Introduction of Lifecycle Funds by the Thrift Savings Plan

1
Introduction of Lifecycle Funds by the Thrift
Savings Plan

• A case study
• James B. Petrick

2
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
•  

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Annual Year-End BalancesG, F, C, S, and I
Funds( millions)
173,281
152,009
128,925
99,312
100,553
97,686
94,649
77,268
58,166
44,889
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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  on earnings until withdrawn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

5
What is the TSPs 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
• TSP
• Originally 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

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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

7
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

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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 SP 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

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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

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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

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Why Did the TSP Need Lifecycle Funds?
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Knowledge, Interest, Time

• Studies show participants do not have
• Knowledge
• Interest
• Time
• to manage their portfolio allocations

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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

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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

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The Cumulative Effect of Chasing Returns
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Not Rebalancing

• In 2002, only 16 of TSP participants made an
  interfund transfer
• Many participants never reallocate their accounts

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How Will Lifecycle Funds Help?
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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

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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

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Current Trends
New Trend

• 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

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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 didnt want to be involved in
  their investments

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Risk profiles of TSP Funds

• 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

Range of Returns Bar Graph
Return
January 1988 - December 2003
Legend
20.0
15.9
Highest
15.6
18.0
16.0
11.4
14.0
12.0
10.0
8.0
3.8
6.0
0.8
4.0
2.0
0.0
0.2
-2.0
G Fund Actual Returns
-4.0
-3.4
Average
-6.0
-8.0
F Fund Actual Returns
-10.0
-12.0
-14.0
-13.8
-14.5
-16.0
-18.0
I Fund Composite Returns
C Fund Actual Returns
-20.0
-19.4
-22.0
S Fund Composite Returns
-24.0
-26.0
-28.0
-30.0
Lowest
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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

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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

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

• More return for the same amount of risk, or
• The same returns with less risk

C Fund
(1.06)
TSP
(1.30)
G Fund
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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

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Mercers 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.

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Mercers 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

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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

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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

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Initial Lifecycle Fund Allocations
2010
2040
42 C Fund
18 S Fund
43 G Fund
27 C Fund
10 F Fund
7 F Fund
25 I Fund
5 G Fund
8 S Fund
15 I Fund
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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

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Initial Position of Recommended Lifecycle Funds
on the Efficient Frontier
Expected Geometric Return
S-Fund
2040
2030
2020
2010
C-Fund
I-Fund
Current Income
F-Fund
G-Fund
Standard Deviation
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Rolling Down the Efficient Frontier

• The 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

2040
2030
2020
2010
INCOME
RETURN
RISK
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Expected results

• For 27 year old investing in L2040, at age 62
• 4.76 median real return
• 14.61 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

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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

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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

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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

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Returns of L Funds vs. Underlying FundsInception
(August 2005) to Date
Income
2010
2020
2040
2030
G
F
C
S
I
Underlying Funds
L Funds
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Future initiatives

• Make L Funds the default funds
• Requires statutory change

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Questions?