David Fulton is a Colorado Springs, CO fee-only financial planner providing Hourly and On-Going Financial Planning and Investment Management. While he works with a broad range of clients, David specializes in working with Active and Retired Military, Federal Employees, and Families with Special Needs Children.
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If you are a Military Service Member or Federal Employee you will face an important decision on what to do with their savings when retiring or separating from government service. Each member has access to a defined contribution plan called the Thrift Savings Plan (TSP).
The decision will be whether to retain your contributions inside the TSP or to roll those contributions over to an Individual Retirement Account (IRA) or subsequent workplace retirement account such as a 401(k). That decision used to be fairly straight forward as the TSP was at one time a very rigid and inflexible tool and often forced people to make this decision as soon as they separated.
In September 2019, an update to program rules changed everything. If you currently have access to the TSP, you should think twice before choosing to roll it over. Here's why...
Watch Out For Bad Advice
There is a lot of readily available financial advice out there. The difficulty is in knowing if it is good advice. Much of the advice you may find on the internet may be dated and inaccurate. Making matters worse, the financial services industry has powerful incentives that often create conflicts of interest and prevent advice truly in your best interest. If you are a Federal Employee or Military Service Member you should be wary about what advice you accept regarding the Thrift Savings Plan (TSP).
Unfortunately the TSP is unfairly maligned and underutilized by our Military and the Federal workforce. The TSP does a terrible job of advertising and extolling its benefits. Quite frankly, its just not a very sexy investment when compared to so many other effective advertising campaigns littering the financial services landscape.
If you are separating from the Military or Federal service you may have been told that once you separate your best option is to roll your TSP account into a broker sold or advisor directed Individual Retirement Account (IRA). One of the most common reasons given for doing so is that the TSP is much too difficult to manage and is very inflexible when it comes to withdrawing money when you need it most. With just five investment options the TSP is also accused of being too limited for proper portfolio construction. Perhaps the main reason people choose to move on from the TSP is that there are so many other investments available elsewhere that can presumably generate higher returns.
While this advice may look good on the surface, there is always a cost with following it. Before you decide to ditch the TSP it's worth reviewing a few reasons why you may want to think twice.
Reason #1: Simplicity
The TSP is simple! It's too simple for some people. With just five funds to choose from, you may be inclined to think it just can't get the job done. While some asset classes are admittedly underrepresented, such as small-cap value, the TSP contains almost all the core holdings you would want in any properly allocated portfolio. This simplicity is often the very reason for its success.
So what’s so good about only having five fund options? For one, with so few options you likely won’t make mistakes. It's very easy to over-complicate a portfolio. Investors often find themselves investing in assets that assume too much risk for their needs, or they create an over weighted portfolio in certain asset classes that cause their portfolio to have too much volatility. With the TSP, you won't have to worry much about portfolio construction.
In fact, it is not even necessary to own more than a couple of funds to achieve effective diversification. It's a myth that more funds mean more diversification. This runs contrary to what is routinely pitched by the financial services industry to make investing seem overly complicated and difficult for the average investor. Look no further than the Vanguard Total Stock Market Index (VTSAX) as an example of incredible diversification held in a single fund. VTSAX holds stock positions in over 3,535 individual companies, giving the investor sufficient diversification in just one holding. The TSP operates similarly using broad-based stock indices to hold much of the market in just a few funds.
A simple portfolio has many secondary advantages as well. The simpler the strategy, the greater the propensity that you’ll stick to the plan over the long-term and won’t be tempted to chase every new investment opportunity. Benefits also include lower transaction costs, simplified rebalancing and portfolio analysis, and ease of tax-preparation.
Reason #2 Professional Management
While the TSP may be simple, don’t think it isn’t professionally managed. Four of the five funds are currently managed by Blackrock Capital Advisers and are available only to TSP participants. Blackrock Capital is the biggest investment company in the United States with the largest market share of any of the other large investment companies to include Vanguard, State Street, Fidelity, and JP Morgan! This is a professional company managing much of the country’s retirement plans.
In February 2020, The Federal Retirement Thrift Investment Board chose to continue using Blackrock for the foreseeable future for much of the investment needs of TSP participants. In fact, the TSP has been held out as an example of what right looks like for other retirement plans to emulate.
Perhaps the most compelling argument for the TSP is the rationale behind a lawsuit launched in 2017 against Blackrock Capital by its employees. Why the lawsuit? Because Blackrock's employees were upset the investment options in their own company's retirement plan failed to achieve the simplicity and performance of the TSP.
The lawsuit argued that "after taking into account the compounding of returns realized every year, the LifePath1 funds underperformed the TSP funds by 5.6% on average during this period.”2
Many people would be thrilled to have an investment opportunity that so many Federal workers take for granted.
Reason #3 Cost
According to a recent Vanguard study the average mutual fund expense ratio in the industry is 0.57% (57 basis points). This means that for every $100,000 invested, the fund manager will charge $570 per year in exchange for their expert management of the mutual fund. These costs matter as over time those relatively small fees add up to a sizable sum.
For example, over 30 years the opportunity cost of 57 basis points could cost you upwards of $50,000!3 The TSP on the other hand, has some of the lowest fees in the industry charging only .042% (4.2 basis points). This means the same hypothetical $100,000 investment will cost you only $42 per year and generating a savings of $45,000 over the same 30-year period.4 For it to make sense to invest in something other than the TSP, the other portfolio would need to outperform the TSP by the difference between its expense ratio and the fee charged by the TSP, every single year. The likelihood of a portfolio outperforming the underlying index by 0.52% year after year becomes quite small over time.
While the expense ratio is a compelling enough reason by itself to keep the TSP, it is not the only fee you will be paying if you choose to roll it over, not even close! As part of the rollover process, you will pay trading fees for each trade used to purchase the new funds in the rollover account, and likely a new account origination fee with the custodian, and 12b-1 marketing and distribution fees. There may also be commissions or loads charged by a broker or if you are working with an advisor you will likely pay an ongoing advisory fee. The industry-standard for advisory fees are 1% of total assets under management. This is in addition to all the other fees already described. With the TSP, you pay no trading fees, no commission, no custodial fees, and no advisory fee. What a deal!
Reason #4: Flexible Withdrawals
For years, the knock on the TSP was that it was too inflexible when it came time to withdraw funds to start paying those retirement bills. This may have been true at the time, but the TSP now gives an investor choice of how they want to distribute their funds.
In September 2019, an update to program rules based on the 2017 TSP Modernization Act ended the policy of limiting account holders to only one partial withdrawal post-separation. Much of the negative treatment of the TSP is based on this legacy rule. With the program update an account holder can now initiate an unlimited number of withdrawals from their TSP which has dramatically changed the utility of the fund and blunted one of the main arguments in favor of rolling over the account.
These new flexible withdrawal options now include the ability to withdraw funds in a single lump-sum payment, as an annuity with a set payment schedule, or as an installment plan with monthly, quarterly, or annual withdrawals.
One of the best new features from the 2019 program update is the added choice to withdraw funds from either the Traditional TSP or the Roth TSP portion. Prior to the update, withdrawals were made “pro-rata”, meaning they had to come from both sub-accounts equally. This new feature adds increased tax planning opportunities for savvy planners such as withdrawing from the Roth portion during high tax years and the Traditional portion during lower tax years for those with both types of sub-accounts.
The TSP now has the same flexibility as any other tax-advantaged retirement account and flexibility should no longer be a driving factor for leaving the TSP.
Reason #5: The "55 Rule"
If you are a Federal Employee, and you want to retire early, you may have a gap in your retirement planning. Because IRAs prevent penalty-free withdrawals prior to the age of 59½, you will have to figure out how to cover your expenses until you can start your retirement distributions penalty-free from the year you retire to the year you reach 59½.
This is where the TSP can significantly help Federal workers. A TSP pitfall has been fixed to allow you to withdraw funds as early as 55 years old when you retire from Federal Service. This “55 Rule” fixes the gap between your Federal retirement date and your ability to withdraw funds penalty-free from your IRA in effect allowing you to fully retire when you federally retire. If you rollover your TSP into your IRA you lose this penalty-free “55 Rule”.
Reason #6: Inter-fund Transfers are Free
Choosing a mix of different kinds of investments (stocks, bonds, cash, etc.) and maintaining that mix are among the most important ingredients in your long-term investment success. The goal is to select an asset allocation that gives you enough peace of mind that you can sleep at night, and avoid the urge to sell when the market plummets and prevent the tendency to sell low and buy high while still taking enough risk to achieve your objectives. It is a tough balancing act, but one every investor must make.
Choosing an appropriate asset allocation essentially comes down to how much risk you can and want to take. If you are young with plenty of working years ahead you can count on a steady stream of future earnings, you can assume more risk. If you are closer to retirement you may want to be more conservative. Stocks typically provide more long-term growth, but they can also be unpredictable and subject to the whims of the market. Bonds, on the other hand, are usually more stable but offer less of a return.
As an investor ages, they will naturally begin trading stocks for more bonds in their portfolio. As the portfolio gets more conservative over time, each of those moves incur trading costs. The TSP has a function called an interfund transfer that simulates a trade from one fund to another fund. For example, an investor may want to trade shares of the C-Fund and purchase shares of the F-Fund as they approach retirement. This interfund transfer between the C and F-Fund are completely free. An investor can make as many such transfers as they wish. This is uniquely beneficial for a TSP investor and helps facilitate proper risk adjustments along the way.
Why It Matters
The decision to roll over your TSP into another retirement account is a wholly personal matter but should be made only after analyzing the entirety of your financial picture. Moving your assets from a simple and cost-effective solution like the TSP to a more complex, and certainly more expensive broker or advisor managed account can have lasting effects on the return of your retirement savings.
Unfortunately, financial advice may not always be in your best interest, and as a consumer you must educate yourself on the benefits and consequences of what is being proposed. For those about to retire or separate from government service it is worth at least questioning the advice you receive before deciding to forgo your TSP. While there may indeed be good reasons to decide to move on from the TSP, those reasons are likely not based on a pure dollar for dollar comparison and often come down to other more complex variables.
As a Fee-Only Financial Advisor who specializes in working with Active and Retired Military and Federal Employees I am also a Fiduciary, meaning I am compelled to work in the best interest of my clients at all times. The facts presented in this paper are the very type of conversations I have with my clients to ensure they understand their full options and the ramifications of their financial decision making.
If you are interested in working with a fiduciary advisor who will represent your best interests, we are always looking for quality clients who appreciate sound advice and detailed financial planning. Contact us to get started!
LifePath Funds are Blackrock's proprietary investment for their employee 401k
Quote from: World’s Largest Asset Manager Slapped With Proprietary Fund Suit, by Nevine E. Adams, April 07, 2017
Future Value of an annual $570 payment compounded for 30 years at 6.5% is $49,233
Future Value of an annual $42 payment compounded for 30 years at 6.5% is $3,627