The United States Postal Service announced Feb. 8 that it was ending Saturday first-class mail delivery due to cost-cutting initiatives. Its pension liability is an oft-mentioned cause of the service's slow demise. However, any post office employee hired after 1983 joined a defined contribution plan similar to those in the private sector. The Thrift Savings Plan (TSP) is the backbone of the Federal Employee Retirement System. Let's look at its investments.
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Simple Is Best
The TSP offers plan participants five basic investment funds: Money Market, Fixed Income, Mid- and Large-Cap, Small- and Mid-Cap, and International. In addition, employees are offered lifecycle funds, which invest in all five funds with asset allocation targets based on their particular retirement horizon. The individual funds are managed by BlackRock (NYSE:BLK) Institutional Trust Company except for the G Fund (money market), which is handled internally by the Federal Retirement Thrift Investment Board. The L Funds (lifecycle) are designed by Mercer Investment Consulting.
Each employee's contributions are invested in commingled trust funds with other tax-exempt institutions, pension plans and endowments. The set-up is incredibly inexpensive. For instance, the small-cap fund has an annual expense ratio of 0.024%, which compares very favorably to the two mutual funds that most closely resemble the Dow Jones U.S. Completion Total Stock Market Index: USAA Extended Market Index Fund at 0.50% and Fidelity Spartan Extended Market Index at 0.10%. The index includes every U.S. stock that's publicly traded, excluding the S&P 500, as well as those traded on bulletin boards. Although there isn't an ETF substitute, it wouldn't matter because the cheapest ETF I know of has a management expense ratio (MER) of 0.04%, which is 66% more expensive than what postal workers and other public employees currently pay.
Who says MERs don't make a difference? The TSP's S Fund gained 18.57% in 2012 compared with 18.01% for the Fidelity fund and 17.47% for the USAA fund. Government employees benefit tremendously from economies of scale. The TSP's 2011 financial statements list the S Fund's assets at $25.7 billion compared to $8.34 billion for the two mutual funds combined. Over a 10-year period, if a postal worker invested $10,000 in the S Fund and $10,000 in the Fidelity fund, the worker would have an additional $2,539 investing in the former instead of the latter. That's a significant amount when you consider the components of the two funds are identical and the MER differential is a measly 7.6 basis points. Think about that the next time you look at a fund's MER.
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"A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money."
These words were spoken by Warren Buffett at a press conference the day after his 2007 Berkshire Hathaway (NYSE:BRK-B) annual shareholder meeting. Since then there's been much debate about whether he truly felt this way. I myself wonder what would happen to stock prices if everyone, all at once, decided to invest exclusively in index funds, eschewing individual stocks. Would stock prices flatline? It's a question we'll probably never be able to answer, because too many people enjoy the act of picking stocks, much like any other extracurricular event.
I've examined a lot of 401(k) plans over the past few years, and I can say with certainty that many of them are far more complex in both the number and style of investment choices available. Ten years ago, when I was working in the financial services industry rather than writing about it, I would have said it was a good thing. Now I'm definitely a convert to Buffett's way of thinking.
Take IBM (NYSE:IBM) for example. Brightscope, an investment research company specializing in evaluating 401(k)'s, rates Big Blue's as the 14th best for plans with assets greater than $1 billion. IBM's 2012 11-K indicates that employees have 32 fund choices in the $37.3 billion plan - not to mention the 150 fund options in its "mutual fund window". That compares with just 10 options for federal employees including five lifecycle funds. People don't have the time or the inclination to be picking investments. Postal workers and their colleagues in the federal government have it just right.
The Other Funds
This is the biggest of the five funds in terms of assets. It represents 51% of the $289.2 billion (2011) in investments held by the TSP. The G Fund holds short-term U.S. Treasury securities specially issued to the TSP with the interest and principal guaranteed by the federal government. It has achieved an annual return (after expenses) of 5.86% since April 1, 1987. Over the last 25 years, the G Fund has held a distinct yield advantage to a three-month treasury bill, easily beating inflation. It's no wonder a majority of the TSP is invested in the fund.
The second-smallest of the funds, the F Fund seeks to replicate the performance of the Barclays Capital U.S. Aggregate Bond Index. The cheapest of four ETFs (0.05% MER) that mimic the index is the Schwab U.S. Aggregate Bond ETF (ARCA:SCHZ). The index invests in government, corporate and mortgage-backed bonds. The Schwab ETF has only existed since July 2011, so there's not much of a performance comparison. That being said, the F Fund managed a 4.29% return in 2012, compared to 3.9% for the ETF.
The second-largest of the five funds representing 24.7% of the TSP's 2011 investment assets, it seeks to replicate the performance of the S&P 500. There's less performance differential between the C Fund and the available S&P 500 ETFs. Here we're only talking about a nine-basis-point advantage for the TSP.
This is the smallest of the five funds by assets. It seeks to replicate the performance of the Morgan Stanley Capital International EAFE Index. It's here that the TSP drops the ball slightly. Its five-year annualized return as of Dec. 31, 2012, is -3.3%, six basis points lower than Vanguard's MSCI EAFE ETF (NYSE:VEA). Postal workers shouldn't be concerned about this. Overall, they are well ahead of the average man or woman on the street.
There are five choices: L Income, L 2020, L 2030, L 2040 and L 2050. Like most lifecycle funds, each is an investment with a particular time horizon in mind. The asset allocation of the portfolios changes each quarter, becoming less risky as you get closer to the target date. The exception here is the L Income fund, whose allocation remains the same, with 74% invested in the G Fund, 12% in the C Fund, 6% in the F Fund, 5% in the I Fund and 3% in the S Fund.
As for the funds that do change, the asset allocation is different for each of them. For example, the L 2020, which is the closest target date to the present, currently has 55% of its holdings in equities and 45% in fixed income. The L 2050, which is 37 years out, has 88.5% invested in equities and just 11.5% in fixed income. As time moves on, the equity portion shrinks and the fixed income portion grows. With the exception of the L 2050, which was added Jan. 31, 2011, the lifecycle funds date back to Aug. 1, 2005. Of note, each of the funds that change quarterly will be rolled into the L Income fund when hitting its target date.
The Bottom Line
The pension liability issue facing the post office is not unique. It's something the private sector is also dealing with. Since 1986, it's clear that postal workers and other federal employees have been doing their part to fund their own retirements - limiting their reliance on the federal government. I'm sure the TSP experiences the same problems that the rest of America does when it comes to insufficient 401(k) contributions. However, the federal government is to be commended for creating such a smart, efficient and easy-to-understand retirement plan. If only there were more like it. We should all be jealous.
At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.