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The Government's Retirement Plan Has Appeal, and a Few Holes, Too

TSP participants can use outside assets to boost weightings in TIPS and emerging markets.

In a recent survey, 86% of the government workers who participate in the Thrift Savings Plan--essentially, the 401(k) plan for federal government workers--said they were satisfied or very satisfied with the plan.

You don't have to look too hard to see why. Whereas some 401(k) plans feature overwrought menus of options, extra layers of administrative fees, and costly, also-ran funds, the TSP is a marvel of rock-bottom costs and a utilitarian lineup.

At the same time, however, the TSP doesn't offer exposure to a handful of important asset classes, and the lineup also features a few additional quirks of which participants should be aware. These issues are far from fatal, but knowing about them might prove helpful for TSP participants who can use additional investment assets outside of the plan to augment their TSP holdings.

First, the Good Stuff
I wasn't kidding when I said the TSP is cheap. For 2011, the TSP had an expense ratio of 0.025%, down a hair since I wrote about the plan back in 2010. That means that plan participants are paying just a $0.25 per $1,000 they have invested in the plan. That amount doesn't cover only fund costs, either; it also includes record-keeping, the mailing of statements, and other participant-servicing fees. Scale is a big reason that the TSP has been able to swing such low costs on behalf of its participants: The plan has more than 3 million active participants. Loan fees and forfeitures also help keep a lid on costs. The government contributes 1% of each worker's salary to his or her TSP account, but if the employee leaves before these contributions have vested, that amount gets thrown back into the kitty.

The centerpiece of the TSP is a suite of BlackRock-managed index funds. For U.S. equity exposure, participants can use an S&P 500-tracking vehicle (the C fund) to gain exposure to large caps and obtain small- and mid-cap exposure via a fund that tracks the Dow Jones U.S. Completion Index (the S fund). By using this duo, rather than a total stock market index fund that provides broad-market exposure in a single shot,the plan gives its participants flexibility to adjust their portfolios' weightings in large caps versus small and midsize names. (For example, a younger participant might weight his or her portfolio small- and mid-caps for their better long-run return potential.) For foreign-equity exposure, participants have an MSCI EAFE tracker (the I fund) that skews heavily toward large-cap stocks from developed markets. 

For participants seeking stability and income, the TSP choices are also pretty skinnied-down, featuring a core bond-index fund that tracks the Barclays Aggregate Bond Index (the F fund) as well as what's called the G fund. In contrast with the other offerings, a version of which nongovernment employees can readily buy in index or exchange-traded fund form, the G fund is managed exclusively for the TSP and has some pretty attractive qualities. Consisting of nonmarketable Treasury securities, the G fund is guaranteed to not lose money, but it has also historically generated higher returns than cash. For example, it returned 2.45% in 2011 (an amount I most assuredly did not earn on my cash last year). The G fund is similar to the stable-value funds that appear in many 401(k) plans, but its yield is generally better and the government, and not private insurance companies, is the guarantor.

Rounding out the lineup are a series of target-date funds (L funds) geared toward investors of various anticipated retirement dates, ranging from an income vehicle for those who are already retired to a new vehicle for participants retiring in or around 2050.

Also on the plus side, the TSP will be introducing a Roth option sometime this year, reportedly in the second quarter, thereby giving plan participants the opportunity to contribute aftertax dollars in exchange for tax-free withdrawals in retirement. That addition will allow federal government employees who have already built up solid balances in the traditional TSP plan, which will be taxed upon withdrawal, to obtain tax diversification and tax-free withdrawals in retirement. 

What's Missing?
Yet as good as the TSP is, it has scant exposure to some important market segments.

Perhaps the most significant for younger employees is exposure to emerging markets. The MSCI EAFE Index that the I fund tracks has no direct exposure to emerging markets, whereas total international-stock indexes--which hold companies in a weight proportionate to their market values--have upward of 20% of their assets in emerging-markets names. Of course, with developing-markets exposure comes added volatility, and it's also worth noting that many firms based in developed markets offer ample indirect exposure to Brazil, China, and the like. Nonetheless, emerging markets are a hole that TSP participants might consider filling by funding an IRA or by bumping up the emerging-markets exposure in their spouses' plans.

For older and/or more conservative workers, the fixed-income menu is notable on a couple of fronts. Although the G fund's investment objective is to "produce a rate of return that is higher than inflation," it provides exposure to nominal, rather than inflation-adjusted, bonds, and therefore might not keep pace with inflation over time. That's a particularly big consideration right now, given how low nominal Treasury yields have gotten. Ditto for the F fund: The Barclays Aggregate Bond Index, which it tracks, doesn't include Treasury Inflation-Protected Securities. Thus, a good first stop for those with a substantial share of their assets in either the F or G funds would be to augment those holdings with a TIPS fund in an IRA. ( Harbor Real Return  and  Vanguard Inflation-Protected Securities (VIPSX) are two of Morningstar's favorites.)

Additionally, it's worth noting that the Barclays Aggregate Bond Index that the F fund tracks has a longer-than-average duration (a measure of interest-rate sensitivity)and a higher-quality emphasis relative to other intermediate-term bond funds. (Roughly 70% of its portfolio is invested in government and government-related debt.) That could cause it to struggle in a period of rising interest rates. Those risks help explain why active bond-fund managers are generally straying far from the index in terms of their positioning, as Eric Jacobson explains in this video. Thus, investors looking to diversify the fixed-income exposure they've obtained via the F fund might consider supplementing it with an actively managed bond fund or one that focuses on short-term or corporate exposure.

Finally, as I noted last time I reviewed the TSP, the Lifecycle funds in the plan (L funds) tend to be a bit more conservative than other target-date funds geared toward investors with similar retirement dates. That bias is especially apparent in the L Income fund, geared toward participants who are already retired. It has just 20% equity exposure currently, arrayed across the C (large-cap U.S.), S (small-cap U.S.), and I (international stock) funds, with the rest in the G and F funds. By contrast, the typical target-date retirement-income vehicle has roughly 30% in equity exposure overall. The L Income fund's positioning might therefore be overly timid for some TSP participants, especially those who also have pensions or other guaranteed sources of income to supply a big percentage of their living expenses. As a general rule of thumb, retirees can afford to hold a larger-than-average stake in equities if a high percentage of their living expenses are being replaced by a pension, annuity, Social Security, or some other guaranteed source of income.

See More Articles by Christine Benz

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