Tuesday, April 3, 2012

Asset allocation strategies for the Thrift Savings Plan

Asset allocation is as old as the bible, older in fact. For example, here’s a segment from the Talmud that’s over 3,200 years old: “Let every man divide his money into three parts, and invest a third in land, a third in business and one third let him keep by him in reserve.” The first two parts of this recommendation could be interpreted as investments in real estate and stocks. The third part is not quite as clear. Asset allocation guru Roger Gibson defines "reserves" as U.S. government bonds, whereas others believe that during those ancient Jewish times it would have referred to "silver." Regardless, the concept is crystal clear: spread your risks, and never put all your proverbial eggs in one basket.

The concept of asset allocation is really quite simple. Choose from a set of diverse investments which don’t always move up and down in tandem. Determine a risk level that you are comfortable with, and which is also acceptable based on your time to retirement. Consider all possible asset combinations whose risk meets your tolerance. Calculate the expected gains for each portfolio combination. Select the portfolio combination with the highest expected returns.

Simple though it may be in theory, asset allocation is challenging to implement in practice. For example, what risk level exactly are you comfortable with? How do you even define risk? And even for those scientifically inclined investors who can follow the mathematical calculations, a theoretical understanding of risk and potential losses is not at all the same as experiencing the real deal, as any veteran investor who’s suffered through a few recessions will tell you. Your own survival instincts are your worst enemy, and interfere at the worst possible moment.

Asset allocation for Thrift Savings Plan participants means choosing among the 5 basic TSP funds, or allocating your entire account balance to one of the predetermined asset mixes, the Lifecycle or “L” Funds. This last option is attractive to plan participants who don’t care about the specifics, but as with many choices in life, the easy road is not necessarily the superior one.

The 5 TSP funds are simply different kinds of bonds and stocks. The safest is the G Fund which invests in a bond-like security that is guaranteed not to lose any of your original investment. Its probable returns are therefore also the lowest. The other fixed income choice is the F Fund, which tracks an index of investment grade corporate and government agency bonds. These two bond funds are invested in domestic securities only. The remaining 3 funds are stock funds. The C Fund is held in an index consisting of large cap US equities. The S Fund tracks small cap US stocks. And the I Fund invests in foreign stocks in so-called “developed” markets. Choose well among these funds and you’ll have a decent equity and bond investment portfolio.

It may surprise you to learn that many TSP investors don’t even get this far. Casual conversations among co-workers reveal many who don’t even have a well-diversified portfolio of equities and fixed income, but rather plow most of their money in one concentrated asset class or the other. Some Feds allocate too much to the risky assets (all stocks), while others over-allocate to the conservative (all bonds).

But a knowledgeable investor shouldn’t stop there. As you get closer to retirement, you’ll probably very well own more investment accounts in addition to your TSP plan. After you’ve maxed out the annual contribution, those who still have additional savings can put these in a regular investment account. Or perhaps you have a working spouse who is not a Federal employee. Investors who are in this situation frequently ask: what do I invest those extra funds in? Once you go beyond a handful of TSP funds, things get a little trickier.

Now that you’ve got a basic U.S. stock/bond portfolio put together, consider allocating a portion of it to emerging markets stocks, for additional diversification. One well-chosen additional index fund will do the trick. A good option is Vanguard Emerging Markets Stock Index Fund (VEIEX).

Next you could add real estate, which also has historically shown low correlation to the basic TSP funds. The simplest adjustment you can make here is to add a Real Estate Investment Trust (REIT), such as the Vanguard REIT Index Fund (VGSIX).

Next, let’s take a look at alternative investments such as commodities. This is an asset class that’s often neglected. The simplest way to invest in commodities is by owning an exchange traded fund (ETF) that invests in this asset class. ETFs trade very much like stock shares, and you can buy and sell them through any online broker. For most TSP investors the most suitable commodity ETF is one that follows a broad index. One example of a commodity index fund is the Elements Rogers International Commodity Index ETN (RJI), but there are other funds that follow different indexes. For investors with larger portfolios, a small allocation to more granular commodities could make sense. For example, to benefit from rising prices in gold, you can invest in the SPDR Gold Fund (GLD). Or to follow the price of crude oil, try the PowerShares DB Oil Fund (DBO).

Keep in mind that you should always practice moderation and don’t put too much of your retirement into any one “basket”.

Thursday, November 10, 2011

Introduction to the Thrift Savings Plan

The Thrift Savings Plan (TSP) is a retirement plan for U.S. government employees, established in 1986. In many ways, it is similar to a 401(k) plan. Its purpose is to provide retirement income to U.S. Government employees. Almost 5.8 million government employees participate in the plan.

The TSP is offered to employees covered by the Federal Employees Retirement System (FERS), Civil Service Retirement System (CSRS) and members of the U.S. military. The TSP is managed by the Federal Retirement Thrift Investment Board, with administrative and day-to-day assistance from several private sector companies.

The TSP is a defined contribution plan, which means that you determine how much of your salary to contribute, and these contributions go into your personal TSP account. As such, your retirement benefits are the result of your personal investment choices: how much you contribute and which TSP funds you invest in (how much your investments gain in value) during your federal employment. This contrasts with a defined benefit plan, where your employer stipulates a monthly benefit or pension at your retirement.

Benefits of the TSP

There are several major benefits of enrolling in the TSP. Contributing a a portion of your earnings to the TSP actually lowers your taxes. This is due to the fact that the contributions you make are "pre-tax": no payroll tax is deducted, and the money goes directly into your TSP plan. This reduces your taxable income by the amount which you invest in the plan. There's an annual limit to the amount you can contribute, but it's a tidy sum: $16,500 in 2011 and $17,000 in 2012. Participants in private sector 401(k) plans are subject to the same annual contribution limit, and the amount is increased every couple of years to adjust for cost of living increases. Also, any investment gains on the money in your TSP account won't be taxed until you start making withdrawals during your retirement.

If you're a FERS employee you're also entitled to receive matching contributions. Simply put, for every dollar you contribute to the TSP, your agency will make a matching contribution, up to a maximum 4% of your salary. The regulations are somewhat complicated and subject to some limitations, so check the details with your agency personnel office. Unfortunately, Civil Service Retirement System (CSRS) employees are ineligible for matching contributions.

If you got off to a late start with your retirement savings or want to invest more, and you're fifty years or older, you can make catch-up contributions to your TSP account. The annual catch-up contribution limit is adjusted every few years, but currently you are able to add an extra $5,500 catch-up amount to your TSP every year, in addition to the usual annual limit.

It's very straightforward to roll over existing IRA and 401(k) assets into your TSP account, or to transfer your TSP assets to a private sector retirement plan when you end your federal career. Under certain conditions, you can even obtain a loan (borrow against your TSP assets), or make financial hardship or age-based withdrawals before your planned date of retirement. Always seek advice from a financial professional and your agency personnel office if you're considering any of these actions, in order to avoid unexpected consequences.

TSP Investment Options

The Thrift Savings Plan offers 10 different funds for employees to invest in. Five of the TSP Funds are U.S. and international stock and bond index funds. They mirror the performance of broad market indexes, and contain a diversified portfolio of thousands of individual stocks and bonds. The other five TSP funds, the Lifecycle Funds, are professionally managed portfolios which consist of a mix of the 5 primary TSP index funds. You select one of the Lifecycle Funds based on the target date: approximately when you plan to start making TSP account withdrawals (typically during your retirement). The asset mix of each Lifecycle Fund is slowly adjusted to be more conservative (fewer stocks and more bonds) as its target date approaches.

In summary, the Thrift Savings Plan is a excellent retirement plan, and federal employees would be smart to max out their TSP account every year.

Investing in the TSP Funds

The Thrift Savings Plan presently offers ten investment funds. Five are U.S. and international stock and bond index funds: they replicate the performance of broad market indexes. The other five TSP funds, the Lifecycle Funds, are professionally managed portfolios that are invested in a specific target allocation of the five individual TSP index funds.

The TSP Funds are invested in a diversified portfolio of thousands of individual stocks and bonds. Investing passively in index funds like these is generally regarded as a smart retirement savings strategy. The alternative is for you or an investment manager to actively pick individual stocks and bonds to buy and sell. Apart from being impractical for individual investors, this second approach usually also leads to inferior investment results: studies have shown that the majority of professional active fund managers under-perform a passively managed portfolio of index funds like the TSP funds.

Here's a summary of the five primary TSP funds:
  • The G Fund is invested in U.S. Treasury securities which are guaranteed by the U.S. government. The nice thing about this fund is that it's practically risk free (your investment is guaranteed not to lose any money), and yet the rate of return is much greater than that which you might earn in other safe investments like bank savings accounts, certificates of deposit, or money market funds. For anyone who is very risk-averse, this is definitely the place to park your savings.
  • The F Fund is a bond index fund, invested in investment-grade U.S. government and corporate bonds. Its performance is identical to the private sector iShares Barclays Aggregate Bond ETF (ticker: AGG).
  • The C Fund is a U.S. stock index fund that mirrors the returns of the S&P 500 Index, which contains 500 stocks of large U.S. corporations. Its returns are essentially identical to the SPDR S&P 500 ETF (ticker: SPY).
  • The S Fund is invested in the stocks of small- to medium-sized U.S. companies. It complements the C Fund, so if you invest in both, you basically own shares in almost all U.S. stocks. There aren't many index funds that track these companies, but if you own both the TSP S Fund and C Fund, then your investment performance will correlate closely to a broad U.S. stock market index fund such as the Vanguard Total Stock Market ETF (ticker: VTI).
  • The I Fund is allocated to international stocks. It provides you with the opportunity to diversify your portfolio by investing in the stocks of companies in 21 developed countries in Europe and the Far East. A number of publicly available funds track the same index as the I Fund, including the iShares MSCI EAFE Index Fund (ticker: EFA).

The other five funds, the TSP Lifecycle Funds, consist of professionally determined investment portfolios created to meet investment objectives for a specific target date (the date on which you expect to begin withdrawing your savings). The L Fund assets are invested in the individual TSP funds (the G, F, C, I, and S Fund), following a target portfolio allocation which is adjusted quarterly. The target allocation starts out relatively risky, with a large percentage of stock funds like the C, S, and I Fund. As the target date approaches, each L Fund slowly becomes more conservative, by shifting a greater portion of your assets into bonds such as the F Fund and G Fund. This investment strategy assumes that, while you are still a long time away from retirement, you're in a position to take on greater risks so that you can increase your potential investment returns. Also, while you're still at the beginning of your career, you have a longer time horizon to recoup potential investment losses, especially if you consider that you'll keep making monthly contributions to your account for decades.

Depending on your individual circumstances and target retirement date, you select one of the five L Funds: L Income, L 2020, L 2030, L 2040 or L 2050 Fund. The L Income Fund is the most conservative portfolio and assumes that you've already begun to withdraw your savings. The L 2050 Fund is the most risky allocation, with currently about 90% invested in stocks and 10% in bonds.

Pros and Cons of Investing in the TSP Funds

Many investment advisors recommend that for long-term retirement savings, you buy and hold a low-cost, broadly diversified portfolio of domestic and international stock and bond index funds. Using the available TSP investment funds, you can do an OK job at this. By investing in all five individual TSP funds, or alternatively in one of the Lifecycle Funds, you'll have a reasonably diversified portfolio, with an ownership share in thousands of U.S. and international stocks and U.S. bonds. And the TSP funds have very low annual expense ratios, several times lower than comparable publicly available index funds, keeping more of your money working for you.

So what's lacking in the list of currently available TSP investment choices? Some investors want to own Emerging Markets stocks (in addition to the Developed Markets international stocks offered by the TSP I Fund). Or an allocation to real estate (REITs), or inflation-protected securities (such as TIPS). Others would even like exposure to more specialized investments like international bonds, high-yield bonds, and other hedges against inflation (commodities and precious metals like gold and silver). Professional advisors would disagree about how suitable these investments are. Most would agree that TIPS are a good idea, and for more risk-tolerant investors, perhaps a small allocation to REITs and Emerging Markets stocks.

One major advantage of investing in an L Fund is simplicity: it's a "set it and forget it" investment plan. You select an L Fund, determine your monthly contributions, and the fund administrators handle everything else: regular portfolio rebalancing, and gradually shifting the asset allocation as you approach retirement. But there are also a few downsides. First, the L Funds with the longer time horizons are fairly risky allocations (for example, currently 90% stocks and 10% bonds for the L 2050 fund), and you should carefully evaluate whether you can handle the inevitable volatility that goes along with having a portfolio with such a large allocation to stocks. If you've owned stocks for the past decade then you already know this: it can be quite a roller coaster. Also, some investors would like to have more control over their exact portfolio components, when to rebalance, and how soon to start shifting the allocation to a more conservative asset mix as they approach their planned retirement date. Some investors also prefer a tactical asset allocation, shifting their mix based on asset class trends, economic circumstances or other criteria. Owning a portfolio of the individual TSP funds is a better choice for these investors.