouse has $200,000 in 401(k) savings; if you’re using the 4% rule, you will withdraw $28,000 in your first year of retirement ($700,000 x .04 = $28,000).
However, in subsequent years, you’d adjust the dollar amount of your withdrawal to account for inflation.
So, if we continue with our example from above, and in your first year of retirement, inflation was 5%, you’d withdraw $29,400 in your second year of retirement ($28,000 x 1.05 = $29,400). You’d continue this process of adjusting for inflation every year.
One common misconception with this rule is that the retiree is withdrawing 4% yearly, which is not the case. In the above example, the federal retiree would have withdrawn 4.2% of the original portfolio balance in year 2 of retirement.
Where Did The 4% Rule Come From?
The 4% rule is based on William Bengen’s research study published in 1994. The study analyzed how sequence of return risk impacts the lifetime returns of a portfolio and, as a result, the sustainable withdrawal rate.
In simple terms, the study found that for a 30-year retirement, a portfolio consisting of 50% stocks and 50% bonds, in a worst-case scenario (based on historical data), could provide a maximum sustainable withdrawal rate of 4.15% adjusted annually for inflation. In other words, if the above criteria were met, you could withdraw 4.15% (increased annually for inflation) of your TSP without the risk of running out of money.
Should You Use The 4% Rule?
When determining how much you can withdraw from your TSP, the 4% rule is a reasonable starting point. HOWEVER, there are a few caveats:
Many federal employees have most of their retirement savings in the traditional TSP, which means that their withdrawals will be taxable. The 4% and subsequent inflation-adjusted withdrawals do not factor in taxes; the rule assumes that the withdrawals will cover taxes and fees. So, when calculating the withdrawal amount, remember that taxes and fees will need to be deducted.
Your Mix of Investments Matter
The results of the 4% rule were based on a specific portfolio composition of 50% in stocks (S&P 500 or the C fund) and 50% in bonds (intermediate gov’t bonds or the F fund, although not an exact substitute). Additionally, Bengen recommended that retirees invest as much as 75% of their portfolio in stocks and never less than 50%. Hence, if your portfolio’s mix of investments differs, you can’t expect the results delivered by the 4% rule.
Another assumption made by the 4% rule is that retirement will be for 30 years. Depending on your retirement age, 30 years may be too long or short. Consider your health and family history when thinking about how long your retirement may last. At what age did your parents pass away? Does it make sense to use the Social Security Administration’s Actuarial Life Table, which is based on the average person, or should you plan for a longer or shorter life?
These questions further illustrate the difficulties of using a fixed withdrawal rate like the 4% rule; it doesn’t factor in your unique situation. If you expect your retirement period to differ from the 4%’s 30-year retirement, the 4% withdrawal rate may be too large or too little.
Life is dynamic, things happen every year that were not in our plans, and retirement is no different. In a previous article, I covered spending shocks in retirement, meaning large unanticipated expenses, the most common of which are rising health care costs, changes in-home needs, and inflation.
Again, the rigidness of the 4% rule is shown to be a significant weakness. While the rule does factor in inflation, it doesn’t account for the fact that many retirees may need to make larger withdrawals at some point for unanticipated expenses. Federal employees would be better served by adjusting their withdrawals periodically based on their retirement savings balance and whether anticipated investment growth rates were realized.
When it comes to retirement planning, there is no single “right” answer to how much you should withdraw from your TSP. While the 4% rule works great as a general guideline, it isn’t dynamic enough to account for common changes in retirement.
Your retirement is much more likely to be successful if you adopt a personalized withdrawal rate based on your time horizon, investment allocation, and risk tolerance and then monitor and update it as necessary.
Planning your retirement can be challenging and stressful, which is why I recommend every federal employee works with fee-only Certified Financial Planner™ to develop their personalized retirement plan. The goal, after all, isn’t to worry about running out of money in retirement; it’s to enjoy the life you envisioned.
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2023 Legislative Change Notice
The SECURE ACT 2.0 passed and impacted many of the articles on this website. While the articles were correct when written, it’s impossible to re-write every article. Please consult a qualified professional (i.e., CFP®, CPA, or attorney) before implementing any strategy.