Introduction of Lifecycle Funds by the Thrift Savings Plan

A case study

James B. Petrick

TSP Facts and Statistics

• Largest defined contribution plan in the world

• Over 3.5 million participants, serving employees of the U.S. Federal government, including all U.S. military personnel

• Almost $180 billion in assets• Over 340,000 transactions each month 

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

G Fund F Fund C Fund S Fund I Fund L Funds

Annual Year-End BalancesG, F, C, S, and I Funds

($ millions)

$152,009

$128,925

$99,312

$100,553

$97,686

$94,649

$77,268

$58,166

$44,889

$173,281

What is the TSP?

• Employee benefit plan – U.S. tax-favored arrangement. Not taxed on money contributed or on earnings until withdrawn

• Defined contribution – Benefits are based solely on participant contributions and earnings

• Participant-directed – Participants decide how much to contribute and how to invest

• Like “401k” plans

What is the TSP’s purpose?

• Provides retirement income that is complementary to the defined benefit component

• For its core group (FERS), one part of a three-part retirement program– Defined benefit component– Social Security– TSPOriginally estimated would match old system replacement

ratios (56% of final three salary at 30 years and age 55), but not being tracked.

• For other groups, supplements a full defined benefit

Why was TSP established?

• Social Security reforms in 1983. Needed to include federal workers to enhance solvency

• End “unfunded liability” of old defined benefit program

• Increasing mobility of workforce required portability – you could take TSP to and from a private sector plan

• Deficit reduction – Accounting gimmick kept government securities “on budget” - since changed

Investment Structure

• Law requires use of index funds for equity options– Index funds are designed to follow entire markets or

broad slices of markets

– Ensures decisions are “passive”

– “Active” decisions could be based on politics

– Index funds are low cost

• Board decided to use indexing for fixed income also

TSP Investment Options

• G Fund – Specially issued government securities• F Fund – U.S. corporate and government bond

index fund. Tracks the Shearson/Lehman Bros. Corporate Bond index

• C Fund – Large capitalization U.S. stocks. Tracks the S&P 500 index

• S Fund – Small to medium capitalization U.S. stocks. Tracks the Dow Jones Wilshire 4500 index

• I Fund – International stocks. Tracks the EAFE index

Post-employment withdrawals

• Three options:– Lump-sum payment

– Phased withdrawals

– Annuity

• Can mix options• Transfer certain payments to IRAs or other plans• One-time partial withdrawal• Required to begin by age 70 ½

Annuities

• Only an option (not required unless spouse insists)• 18 different annuity types (single life, joint and

survivor, etc.)• TSP selects vendor and monitors performance.

No liability once annuity is purchased• Annuity provider competitively procured• Insurance companies compete on price• Not yet a popular option, although numbers

increasing

Why Did the TSP Need Lifecycle Funds?

Knowledge, Interest, Time

Studies show participants do not have:

• Knowledge

• Interest

• Time

to manage their portfolio allocations

Poor Allocation

• TSP looked at their own statistics and found evidence of poor investment practices

• Poor investment allocation by over 60% of participants– 38% invested only in G Fund; 13% only in C

Fund– Another 12% had “barbell” investments –

Totally G Fund and one other risky fund

Return Chasing

• Participants are “chasing returns”

• Investing in the fund with the best return or highest price last month or yesterday

• Buying high and selling low

Quarterly Net New InvestmentContributions and Interfund Transfers

(1993 through 2004)

($2,000)

($1,500)

($1,000)

($500)

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Milli

ons

G Fund F FUnd C Fund S Fund I Fund

The Cumulative Effect of Chasing Returns

Not Rebalancing

• In 2002, only 16% of TSP participants made an interfund transfer

• Many participants never reallocate their accounts

How Will Lifecycle Funds Help?

What Are Lifecycle Funds?

• Target date asset allocation funds

– Target date - when you begin to withdraw (not necessarily retirement date)

– Target date farther away – higher risk investments

– Target date closer – change automatically to lower risk investments

Compare With “Lifestyle” Funds

• Investing style – “conservative” (low risk), “moderate” (medium risk) or “aggressive” (high risk)

• Do not change over time. If you are getting near to retirement, you must change them yourself

• Terms are not applied consistently. Sometimes you will hear lifecycle funds called “lifestyle” and vice versa

New TrendCurrent Trends

• 55% of U.S. private sector plans now use these funds; number continues to grow

• Up 20% in past 2 years

• When offered, 10% of assets invested in these funds

Reasons TSP Chose Lifecycle Over Lifestyle

• Size of plan requires simple approach – Not feasible to design or implement tailored solution for 3.5 million participants

• Easier to communicate– No need for questionnaires about “your investing style” or “your

tolerance for risk”

• “ Turn-key” approach. No further action by participants needed– Simply choose a date when you want to begin withdrawing your

money. Allocations change automatically over time to meet your needs

• Matched assumed profile of those we wanted to reach – people who didn’t want to be involved in their investments

“Risk” refers to how far annual returns vary from the average return over time. The more variance, the higher the risk. Here are the risk profiles for the five TSP funds:

Risk profiles of TSP Funds

ReturnJanuary 1988 - December 2003

Range of Returns Bar Graph

-30.0%

20.0%

-28.0%-26.0%-24.0%-22.0%-20.0%-18.0%-16.0%-14.0%-12.0%-10.0%-8.0%-6.0%-4.0%-2.0%0.0%2.0%4.0%6.0%8.0%

10.0%12.0%14.0%16.0%18.0%

0.8%

0.2%

3.8%

-3.4%

11.4%

-14.5%

15.6%

-19.4%

15.9%

-13.8%

Highest:

Average:

Lowest:

Legend

G Fund Actual Returns

F Fund Actual Returns

C Fund Actual Returns

S Fund Composite Returns

I Fund Composite Returns

Time Reduces Risk• Participants with longer time horizons can invest in higher risk funds,

because time mitigates risk

• As horizon shortens, portfolios can be adjusted to have lower risk investments

The Efficient Frontier

• Allocations that achieve the greatest predicted return for a predicted level of risk are said to be on the “efficient frontier”

• Based on predicted economic trends and investment performance. Historical results are only part of the prediction

The efficient frontier can be shown as a line representing all portfolios that yield the greatest returns at all levels of risk:

Lifecycle Fund Goal

4%

6%

8%

10%

12%

14%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18%

Risk (Std. Dev.)

Ret

urn

TSP

G Fund

C Fund

(1.0

6%)

(1.30%)

More return for the same amount of risk, orThe same returns with less risk

Obtained expert advice

• After competitive procurement, Board hired Mercer Investment Consulting to advise us on:– Number of funds to use

– Target dates for the funds

– Asset allocation schedules for the life of the funds (to put investors nearer to the efficient frontier

• Required to use only existing TSP investment options (statutory constraint) – Existing funds provided adequate diversification

Mercer’s process

• Chose target participants – e.g., FERS participant who is currently 27 with a $7000 account, retiring at age 62. (Based on our demographic studies)

• Mercer used its economic assumptions about asset classes to calculate risk and return of 5 funds.

• Also developed correlation assumptions among asset classes represented by TSP funds.

Mercer’s process (continued)

• Devised sample portfolios lying along efficient frontier (based on their economic assumptions about future performance)

• Stochastic modeling of results for these portfolios over next 50 years under difference combinations of economic scenarios

• Assumed participants would increase contributions over time and retire at age 62

The Recommended Funds

• Five funds selected - 10 considered but rejected as too complex– Income Fund

• For those already withdrawing their accounts

– 2010 Fund– 2020 Fund– 2030 Fund– 2040 Fund

The TSP Lifecycle Funds

• Funds with higher target dates, primarily equities (C, S, and I Funds)

• Income Fund largely, but not entirely, invested in fixed income (G and F Funds)

• Over time, as target date nears, fund allocations will move towards fixed income

2010

27% C Fund

8% S Fund15% I Fund

7% F Fund

18% S Fund

25% I Fund5% G Fund

2040

10% F Fund

Initial Lifecycle Fund Allocations

43% G Fund42% C Fund

Lifecycle Allocation Schedules

• The allocation schedules– Set up at the beginning

– Will change at regular intervals

– Will be reviewed and may be revised from time to time

• Rebalance funds to the schedules

Initial Position of Recommended Lifecycle Funds on the Efficient Frontier

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

0% 5% 10% 15% 20% 25%

Expected Geometric Return

Standard Deviation

C-Fund

G-Fund

I-Fund

F-Fund

S-Fund

Current Income

20102020

2030 2040

Rolling Down the Efficient FrontierThe fund with the farthest target date would “roll down the efficient frontier” until, at its target date, it would merge with the income fund. As each fund merges, a new one is created

RISK

RE

TU

RN

2040

20302020

2010

INCOME

Expected results

• For 27 year old investing in L2040, at age 62: 4.76% median real return14.61% standard deviation$1,630,000 median account balance with

57.6% replacement ratio$981,000 5th percent account balance with

34.2% replacement ratio (worst case scenario)

.1% probability of decline in last 3 years

TSP Communications Strategy• Sought expert advice concerning

communications rollout

• Key idea – – “Up-front” choice between lifecycle funds and

managing their own accounts. – “Two-path” or the “fork in the road” solution– Allows those who want to invest for themselves

to continue

Participant Investment in a Lifecycle Fund

• Participants not restricted in their use of L Funds– Can choose to invest in L Funds and other TSP

funds– Can choose to invest in more than one L Fund

• But -- present L Funds as a single fund solution if used as intended

Results (after 7 months)

• 8% of FERS participants using L funds

• 6% of assets invested in L Funds

• L Funds assets are almost $10 billion

• Different groups (by age, retirement system) appear to be using funds appropriately

Returns of L Funds vs. Underlying FundsInception (August 2005) to Date

3.58%

5.48%6.49%

7.11%7.84%

2.65%

1.32%

4.81%

7.84%

17.25%

-2%

2%

6%

10%

14%

18%

Income 2010 2020 20402030 G F C S I

L Funds Underlying Funds

Future initiatives

• Make L Funds the default funds

• Requires statutory change

Questions?