Thoughts, ideas, suggestions and education from financial adviser Jim Ludwick, Founder of MainStreet Financial Planning, Inc. of Odenton, MD; Washington, DC; New York City, and Santa Barbara, CA

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Tuesday, March 26, 2013

Why Don't Some Retiring Feds Get It?

Why don’t some federal workers nearing retirement in today’s interest rate environment, get it?  It’s all about the G Fund and bond allocation in a time period approaching increases (ok, I have no crystal ball) in interest rates after having been kept artificially low by the Federal Reserve in an effort to simulate the economy.   This is called interest rate risk.

Recently I was counseling a newly retired federal worker as he approached his 70th birthday and faced his first required minimum distribution, having received an announcement from TSP officials of his need to make some decisions.

Versus an IRA, the TSP is much more limited in taking withdrawals in retirement.  You can take up to two partial withdrawals and you can take a fixed amount monthly or annually or just your Required Minimum Distribution (RMD) of about 3.6% of last year’s balance.  IRAs are a lot more flexible and give retirees a lot of options beyond the same percentage withdrawal requirement beginning at age 70.5.

But let’s stick with our retired federal worker for the moment.  Faced with blunt demands from TSP, most workers opt for a rollover to a traditional IRA.  Folks who sell products (mutual funds, stocks, bonds, annuities) like this.  It’s an opportunity to make some money, sometimes at the consumer’s expense (another story).

We frequently encourage our clients to take a partial withdrawal from the TSP and leave the remainder in the G Fund.  Why?  Because its magic.  How is it magic, you ask? Well, it doesn’t go down in value like normal bond funds when interest rates rise.  Why not?

The G Fund, for federal workers and the military, is special.  It’s based upon an index of various maturities of Treasuries and that is what depositors in the G Fund receive each year.  It is not subject to the supply/demand fluctuations like other securities in the rest of the TSP and in the real world of securities transactions.

Most retirees become more conservative in the allocation to stocks (equities) as they grow older for two reasons: 1) they don’t want so much volatility opportunities and 2) they want more assured income that bonds or cash instruments like CDs or immediate annuities offer to depositors or owners.

With that assured income stream comes the risk of early redemption.  The market re-prices bonds and bond funds just like appraisers re-price houses based on previous sales.  CDs suffer an interest penalty for early withdrawal. So if interest rates have risen since you purchased your bond or bond fund, then those higher paying bonds are more attractive to new purchasers.  Your bond or bond fund will have to sell at a discount (read: loss) to meet the same income stream for a potential purchaser.

The G Fund does not operate the way we just described.  It never goes down due to supply/demand.  It’s not publically traded.  It is a true fixed (annually) income stream.

So Federal workers, after you’ve determined your comfort level and/or need of exposure to equities, consider using your TSP as your “fixed income-holding bank” up to the percentage of fixed income you need in your family asset allocation.  If you’ve been a diligent TSP saver, you’ll have more than enough in your TSP to have your bond percentage in the G Fund and either retain the rest in equities, or for more flexibility send the equities to a rollover IRA.

Now this is just a general discussion and not investment advice.  For that you have to pay me. This concept, however, comes to you courtesy of the TSP.  Don’t forget after you bail out of the TSP as a retiree, you can’t get back in.

Jim Ludwick is the President and founder of MainStreet Financial Planning, Inc., an hourly fee-only provider of advice on many financial issues.  This is just an educational story and not individual advice, says my attorney.

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