A Look at

TSP Lifecycle Funds

&
Vanguard Lifecycle Mutual Funds


What are Lifecycle Funds?


Lifecycle funds are designed for investors to simply select the Lifecycle fund that corresponds to their retirement date (such as 2040 or 2050).  Both Vanguard and the government's TSP program offer Lifecycle funds. The Lifecycle funds adjust allocations internally so you don't have to.   While this is simple, we will look at the consequences.  The Lifecycle fund investments are "professionally" determined based on mainstream thinking on how investors should be diversified to reduce risk as you grow older.  The allocation mix is adjusted to be more "conservative" as one nears retirement and then moved into a very low risk (and return) income producing fund in retirement.  It sounds good so far.


A main take-away from this page is that the entire concept of how Lifecycle funds are allocated is based on a theoretical returns that does not take into account where the markets are today in terms of both interest rates and stock market valuations.  


The Strategy


The investment strategy assumes that the greater number of years you have until retirement, the more willing and able you are to tolerate "risk" which portfolio managers define as merely fluctuation in your account in order to "pursue" higher returns.  The idea is that for a "given risk level" and time horizon (your retirement) there is an optimal mix of investing in stocks and bonds to provide the highest "expected" return.  The next graph comes from the TSP Factsheet on Lifecycle funds.  Here we see how allocations differ based on your target retirement date (plus or minus 5 years). Note the "L Income" fund is for those who are retired and can not afford to take large losses so it is holding 74% the safe TSP G fund and only 20% in stocks.


Lifecycle Funds Allocation Targets


The government's TSP Lifecycle funds invest in a mix of the five basic TSP funds (as seen in the chart above) based on your years to retirement.  The Vanguard Lifecycle Mutual Funds add international bonds and other instruments, but lacks the TSP G fund so Vanguard investors have to assume more risk in retirement.  The Lifecycle funds come with all the risks associated with the basic mix of funds they invest in.


The Stated Risk


The primary risk for any equity (stock) fund is market risk or the fact that the stock market can lose a significant amount of your funds in a very short period of time.  Portfolio managers often recommend setting a mix of stocks to bonds such as 70/30 when younger and moving to 20/80 in retirement.  


Since bonds are less volatile than stocks this simply reduces the "fluctuation" of your overall investments which is their definition of "risk".  As highlighted by the orange ovals in the next chart, we see what this really means is your account loses less in a down market but gains less in an up market.  Whether you beat the basic funds depends simply on what time period you refer to.  






The Real Risk


It is important for investors to understand that the Lifecycle fund's primary strategy is buy and hold no matter where we are in the stock market cycle.  The unwritten assumption of these funds is that market risk and "expected" future returns are static - which is far from reality and easily observable on any long term chart. The true risk of investing in any fund is the risk of significant losses and this risk changes over time and is more pronounced the higher market valuations become.


The next graph comes from the TSP Fact Sheet on Lifecycle funds with my markups in blue.  If you compare the actual price movements in the chart above with the "expected" future returns in the chart below, you see that future returns really depend on where you are in the stock market cycle.  More so for those retiring within the next 20 years. 


The fact sheet never adjusts their marketing to interest rates or valuation levels that are highly correlated to future long-term returns.  You will note my added in curve circled in green is based on the next 10 years and not the lifecycles beyond 2030.  If the equity funds drop in price over 50% relative to sustainable earning streams, only then can you expect something close to the fact sheet's curve.




reference



In the last 20 years, the popular SP500 index fund that holds about 80% of the value of the entire US stock market lost over 50% twice.  While marketing data points to many years of great returns, what is missing from this data is the fact that it takes 100% of gains to simply break even after a 50% loss on your portfolio.


The L income fund only took a 10% hit due to its low holdings of stock funds during the 50% bear market as it was designed to do and this is a good thing for retirees.  I have the least amount of concern for the Income Fund once investors move to it, although I do think its returns can be improved without taking on more risk.


In the price chart above we see it took all the Lifecycle funds as well as all the equity index funds over five years to catch up with the lowly TSP G fund after each decline.  Please do not get the idea the F fund is a better investment today because it outperformed the TSP G fund since 2007.  The largest allocation TSP gives to the F fund in Lifecycle funds is only 6% for all age groups! There is a reason for this.


Like most funds, TSP gives lip service to the fact the future "may" not look like the "past" - it won't.  The following paraph is found in the TSP factsheet on the Lifecycle fund...




As you move to the farther retirement dates, one could argue that the market cycle matters less and thus using the past average returns to market the expected future returns is justifiable.  With 85% of the 2050 fund invested in stocks, using an 8% average gain on the stock market looking back leads you to an expected return of 7% in the chart above.  


But even with this long time horizon, it is hard to justify a buy & hold strategy when the stock market is flirting with the same high market valuation levels relative to sales, dividends and many other factors as seen in 1929 or the stock market bubble of 2000.  In other words, it is highly probable the stock market will be no higher in 12 years as it is today with much better buying opportunities during the next decade.


Another assumption presented as fact in most marketing material is that investors have to assume more "risk" in order to "pursue" higher returns.  I disagree with this concept thoroughly and as we see with the Lifecycle funds the changing mix of investments between stocks and bonds merely reduces the fluctuation in the fund to both the upside and downside. While the safer funds (with more bonds) take just as long to get back to even.


Investors should reduce exposure to stocks as they approach retirement.  This is a sound principle but the Lifecycle funds even fail this principle in the last 10 years prior to retirement as highlighted in the "Details" section below. 


But more important is the failure of the Lifecycle funds to reduce exposure to equities when the stock market risk is most elevated. This is different from market timing or moving into and out of stocks based on a 1000 great ideas.  It is simply sound investing and does not require many allocation changes.




A Better Risk Reduction Strategy



Please realize that I am not mainstream in defining "risk".  My definition of risk is avoiding taking significant losses on your holdings and not just reducing volatility to the up and downside. Yes, the Lifecycle funds are less volatile but in the end, but the price is a smaller nest egg in retirement than someone who simply avoids the bulk of the bear markets.



Please review our Seasonal Investing section to understand the overall strategy.  This strategy has significant academic and real-world backing, but is not popular with fee earning advisers and funds.  The basic premise is to avoid stocks the 6ish months of the year that (on average) under-perform safe interest bearing funds.  It's that simple.  By doing this you cut your exposure to stocks by 50% and this could allow you to hold a higher percentage of stocks during the favorable months than you might otherwise - the months with the fewest and smaller market corrections. 


The graph below shows the cumulative returns of being invested only during the unfavorable season for equities (summer/fall) based on our Bellwether signal. The green line is the TSP G fund, all others are equity funds.  






The chart above shows you how you end up with the results in the next chart. The dotted blue line below is the buy and hold performance of the TSP C fund (SP500).  It shows a respectable 160% gain since 2000 which was turned into a 400% gain by simply sitting out the summer and fall each year in the TSP G fund.  The red line shows the effect of seasonal investing on the small cap TSP S fund.  Small cap stocks are more volatile in general to include seasonally which makes them the best candidate for season investing.






To learn more of how you can reduce risk while increasing your returns read about what we think is absolutely the best TSP strategy and how it can also be applied to any retirement account or learn how the Bellwether timing signal evolved.








The details of Lifecycle Funds



Both the Vanguard and TSP Lifecycle fund investment allocations were set by professional investment consultants who are investing for the typical investor.  So what better baseline data to start with for your own allocation percentage decisions.   We will be discussing the limitations of these funds - basically they are buy and hold funds that do not avoid market risk in general, just diversify it.

 

In the table below, I took a snapshot in time of their recommended allocation levels based on when you expect to retire.  I assume they consider 65 the retirement age and plugged that into the table.   The basic stocks allocation verses bonds percentages are in the same ballpark for TSP and Vanguard.  As expected, as you move closer to retirement the recommendation from both is to reduce exposure to equities (stocks). 

 

Before delving into the table, I want to make clear that I do not like lifecycle funds and I only present the data so you can obtain a rough guide as to what your baseline allocation to equities should be based on your age.  I do not like lifecycle funds for the same reason I do not like the buy & hold mantra of wall street.  Buy & hold investors take significant losses that take years to get back to where their balance sheet started.   I do not espouse speculation and trading either with one's nest egg, but I strongly believe there are times when market risk (risk of significant losses) is elevated and you should not be in the market, period.  Eight years of bull market gains can evaporate in a very short period of time.

 

Okay, lets jump to the table.  The "stocks/bonds" section provides a general look at the allocation split between stocks and bonds.  Vanguard does not have the advantage of investing in the G fund which provides a risk free return based on short term US gov't bonds.  The only risk free allocation Vanguard shows in their funds occurs in their "retired" fund in with a 10.8% allocation.  Otherwise they invest in bonds, shifting to safer short term bonds as one closes in on retirement.  Vanguard does invest in International bonds where TSP does not have that option, but I do not think it provides much in terms of diversifying risk.  

 

What surprised me initially was that TSP remains at approximately 6% in the F fund regardless of age thereby shifting funds from equity to the G fund as one closes in on retirement. Presently both funds are providing the same yield, but the G fund comes with much lower risk.  Frankly, I can see them moving to no allocations to the F fund in the near future if interest rates start rising.

 

 

 

Even in retirement, both TSP and Vanguard recommend holding some equity.   Both funds show a significant drop off in recommended equity allocations from 15 years prior to retirement compared to "in retirement".   If you lose a significant amount of your retirement funds in those last 5 years, you can not make it back.  Maybe they assume you could delay retirement if you lose money while working, but after you retire you probably are not going to get that job back.  


Vanguard appears to have shifted to holding too much exposure to equities in retirement (44%) compared to TSP's 20% for buy and hold investors.


Why the last ten years matter?  


The market cycles in less than 12 years in bull and bear markets.  If the market tanks when you have 9 years to go to retirement, there will probably be another bull market to regain some of your losses.  If it tanks with 2 years to retirement, you will take the hit but miss most of the bounce back during the follow-on bull market with lower equity holdings.  Another major assumption is that the market always bounces back to a new high and this may be tested after the next bear market. Japan's stock market still has not exceeded its 1989 bubble top.  Of course, the better solution to holding until the market "always" bounces back, is we need to avoid most of those bear market losses and significant corrections all together.


Another target date issue occurs close to retirement dates that per TSP guidance as seen below.  If you are retiring in 2018 and you use the 2020 fund you would be holding a higher exposure to equities your retirement year than someone retiring in 2024.   There is a bit of allocation averaging here that would not be helpful in a bear market for some investors.



 

 

 

How can you can use this information as a guide to develop your baseline allocations in stock funds (TSP C/F/I funds)?

 

If you are going to retire in 2030, you can see TSP is holding a 65% allocation to equity funds and Vanguard is holding 75%.   Since stocks tend to gain and lose more than bonds, this is the most important takeaway from the chart.  The decision between the fixed income funds (TSP F fund) and no-risk funds (TSP G fund) will have a much less impact on your returns than what happens in the stock market.  


As for international exposure in the international funds, the S&P 500 index (TSP C fund) has significant exposure overseas and if the US economy and markets tank, the rest of the world will too.  The MSCI EAFE index fund (TSP I Fund) invests in 85% of the developed world's listed companies (does not include US, Canada and China).   The SP500 index receives over 38% of its revenues from international sales.  If you add in an international fund you are actually over-weighting international stocks.


I another issue with MSCI Developed World index funds (TSP I fund) - it is highly exposed to financials and has little technology exposure. All the global large tech firms are US companies or listed in the US.  In today's world, the financial industry is at great risk (low interest rates & bad practices).  Profit growth has been in technology and online retail and the leading world companies are listed in the US and not in Europe or Japan.


Don't think in terms of geographic diversification with the funds, think of the US dominance in technology profits sitting in the SP500.  Instead of diversifying with an international fund, I would stay focused on decreasing market risk in the US funds during times of market distress.  The US market is also backed up by the world's reserve currency and a central bank that is the most capable of providing support to the financial markets.  This support is not available in the rest of the world.


Large Cap funds verses Small Cap funds


The SP500 equals about 80% of the US market cap and the small cap fund (TSP S fund or VXF ETF) equals the other 20%.  So this means holding four parts the SP500 fund to one part non-sp500 fund gives you the proper weighting to equal the total US stock market. Looking at the TSP C to S fund ratio, we see the TSP Lifecycle funds give young investors a higher ratio of small caps to the large caps (more risk).  As the funds approach retirement they shift close to the 4:1 ratio.


One of the points I want to make here is that merely splitting your equity funds in 33/33/33% would not give you a balanced portfolio in terms of market capitalization, international exposure or high-growth tech exposure. It would actually work against diversification of the most profitable companies.


 

Invest safe, invest smart.



 

An investment adviser who asks you what is your desired "level of risk" is no different than a used car salesman asking you what amount of monthly payment you can afford.  Neither question is pertinent.   You want the highest possible returns with the lowest possible risk.  Lifecycle funds with their buy & hold strategy will get you neither.

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