The Purpose of TSP’s Lifecycle Funds (and Why You Should ‘Set it & Forget it’)

There are a lot of people who wonder what TSP’s Lifecycle funds (or L-funds) are, what they are supposed to do, and how they are supposed to invest in them. This article aims to answer some of these questions and provide a little clarity.

TSP Overview: In order to understand more about L-funds, it’s best to understand a little more about TSP’s 5 primary mutual funds:

 

• G-Fund: Comprised of U.S. Treasuries
• F-Fund: Index fund comprised of investment-grade U.S. corporate debt. Aims to track the Barclays Capital U.S. Aggregate Bond Index.
• C-Fund: Index fund comprised of stocks from the top 500 U.S. Companies. Aims to track the S&P 500 Index.
• S-Fund: Index fund comprised of stocks from U.S. companies not in the S&P 500. Aims to track the Dow Jones U.S. Completion Total Stock Market Index.
• I-Fund: Index fund comprised of stocks from international companies. Aims to track the MSCI Europe, Australasia, & Far East (EAFE) Index.

You can find out more about TSP’s primary funds in this article that I previously published here.

Lifecycle fund overview: TSP’s L-funds are simply target-date funds that consist of different combinations of its G, F, C, S, & I Funds. A target-date fund is simply a fund that initially invests in growth assets, but gradually shifts to more conservative investments over time until reaching a predetermined date. For example, the L 2020 fund will gradually adjust its investment mix until the year 2020, when it will shift to the L-Income fund, which is the most conservative of the L-funds, and most heavily invested in U.S. Treasuries. Currently, TSP provides the following funds (in order from most conservative to least): L-Income, L2020, L2030, L2040, and L2050.

Let’s compare the two extremes: L-Income & L2050. As its name indicates L-Income is the fund of choice for people in retirement (actual retirement, not retiring from the military), who depend on a safe, predictable income from stable investments. Conversely, the L2050 fund is for people who don’t expect to use those investments until 2050 or beyond. As you would expect, L-Income contains a lot more of its investments in the G-fund than L2050, which has most of its investments in C, S, & I funds. The other funds fall somewhere in between, but vary based upon the investment horizon. The current breakdown (as of March 2015) is below, but can be found on the TSP L Fund information page.

                         L-Income       2020                2030                2040                2050

G                            74%                    44                     29                       19                      10

F                               5                           5                      6                         6                        4

C                             12                        27                     34                      38                      42

S                               3                          8                      12                      16                       18

I                                5                         15                      19                      21                      25

As you can see, G & F funds (both bonds), make up almost 80% of L-Income, but only 14% of L2050. This allows L-Income to provide consistent income with a less risky portfolio. Conversely, stocks make up just 20% of L-Income, but 85% of L2050, which positions L2050 for long-term growth.

Asset allocation. Now that we know a little about the L-funds, let’s talk a little about the asset allocation. Asset allocation is simply the process of taking a certain number of investments (in this case the five TSP funds), and figuring out how much of your money to put into each. It’s a decision that everyone has to make, whether you want to or not. A lot of people decide to perform their own asset allocation, and choose which investments to put their money in. For TSP’s L-funds, asset allocation is done based upon investment modeling by Mercer Investment Consulting, one of the world’s largest investment consulting firms. By choosing an L-fund, you are making a decision based upon analysis performed by a consultant.

Mercer Investment Consulting. If you’re trusting a decision based upon a consultant’s work, it might be worthwhile to learn a little about that consultant. According to Wikipedia, Mercer Investment Consulting is the world’s largest HR consulting firm, and has been around since 1937, when it started as the employee benefits department at Marsh & McLennan, Inc., the company who still owns it today. One of Mercer’s primary business lines is performing worldwide consulting work with companies & governments who administer retirement plans like TSP. Without going into more detail, let’s assume the folks at Mercer Investment Consulting know what they’re doing.

Efficient Frontier. Now that we’ve established who makes the decisions on your L-funds, we should look a little more into how they make those decisions. The TSP fact sheet does a really good job of explaining the ‘efficient frontier,’ which is the basis of the L-fund asset allocation. Simply put, there is a risk/return relationship between any investment, or any combination of investments. The risk is measured in standard deviation, while the return is measured in annual percentage return—you can plot any investment on a graph that reflects these two measures.

The efficient frontier is a theory that all of the best possible investment combinations are plotted on a line in order from least to most risky. This line is known as the efficient frontier.  The L-funds information page does a great job of explaining this with a graph on Page 2.

In this case, we’re using TSP funds (and combinations of them), without respect to any other mutual fund, stock, or any other securities. Any investment that is above the efficient frontier line is not attainable (for example, 0% standard deviation and 30% expected annual return), while any investment below the line is less than what you can expect (for example, 2% return at 5% standard deviation). As you can see, L-Income is much further to the left (indicating lower risk & lower expected return) than any of the target-date funds. As we get closer to the maturity of a target-date fund, you can expect that fund slide further to the left and approach the L-Income fund.

What happens when you start tinkering with other funds…you miss the point of having an L-fund.

Now we get to the point. When you invest in TSP’s L-funds, you are:

1. Making a decision as to when you need this money
2. Trusting the Mercer Investment Consulting asset allocation model

If you ‘set it & forget it,’ then you’re investing on the efficient frontier (or at least Mercer’s definition of it). Not only that, but the L-fund automatically adjusts over time to lower the portfolio risk. If you invest in an L-fund, then put a bunch of money in one of the other funds, then you’re probably going to screw up the asset allocation. This means you’ll either be taking too much risk for the return you expect to make, or you won’t be making as much money as you should expect for the risk you’re taking…you’re under the line. Not only that, but you’ll need to make regular adjustments to make sure your portfolio is properly balanced, which you don’t need to do with an L-fund.

You might have money in other accounts, that you cannot put into TSP. There is nothing wrong with that. However, you should recognize that your asset allocation within TSP may be altered by outside investments. By sitting down with a fee-only financial planner, you can make sure that your asset allocation will meet your investment goals.

Bottom line, if you plan to use L-funds within TSP (outside investments notwithstanding), then use them exclusively. If you want to manage the funds yourself, please feel free to do so. However, don’t use L-funds, then make adjustments because you think you can add value. There is virtually zero chance of you being better off.

As always, this blog serves to answer your questions and address concerns.  If you like this blog, please forward it on to other people who may benefit.  If you have issues or concerns, or if you have a question you’d like me to answer, please feel free to contact me.  You can reach me through my website or via email.  In the meanwhile, take charge of your life!