Federal retirement expert, Chris Kowalik, shares the advantages and disadvantages of the Lifecycle Funds (L Funds) within the Thrift Savings Plan .
- What are the Lifecycle Funds — and how are they different than the other funds in the Thrift Savings Plan?
- Some important challenges of the L Funds
- How the mixture of investments in the L Funds changes over time
- What rate of return investors in the L Funds can expect
- How L Funds work in the Traditional TSP and Roth TSP
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Scott: Hello, and welcome to this episode of FedImpact – candid insights on your federal retirement. I’m Scott Thompson with myfederalretirement.com. I’m here again today with Chris Kowalik of ProFeds, which is home of the Federal Retirement Impact Workshop. In today’s episode we’re going to be talking about the Lifecycle funds within the Thrift Savings Plan. Hello, Chris.
Chris: Hi Scott. Always great to be here.
Chris: Yeah. You bet. I get a fair number of questions of employees who are confused about which funds they should be invested in within the Thrift Savings Plan. They’re afraid of being too aggressive, and they’re afraid of being too conservative. They wonder if maybe the lifecycle funds is the best choice for them.
Today I’d like to share with our listeners a little bit about the perk of this idea of the lifecycle funds. How these change over time, and some challenges that they might experience by using the lifecycle funds as well. All in all, the lifecycle funds are a great choice for many federal employees, but we want to make sure they understand how they work before they jump in.
Scott: That makes complete sense. What’s our first topic?
Chris: Before we jump into the lifecycle funds, I’d like to give just a little bit of background. The vast majority of our audience knows that there are five funds within the Thrift Savings Plan. Those are the G, F, C, S, and I. Each of these funds have advantages and disadvantages associated with them. Let me give you two examples. I’ll kind of pull two extremes.
The G fund has the advantage of being very safe. But the disadvantage that employees who are invested in the G fund experience is, they don’t make a lot of money there. There’s not a big rate of return on the G fund. The S fund, S as in Sam, the S fund on the other hand is not safe at all. But the advantage is that a participant has the opportunity to make a hefty return.
Scott: Now do employees have a good sense of how they should be invested?
Chris: Well no, for the most part. That’s really part of this challenge. Typically employees don’t have the right balance between the five funds. It can be challenging for them to know what that right balance is, and how it changes over time as they get closer and closer to the time that they retire from federal service. Even beyond that point in retirement, finding the right mixture can be tough when employees really don’t have any proper guidance.
Scott: How do the lifecycle funds play into all of this?
Chris: If we were to picture a pie chart, each one of the five lifecycle funds have the same ingredients in the pie, the G, F, C, S, and I. But they’re all in different mixtures, and those mixtures change over time. The lifecycle funds were designed to provide this optimal balance between the expected risk and return associated with each of the five individual funds. Again, the G, F, C, S, and I.
It’s based on the timeline of when the participant expects to begin needing the money out of this bucket. There are five lifecycle funds and they are called the L2050, 2040, 2030, 2020, and the L Income. Now remember, each of these include the same funds, the G, F, C, S, and I, they’re just in different mixtures.
Scott: Would you explain for our listeners how these lifecycle funds are different?
Chris: If we start with the L2050 fund, that is the most aggressive of the lifecycle funds, because it’s designed for people needing the money around the year 2050. That’s where the name comes from. For instance, younger employees who have just recently been hired by the federal government may choose the L2050 fund because they know they have a very long horizon before needing access to the money.
On the other end of the spectrum, the L Income fund is the most conservative of the lifecycle funds. It’s designed for people needing the money right about now. It is far more conservative, for employees who are right on the doorstep of retirement. They typically don’t have the capacity (or the stomach!) for losing a good deal of money, so frankly they don’t have the time for the market to recover if they start to pull money out now or soon.
Scott: Would you consider the L Income fund safe?
Chris: From a financial planning sense I would say no. The L Income fund is not safe at that holistic view of it. There are safe parts to it, but the L Income fund does have the capacity to lose money. It certainly did in 2008. When we say safe, it means there’s no risk of losing money, and that’s not true for the L Income fund.
Now when we think of the L Income and we say it’s designed for people needing the money right about now, how on Earth could it lose money? That might cause some of our listeners to shake their head and wonder, “Why would I put any of my money at risk at that stage of my life?”. While I’ll not spend a tremendous amount of time on this point, it is important for our listeners to understand that it’s important for your money to continue to grow in retirement. In order for that money to have an opportunity to grow at a rate of return higher than the G fund, it means that we need to expose a portion of that portfolio to some risk.
Scott: Now you mentioned that the mixture of the lifecycle funds change over time. Could you dive into that a little bit?
Chris: Yeah. Let’s go back to my earlier example of the L2050 fund. I shared with you that the L2050 is a very aggressive fund because it’s designed for people not needing access to this money for a very long time. At its inception, the L2050 fund was primarily made up of the C, S, and I funds. Those are the equity funds that are indexed against the stock market. There is a very small percentage of the L2050 that is made up of the G and the F fund. Golf and Foxtrot funds. But even though it starts with that mixture, or in the investment world we call that an allocation, it won’t actually stay that way for very long. In fact, each quarter the mixture of the lifecycle funds, the G, F, C, S, and I, those shift to be a little bit more conservative each and every quarter.
This shift is so small that most employees wouldn’t even notice it on their statement or by looking at their account. Once 10 years have passed, the L2050 fund allocation will look just like the 2040 does right now. In 10 more years, it will look like the 2030, then the 2020, until eventually it rolls into the L Income fund. We’re really approaching an interesting time here soon, because in 2020 the L2020 fund will be retired, and the L2060 fund will be created.
Scott: Now would you say, Chris, it is the Thrift Savings Plan’s view that employees should just leave their money there until they take it out in retirement?
Chris: That is the way the lifecycle funds were designed. Participants are supposed to put all of their TSP money in one single lifecycle fund and let it automatically transition over time to be more and more conservative. That’s exactly what the TSP had in mind when these lifecycle funds were created. Essentially the TSP tried to make a pretty hands off approach to investing.
Scott: What would be the advantage of doing that over a person just going in and manually changing their allocation?
Chris: Unfortunately there are two things that tend to get in the way with that. It’s emotion and time. The idea with the lifecycle funds is that because everything is already set to happen on a schedule, the employee is less tempted to go in and make manual adjustments because of an emotional reaction to something. Like the market’s high or the market’s low, the market’s about the make a correction. That’s the new buzzword of the year.
The other part of this on the time side is, employees don’t have to set aside the time or simply remember to make the change. In some ways this is kind of like the Ron Popeil rotisserie chicken commercial. You’re supposed to set it and forget it. That’s exactly that the TSP wants participants to do.
Scott: Right. Okay. That makes sense. Now is the lifecycle concept unique to the TSP?
Chris: No. In fact, in the private sector there are similar options that go by some different names, like age based or timeline based or horizon based portfolios. They go by these similar automatic adjustment models that help keep emotions and timing out of this equation, but definitely not unique to TSP.
Scott: For a federal employee who participates in the lifecycle funds, what should they expect as far as a rate of return?
Chris: That’s a great question. The rates of return for the lifecycle funds are directly determined by the rates of return on the individual funds that make it up. The G, F, C, S, and I. The L Funds technically don’t have their own rates of return because they’re ultimately made up of the individual funds and how they perform, and that ultimately determines the L Fund’s performance.
Scott: A while back we did a podcast on the Roth TSP option. You drew a lot of comparisons between the Traditional TSP and the Roth TSP. If an employee wants to do the lifecycle funds, can they choose the Traditional and or the Roth option in the TSP?
Chris: Of course. Let me explain how this works. The best way that I can describe this is that there are two layers of choices or decisions when an employee is figuring out how to invest in the TSP. The first decision is, “What funds am I going to be invested in? Am I going to go the G, F, C, S, and I? Do I do a lifecycle fund? Do I do some sort of combination of something? But what funds am I going to invest in?” Decision number one.
Decision number two is, “How do I want to be taxed?” We don’t have the option of, “No”, right? You’re going to be taxed at some point in time. Let me give a quick example. Let’s say we have an employee that wants to put 100 percent of their pay period contribution that they want to put into TSP, that they put that into the L2020 fund. But they decide they want half of it to be taxed as Traditional and half of it to be taxed as Roth. That’s all the new money going in each pay period. That is a perfectly acceptable election.
To be clear, I’m not suggesting this. I’m just using these as examples. But the TSP will allow a participant to do this. My point to sharing this example is that the two decisions are independent of one another. How you’re investing and how you’re taxed are two completely different decisions.
But here’s what you can’t do. Let’s say an employee decides to put 20 percent of their contributions in each of the five regular funds. 20 percent G, 20 percent F, and so on. What they could not do is to say, “I want my G and my F fund and those contributions to be Traditional, and I want my C, S, and I funds to be Roth”. The decision initially has to be made, what funds are you investing in? Period. Then the decision overall, how is that going to be taxed? The Traditional or the Roth is taxed proportionally across the entire contribution, and not based on individual funds that a participant elects.
Scott: Well that sounds like a very important distinction for our listeners to understand. Are there any other considerations a federal employee needs to be made aware of before retiring?
Chris: Yeah. The last point that I really want to make here has to do with the time that the money starts to come out of the Thrift Savings Plan. Since this podcast has been focused on the lifecycle funds, I’ll use that as an example. But this really applies to regular funds as well.
Let’s say someone has retired, and they have their money in the L Income fund. At that point, 74 percent of their portfolio is in the G fund, and all of that G fund money is safe. The rest of the money is spread in smaller percentages between the remaining F, C, S, and I funds. They’re not equal percentages, but they’re certainly much smaller than the 74 percent that’s in the G.
If we were to rewind back to 2008 when the market crashed, remember that the people who had their money in the L Income fund did lose money. If we come back to our example, here we are, we’re in 2008. The market has just crashed, but I still need money out of the TSP. If I had my choice, I would not want to take money out of the C, S, and I funds because the value just tanked. We had significant drops in the value of C, S, and I in 2008.
What I would prefer to do is to take money out of the G or the F fund. Now here’s the whammy. The TSP does not allow that to happen. When a distribution happens out of the Thrift Savings Plan, it comes out of the funds that a participant has invested in proportionally. You cannot pick and choose which funds the money comes out of.
Now this is not just true of the lifecycle funds, but really all of the TSP. That kind of flexibility, while it’s not available in the TSP, it is available out in the private sector.
Scott: I’m sure sure that can make a pretty difference for people when they’re in retirement and trying to figure out the best way to take money out of the TSP.
Scott: I appreciate that you shared that last point. Do you have any parting words for our listeners, thinking about the lifecycle funds?
Chris: Like always, everyone’s choice in the TSP, they’re very personal. I can’t give blanket advice on this podcast, that I think the L Funds are right for everyone. There are definitely pros and cons. The biggest pro for the lifecycle funds is that it puts someone on the general right path, and it attempts to keep the emotions out of the equation. The biggest con to the lifecycle funds is that it’s not a tailored decision. It’s not tailored to that individual person’s scenario like an investment advisor could do. It might not be taking into account other factors or sources of investment that might cause a person to be better suited for maybe a more aggressive or a more conservative portfolio.
Of course, the more tailored and holistic advice, the better. The lifecycle funds may not be as good as a tailored recommendation from a financial professional, but it’s certainly better than taking a wild guess and hoping that everything works out.
Scott: Right. Well those are really great points, Chris. As always, I love your perspective on these topics, and always appreciate your candor. Thanks everybody for listening today. It’s always a great pleasure to have Chris Kowalik of ProFeds with us. We’d like to ask you to stay tuned to the next episode of FedImpact to get straight answers and candid insights on your federal retirement.