FEDweek

The 4 Percent Rule for TSP Explained

In a previous article about how much money we “should” have in the Thrift Savings Plan by the time we begin withdrawals, I mentioned the 4% withdrawal rule.  I use the word “rule” loosely, as it really is more of a 4% suggestion.  Let’s take a look at this rule/suggestion, including its origins and its applicability to you.

Many financial planners suggest beginning your withdrawals from a lump sum of money at a rate of 4% and taking inflation based increases each year.  These suggestions are based on your odds of running out of money over a 30 year period under different market scenarios.  An individual with a balanced portfolio (e.g., about 50% stocks and 50% fixed income investments) who begins withdrawing at a 4% rate and takes annual inflation increases has a less than 10% chance of running out of money in 30 years based on past market performance.

Sophisticated calculators (dubbed Monte Carlo Simulators) take past yearly market performance going back to the 1920s and mix up the annual returns in different orders.  For example; one scenario might begin with 2008, followed by 1929, then 2002, and so on.  Another scenario might begin with 2013, followed by 2003, then 2009 and so on.  The first of these scenarios would very likely result in a lower overall return (and a greater chance of running out of money in 30 years) than the second.

So, how would one implement the withdrawal strategy suggested by the 4% rule within the Thrift Savings Plan?  One would do it by means of “substantially equal monthly payments of a fixed dollar amount” — that’s the name of one of the withdrawal choices offered by the TSP.  In this strategy, you would select the amount of the monthly payment and have the ability to change it once a year during the TSP’s annual open season for changing monthly payment amounts (October 1 through December 15).  In the following paragraph, we will do an example.

If you had a TSP balance of $500,000 (don’t scoff — it’s achievable if you started early and saved religiously), you would multiply the TSP account balance by .04 and arrive at $20,000 as the amount you would withdraw annually under the 4% rule.  Divide $20,000 by 12 and you would select $1,667 per month for year one.  If there were 2% inflation, you would divide $20,400 by 12 to get the monthly amount of $1,700, and so on for each year.

Of course, past performance is no indication of future performance and, if we were to run into an extended period of low returns, this might not work for you.  A 2013 study by Wade Pfau, Michael Finke and David Blanchett, suggests that (given recent investment performance) a withdrawal rate of less than 4% might be advised.

The good thing about being able to adjust your withdrawals annually during the TSP open season is that you don’t have to automatically follow the “4% rule”.  In a year of poor investment performance, you could forego an increase; in a year of good investment performance, you could take a larger increase.