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Investing Specialists

TSP Is Near Ideal, but Faults Remain

Christine Benz breaks down the pros and the cons of the Thrift Savings Plan for government workers.

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"If only everyone had access to a Thrift Savings Plan!"

I've made that comment when we've discussed the "ideal" retirement plan system in the U.S.--one that would address the fact that many workers don't have access to employer-provided retirement plans as well as the problem that many small employers field plans that are costly and subpar.

In most important respects, the TSP serves as the model for what an employer-provided defined-contribution plan should be. Its fund options, all index trackers or index-based options, are utilitarian and ultra inexpensive; the lineup isn't cluttered with niche option that have the potential to sidetrack investors and worsen their outcomes. Thrift Savings Plan investors also have exclusive access to a unicorn-type bond fund, the G fund, which offers higher returns than cash but guarantees stability of investors' principal. The target-date options, called Lifecycle funds or L funds, are fine set-it-and-forget-it choices for hands-off investors.

But the Lifecycle funds have some notable differences relative to other top target series. Moreover, in the interest of simplicity and keeping costs down, the TSP excludes a couple of asset classes that are worthy of consideration. By extension, investors in the TSP's Lifecycle/L funds miss out on those asset classes, too. Those idiosyncracies should absolutely not deter government employees from investing in the plan; the TSP is still great. But government workers who have additional, non-TSP assets, such as IRAs, might consider carving out positions in those missing/underweighted asset classes with their external accounts.

What the TSP Gets Right (Hint: A Lot)
Choice overload can be an enemy of 401(k) participants, but one of the TSP's greatest virtues is its simplicity. The TSP's core menu includes an S&P 500 index tracker (the Common Stock Index, or C, fund); a small-cap stock index fund (the S fund) that tracks the Dow Jones U.S. Completion Total Stock Market Index; an international-stock fund that tracks the MSCI EAFE Index (the I fund), and a Bloomberg Barclays U.S. Aggregate Bond Index tracker (the F fund). All four of these funds are managed by BlackRock Institutional Trust Company for the TSP.

The TSP also includes the "unicorn" G fund. Managed exclusively for TSP participants, the G fund consists of nonmarketable Treasury securities; it's guaranteed not to lose money, but it has historically generated a yield in line with an intermediate-term Treasury fund rather than cash. Right now it's yielding 2.75%.

The L funds--target-date equivalents managed for investors who are already retired and those who anticipate retirement in or around 2020, 2030, 2040, and 2050--consist of varying mixes of the aforementioned five funds. Like all target-date funds, the near-dated funds are more conservative and equity-light than the funds geared toward investors retiring 20 or 30 years from now. The L series also includes an Income option for retirees; it parks the majority of its assets in the G fund, but also holds a smattering of stocks and other bonds.

Simplicity is great, but the best part of the TSP is its very low costs. Each of the funds in the lineup had a baseline administrative expense ratio of 0.038% (less than 4 basis points) in 2016, plus additional securities-lending fees that vary based on the fund. (The TSP's documents note that any earnings from securities lending is paid back into the fund.) The S fund--focused on small caps--is the priciest option in the lineup, but it's still incredibly cheap at just 0.079% (less than 8 basis points) per year. The G fund, with an expense ratio of 0.038%, is the cheapest. The index options' expense ratios are generally right in line with the very cheapest mutual fund or ETF options available to the public.

And What It's Missing
As solid as the TSP is, however, it's missing exposure to a few worthwhile areas. Those omissions have had implications for performance--for better and for worse--at various points in time.

One of the biggies, especially for younger accumulators, is the fact that the international fund (the I fund) tracks the MSCI EAFE index, which includes developed markets stocks but excludes emerging markets and foreign small company stocks. Emerging-markets equities now represent about 20% of total non-U.S. market indexes. Foreign small caps are a smaller omission on the part of TSP, currently representing about 3% of total non-U.S. index trackers.

For much of the past decade, the I fund's exclusion of emerging markets was a plus, as emerging markets remained mired in a deep trough. More recently, however, it has been a disadvantage; foreign developed markets stocks soared last year, but not as much as emerging-markets equities. At the same time, developed markets equities have historically been less volatile than emerging markets, as measured by standard deviation, so TSP participants will tend to enjoy a smoother ride than investors in more inclusive foreign index funds. TSP investors who seek exposure to emerging markets will need to add it elsewhere in their portfolios, however.

On the bond side, the G fund is a superb option; you won't find anything like it outside the TSP. (The closest analog is a stable-value fund, but technically G is safer.) The F fund, which tracks the Barclays Aggregate Index, is also solid and low-cost. However, the Barclays Aggregate, which the F fund tracks, isn't as inclusive as it could be. It doesn't include noninvestment-grade bonds, though to my mind that isn't a big deal. (High-yield bonds' volatility is sometimes quite un-bondlike.) The lineup also foregoes non-U.S. bond exposure, also not a crucial omission, in my view.

A bigger omission on the fixed-income front is that inflation-protected bonds aren't represented in TSP's fixed-income lineup. The category isn't important for younger accumulators, but it becomes more significant when retirees move into portfolio drawdown mode and have a larger share of their portfolios in fixed-income investments.  Vanguard Target Retirement Income (VTINX), for example, holds about 17% of its portfolio in inflation-protected bonds. BlackRock's  LifePath Index Target Retirement fund (LIRAX) holds a lighter, but still meaningful, allocation to inflation-protected bonds of 9%. To be sure, Treasury Inflation-Protected Securities have posted lackluster returns over the past decade, as inflation has been extremely muted and demand for securities that protect against inflation has been slack. But the category still makes sense as part of retirees' fixed-income allocations, in that it helps protect the purchasing power of nominal bonds' income. Here's another spot where TSP investors should consider adding such exposure to their non-TSP assets. (Inflation-protected bonds are best held in a tax-sheltered account, because their inflation adjustment is taxable right along with their income payments.)

Those omissions also have implications for the L (Lifecycle funds). While the L funds are excellent options, investors with large portfolios who are using one of the L funds to supply all-in-one exposure might consider on bolting on emerging markets and inflation-protected bond exposure, depending on their time frames. Emerging-markets equities make the most sense for risk-tolerant investors with long time horizons, while TIPS bonds are most useful to retirees.

In addition, it’s worth noting that the L funds' baseline glide paths differ from those of corresponding target-date mutual funds, in some cases meaningfully. In general, the L funds tend to be more bond-heavy than their target-date counterparts, likely because of the very attractive risk/reward profile of the G fund. The L Income fund, for example, has three fourths of its assets in bonds (the G and F funds), versus a 65% stake in cash and bonds for the average target-date retirement fund. (The typical retirement income mutual fund holds an additional 3% of assets in "other" securities, usually convertibles and preferreds.) At the opposite end of the spectrum, the L 2050 fund holds 18% in the G and F funds (bonds), whereas the typical target-date 2050 fund holds 7% in bonds and another 6% in cash and other.  

Moreover, the L funds maintain lighter allocations to foreign stocks than is the case for target-date mutual funds of the same vintage. For example, the L 2050 fund's international allocation is 25% versus 33% for the average 2050 mutual fund. The L funds' foreign-stock underweighting, along with their related underweighting in emerging-markets equities, has hurt returns relative to other target-date series recently, especially for the longer-dated funds that are more equity-heavy. For the 12-month period through January, for example, the L 2050 fund returned 21.4%, versus 24% for both  Vanguard Target Retirement 2050 (VFIFX) and  BlackRock LifePath Index 2050 (LIPAX), both Gold-rated funds. Of course, that's a very short time frame by which to judge, and the trade-off is that the L funds will likely have lower volatility than their target-date counterparts.

And Another Thing
Finally, despite having a very clear and transparent public website, TSP could stand to provide more up-to-date performance reporting on the site; as of mid-February, annualized and annual returns are only updated through 2016. TSP participants can retrieve daily share prices, but that's arguably not super useful for most participants. 

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.