Thursday, November 10, 2011

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.