Sizing Up Uncle Sam's 401(k)

Government officials spend a lot of time telling private employers how they may and may not run their employee retirement-savings plans. Turnabout is fair play, so I decided to take a look at what Uncle Sam offers in the defined-contribution pension plan for federal employees.

The Thrift Savings Plan (TSP), as it’s known, has several strong elements. It’s the lowest-cost plan I know of. And its simplicity makes it easy for employees to use. If a private employer's plan doesn't offer simplicity and low prices, employees ought to complain -- unless they're afraid of retaliation. But the TSP also has some major failings.

Let’s start with the good points. The plan is so enormous -- it has 4.3 million participants with $246 billion in assets -- that it can charge rock-bottom prices. The annual expense ratio for each of the funds in the plan is a microscopic 0.028% (that means that for every $1,000 you have invested in one of the funds, you pay 28 cents a year for management and other costs). BlackRock, the world’s largest money manager, won a competitive bid to run all but one of the funds. The government uses the tiny expense ratio charged on the remaining fund, which Uncle Sam runs, to pay plan administrative costs. By contrast, many 401(k) and 403(b) plans offer funds that charge expense ratios well in excess of 1% per year. And many companies make 401(k) participants pick up the tab for a plan’s administrative costs via bloated expense ratios.

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The federal match is generous, too. The government matches employees’ investments dollar for dollar on the first 3% of their contributions and 50 cents on the dollar for the next 2%. Plus, the government contributes another 1% -- even for employees who don’t participate.

The other big plus: The TSP is simple. While many companies offer a bewildering array of choices in their plans, the TSP has just five main funds. For employees who don’t want to choose among them, the TSP offers target-date funds, also known as the lifecycle funds or L Funds. The five funds are arranged into a variety of combinations designed to invest employees in a mix suitable for their planned retirement date.

All the TSP options are index funds. Only about one-third of actively managed funds beat index funds over long periods. That makes the index-fund approach a sensible one, especially given the plan’s girth.

The funds all mirror broad market indexes. The C Fund reflects Standard & Poor’s 500-stock index. The F Fund mirrors Barclays Aggregate U.S. Bond index, which consists of government bonds and investment-grade corporate debt. The I Fund tracks the MSCI EAFE Index, which focuses on large, non-U.S. stocks in the developed world. The S Fund reflects the Dow Jones U.S. Completion Total Stock Market Index -- an index that encompasses all U.S. stocks not in the S&P 500.

The G Fund is the most conservative option. It pays the yield of a weighted mix of all Treasury securities more than four years from maturity -- without any risk of losing money. This is the same deal the Social Security Trust Fund gets. Stable-value funds offered by most 401(k) plans are similar but not as generous -- and they do carry some risk of losing money.

Why don’t they fix it?

For all its advantages, the TSP suffers from flaws, both minor and major. An obvious one: The names of the funds make no sense. They are pure bureaucrat-ese. Yes, you can go to the TSP Web site and find out what each of the letters mean, but why not simply give the funds names such as “large-company-stock fund” and “foreign-stock fund”?

A bigger problem: The TSP has no emerging-markets stock fund. Not only that, but its only foreign fund excludes emerging markets. That’s inexcusable. Emerging markets boast the fastest-growing economies in the world. Over the past ten years through July 5, the MSCI Emerging Markets Index returned an annualized 10.3%. By contrast, the S&P 500 lost an annualized 1.7% over the same period.

My other criticism: The lifecycle funds get too conservative as you near retirement. There’s nothing wrong with the fund for investors who plan to retire in or near 2040. It has 80% of its assets in stocks. The 2030 fund, which holds 30% in bonds, is conservative, but defensibly so.

The 2010 fund, however, allocates just 34% to stocks. And the Income fund, for people already retired, puts just 20% in stocks. I recommend that most of my retired clients keep 40% to 60% in stocks. If you have much less in stocks, you’ll have trouble keeping up with inflation.

Steven T. Goldberg (bio) is an investment adviser.