What is wrong with the Lifecycle Funds (L Funds) in the TSP? The answer is simple - they fail to take into account other features of the Federal Employee Retirement System ("FERS") and the nature of the benefits those other features provide to FERS participants. Specifically, investments in the L Funds tend to overweight retirement savings in bond-type instruments (fixed income, annuity producing, investments) because the L Fund weightings appear to have been assembled without reference to another bond-type retirement benefit earned by all federal employees covered by FERS - the basic FERS Annuity.[1]
Federal employees tend to save for retirement over a long period of time. Any overemphasis on fixed-income type investments early in an employee's career will tend to sacrifice the higher potential returns offered by long-term investments in stock for the unneeded short-term stability of fixed income investments (unneeded because retirement money won't be spent until retirement age is reached). See www.tsp.gov/lifecycle/flash/qs_as.html#Q2
The assumption underlying lifecycle funds is that participants with longer time horizons for investment are both willing and able to tolerate more risk (up and down swings in an investment portfolio) while seeking higher rates of return. A further assumption is that as participants approach the time when they will begin to withdraw their assets from the Plan, their portfolios should be adjusted to reflect a lower tolerance for risk. Thus, a young person who is many years from retirement would invest in a lifecycle fund containing investments with higher risk and higher potential returns (such as stocks), and less in low-risk, lower-return investments (such as Government securities). The investments in each fund would adjust gradually and automatically to low risk portfolios as the fund's time horizon approaches. This process is referred to as asset reallocation.
The L Funds are designed to take these principles into account and provide for asset allocations targeted, as employees age, to achieve an optimal age-based balance between risk and return. See www.tsp.gov/rates/fundsheet-lfunds.pdf:
While exact numbers are misleading and the TSP has failed to provide the basis for its own asset allocation models, some conclusions can be reached based upon broad assumptions. For example, a 32 year-old who wishes to retire at age 65 and who wishes to achieve the "Efficient Frontier" posited by the TSP, will usually be advised to allocate his or her retirement savings 75% in equities (large cap, mid cap, small cap and foreign) and 25% in fixed-income or cash (bonds and cash). See e.g., www.ipers.org/sub/calcs/AssetAllocator.html.[2] A 32 year-old who invests 100% in the 2040 L Fund (a fund calculated to allow the 32 year-old to retire at age 65), will have their TSP account divided up 77% in equities (C Fund, S Fund and I Fund) and 23% in fixed-income type investments (G Fund and F Fund). www.tsp.gov/lifecycle/flash/index2040.html. By itself, therefore, the L Fund appears to provide a stand-alone investment vehicle for achieving the "Efficient Frontier."
However, that same 32 year-old will also have substantial savings provided through both his basic FERS Annuity and Social Security. See https://www.opm.gov/forms/pdfimage/RI90-1.pdf. The basic FERS Annuity is calculated by multiplying 1% of an employee's "high-3 average pay" times years of creditable service. Since an annuity is simply another form of fixed-income investment received by all federal employees covered by FERS, it is critical to factor in the value of the FERS annuity in the fixed income/equity asset allocation. The L Fund does not appear to do that and the results appear to be dramatic.
Very little information is available calculating the comparative value of a FERS annuity and a TSP investment. Any such comparisons are, in themselves, rife with uncertainties. However, examples have been assembled by OPM in Publication RI90 which appear to support this paper's hypothesis. See RI90 pp. 22-24 (examples of retirement benefits). In each one of the four examples assembled by OPM, the resulting value at retirement of an employee who invests 5% annually in the TSP is a TSP benefit with a value equivalent to the value of the FERS annuity. Id.
Consequently, assuming that the value of the FERS benefit and that of the TSP are approximately equal - a 100% TSP investment in equities still results in a 50/50 asset allocation between equity investments and fixed-income investments.
Remember, the TSP's recommendation for a 33 year-old - 77% equities, 23% fixed income. Based on the numbers available, it appears that if that 33 year-old invests 100% of their TSP account in the 2040 L Fund and stays vested in their FERS benefit, they will achieve a mix of 38.5% equity investments and 61.5% fixed income investments - a mix nowhere close to the "Efficient Frontier" posited by the Thrift Board or the mix recommended by anybody else (ranging from 60 to 100% equities).
Again, these numbers are based solely on the information publicly available and some gross generalizations and so should be taken with many grains of salt. But the conclusions are pretty stark and should be considered by anybody contemplating an L Fund investment.
[1] Two important notes. First, the TSP web site does not address whether the FERS annuity was factored in to the L Funds. Second, Social Security benefits (which are fixed-income type benefits) were ignored.
[2] The SEC website links to the Iowa Public Retirement System site (see link at www.sec.gov/investor/pubs/assetallocation.htm). Other sites also provide information relating to asset allocation for retirement. See www.fool.com/foolu/askfoolu/2002/askfoolu020710.htm ("rule of thumb" percent of equities should equal 100 or 110 minus age); www.moneycentral.msn.com/content/Investing/Simplestrategies/P42544.asp (recommending 60-100% equity investment for anybody with more than 20 years until retirement); www.tiaa-cref.org/support/basics/getting_started/asset_classes.html.
Federal employees tend to save for retirement over a long period of time. Any overemphasis on fixed-income type investments early in an employee's career will tend to sacrifice the higher potential returns offered by long-term investments in stock for the unneeded short-term stability of fixed income investments (unneeded because retirement money won't be spent until retirement age is reached). See www.tsp.gov/lifecycle/flash/qs_as.html#Q2
The assumption underlying lifecycle funds is that participants with longer time horizons for investment are both willing and able to tolerate more risk (up and down swings in an investment portfolio) while seeking higher rates of return. A further assumption is that as participants approach the time when they will begin to withdraw their assets from the Plan, their portfolios should be adjusted to reflect a lower tolerance for risk. Thus, a young person who is many years from retirement would invest in a lifecycle fund containing investments with higher risk and higher potential returns (such as stocks), and less in low-risk, lower-return investments (such as Government securities). The investments in each fund would adjust gradually and automatically to low risk portfolios as the fund's time horizon approaches. This process is referred to as asset reallocation.
The L Funds are designed to take these principles into account and provide for asset allocations targeted, as employees age, to achieve an optimal age-based balance between risk and return. See www.tsp.gov/rates/fundsheet-lfunds.pdf:
Expected variability of investment returns is a measure of risk in investing. For each risk level, there is one “optimal” asset allocation that provides the highest expected return. The collection of optimal asset allocations make up the “Efficient Frontier,” which is shown by the curve.
Of course, putting a portion of retirement savings into fixed-income investments makes sense (the past is not a perfect predictor of the future). But because every federal employee also has a significant portion of their retirement benefit tied up in a fixed-income type of investment, their FERS accounts, federal employees investing in the L Funds will tend to overemphasize the fixed-income portion of their investments and fail to achieve the "Efficient Frontier" posited by the TSP. This is because the L Funds appear to ignore the FERS annuity in its calculations.
While exact numbers are misleading and the TSP has failed to provide the basis for its own asset allocation models, some conclusions can be reached based upon broad assumptions. For example, a 32 year-old who wishes to retire at age 65 and who wishes to achieve the "Efficient Frontier" posited by the TSP, will usually be advised to allocate his or her retirement savings 75% in equities (large cap, mid cap, small cap and foreign) and 25% in fixed-income or cash (bonds and cash). See e.g., www.ipers.org/sub/calcs/AssetAllocator.html.[2] A 32 year-old who invests 100% in the 2040 L Fund (a fund calculated to allow the 32 year-old to retire at age 65), will have their TSP account divided up 77% in equities (C Fund, S Fund and I Fund) and 23% in fixed-income type investments (G Fund and F Fund). www.tsp.gov/lifecycle/flash/index2040.html. By itself, therefore, the L Fund appears to provide a stand-alone investment vehicle for achieving the "Efficient Frontier."
However, that same 32 year-old will also have substantial savings provided through both his basic FERS Annuity and Social Security. See https://www.opm.gov/forms/pdfimage/RI90-1.pdf. The basic FERS Annuity is calculated by multiplying 1% of an employee's "high-3 average pay" times years of creditable service. Since an annuity is simply another form of fixed-income investment received by all federal employees covered by FERS, it is critical to factor in the value of the FERS annuity in the fixed income/equity asset allocation. The L Fund does not appear to do that and the results appear to be dramatic.
Very little information is available calculating the comparative value of a FERS annuity and a TSP investment. Any such comparisons are, in themselves, rife with uncertainties. However, examples have been assembled by OPM in Publication RI90 which appear to support this paper's hypothesis. See RI90 pp. 22-24 (examples of retirement benefits). In each one of the four examples assembled by OPM, the resulting value at retirement of an employee who invests 5% annually in the TSP is a TSP benefit with a value equivalent to the value of the FERS annuity. Id.
Consequently, assuming that the value of the FERS benefit and that of the TSP are approximately equal - a 100% TSP investment in equities still results in a 50/50 asset allocation between equity investments and fixed-income investments.
Remember, the TSP's recommendation for a 33 year-old - 77% equities, 23% fixed income. Based on the numbers available, it appears that if that 33 year-old invests 100% of their TSP account in the 2040 L Fund and stays vested in their FERS benefit, they will achieve a mix of 38.5% equity investments and 61.5% fixed income investments - a mix nowhere close to the "Efficient Frontier" posited by the Thrift Board or the mix recommended by anybody else (ranging from 60 to 100% equities).
Again, these numbers are based solely on the information publicly available and some gross generalizations and so should be taken with many grains of salt. But the conclusions are pretty stark and should be considered by anybody contemplating an L Fund investment.
[1] Two important notes. First, the TSP web site does not address whether the FERS annuity was factored in to the L Funds. Second, Social Security benefits (which are fixed-income type benefits) were ignored.
[2] The SEC website links to the Iowa Public Retirement System site (see link at www.sec.gov/investor/pubs/assetallocation.htm). Other sites also provide information relating to asset allocation for retirement. See www.fool.com/foolu/askfoolu/2002/askfoolu020710.htm ("rule of thumb" percent of equities should equal 100 or 110 minus age); www.moneycentral.msn.com/content/Investing/Simplestrategies/P42544.asp (recommending 60-100% equity investment for anybody with more than 20 years until retirement); www.tiaa-cref.org/support/basics/getting_started/asset_classes.html.
