When I first joined the military, in 2008, I chose to set up my TSP account as quickly as I could. Like many folks, I looked at the various funds available to me (without really understanding what any of them were) and chose the Lifecycle Fund that most closely mirrored my age, and expected retirement date. I set up my automatic draft, and promptly forgot about TSP altogether for the next year and a half.
Then, in 2010, I took Dave Ramsey’s Financial Peace University series of classes, and heard him recommend the 60/20/20 C/S/I strategy that I’ve talked about here before. So, I began to look more closely at TSP, and try to figure out why he would recommend that strategy versus the much simpler, much more hands-off, Lifecycle Funds. After all, I reasoned, wasn’t Dave all about “set it, and forget it” when it comes to investing? Shouldn’t he be a big proponent of target-date funds in general, and the Lifecycle Funds within TSP specifically?
To understand why a well-known, and generally well-regarded financial advisor like Dave Ramsey would choose to avoid recommending TSP’s Lifecycle Funds, we have to first understand what the Lifecycle Funds, and other target-date funds, are designed to be and do.
According to Investopedia.com, target-date funds (which is what the Lifecycle TSP Funds are) exist to “grow assets in a way that is optimized for a specific time frame.” Therefore, while most target-date funds are IRA vehicles geared toward a notional retirement date, there are target-date funds for virtually any timeframe. There are 529 college plans that are geared toward target-date funds. There are a multitude of other time horizons, all geared toward achieving a specific monetary outcome within a specific amount of time.
Managers of target-date funds use the time horizon of their specific fund (whether a few years, or several decades in the case of some retirement funds) to calculate risk and make investing decisions. Generally speaking, the “younger” a target-date fund, the more risk and potential for loss its managers will tolerate. As the fund matures, and the target-date draws closer, management is supposed to shift to more stable, less volatile investment strategies focused on preservation of capital. An easy example would be a target date fund that is split between stocks and bonds. Initially, the fund should be made up of a high percentage of stock shares, and a lower percentage of bond shares. As the fund matures, that ratio should swing the other way until, at the maturity date (the “target date” of target-date funds) the money should be invested almost exclusively in bonds and other stable, secure instruments.
A target-date fund can be an excellent “set it and forget it” method of investing, simply because you, as the individual investor, don’t have to remember to rebalance your portfolio as you age. You also don’t have to know anything about the market, or about buying or selling shares, or really anything at all about investing other than how to set up a direct deposit. As your fund matures, and you age, you can rest assured that the smart financial managers working in the background of your fund are making the right decisions at the right time, to ensure maximum value for you.
Or at least, that’s how it’s supposed to work.
The reality is that target-date funds are sometimes too focused on that end date, and consequently, the managers of these funds are much to conservative in the beginning, as an insurance of having maximum capital at the fund’s maturation date. This, in a nutshell, is the problem with the TSP Lifecycle Funds, and why most financial advisors don’t recommend their use by military members.
The simple fact is that the TSP Lifecycle Funds are unnecessarily conservative, even the funds with the longest time to maturation (currently the L2040 and L2050 funds…TSP launched the L2055, 2060, and 2065 funds this year, but there’s too little data on them to make any judgments, since they’re just a few months old.) Here’s a snapshot of the data for the L2040 and 2050 funds, as compared to the good ol’ C, S, and I funds:
As we can see, without exception, even the riskiest Lifecycle Funds are MORE conservative than simply investing in the C and S funds. In fact, we can even see a couple of years where the Lifecycles got beaten by the I Fund!
Why would this be the case? If a target date fund’s focus should be maximizing returns in the earliest years, while still minimizing risk later on down the line, versus simply tracking an index (which is the intent of the rest of the TSP funds), then shouldn’t we expect to see greater returns for the target-date funds in the early years?
Let’s take a look at a non-TSP target-date fund for example. The American Funds 2050 Target Date Retirement Fund (ticker: AALTX) provides a much more promising picture of what a target-date fund can do. Not only did AALTX outperform its target index in 9 out of the 13 years of its existence (frequently by double-digit numbers) but it actually outperformed the S&P 500 as a whole in 6 out of those 13 years! By contrast, the TSP L2050 hasn’t outperformed either its index or the S&P 500 even once in the past decade.
And that, in a nutshell, is the problem with the Lifecycle Funds. While we would expect target-date funds to be growing gradually more conservative as time goes by, and the fund seeks preservation of capital, there’s no justification for the TSP funds to significantly underperform the market from inception. If you want a true “set it and forget it” option that frees you up from having anything to do with your retirement other than remembering to make your contributions monthly, you’d be much better off, and much wealthier on the day you retire, if you chose a target-date fund from a commercial investment company, rather than the Lifecycle Funds offered in TSP.
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Originally published at https://teammwb.substack.com.