[Federal Register: April 24, 2008
 (Volume 73, Number 80)]
[Rules and Regulations]               
[Page 22049-22057]
From the Federal Register Online 
via GPO Access [wais.access.gpo.gov]
[DOCID:fr24ap08-1]                         

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Rules and Regulations
                                                Federal Register
____________________________________________________________
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The Code of Federal Regulations is sold by the Superintendent of Documents. 
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[[Page 22049]]
FEDERAL RETIREMENT THRIFT INVESTMENT BOARD
5 CFR Part 1601
 
Participants' Choices of TSP Funds
AGENCY: Federal Retirement Thrift Investment Board.
ACTION: Final rule.
-----------------------------------------------------------------------
SUMMARY: The Federal Retirement Thrift Investment Board (Agency) amends 
its interfund transfer (IFT) regulations to limit the number of 
interfund transfer requests to two per calendar month. After a 
participant has made two interfund transfers in a calendar month, the 
participant may make additional interfund transfers only into the 
Government Securities Investment (G) Fund until the first day of the 
next calendar month.
DATES: This rule is effective on May 1, 2008.
FOR FURTHER INFORMATION CONTACT: Megan Graziano, 202-942-1644.
SUPPLEMENTARY INFORMATION: 
Preamble
    Under the Federal Employees' Retirement System Act of 1986, the 
Thrift Savings Plan (TSP) was created to offer passive long-term 
investments designed to improve the retirement security of Federal 
employees. As a result of analysis performed in 2007, it became clear 
that a small number of TSP participants were pursuing ``market timing' 
active investment strategies in the TSP. These activities were diluting 
the earnings of the long-term investors, and adversely affecting the 
ability of TSP managers to replicate the performance of selected 
indexes as required by law.
    The Chief Investment Officer reported these findings to the 
Executive Director on November 6, 2007. The Executive Director 
presented the information to the Federal Retirement Thrift Investment 
Board members at their public monthly meeting on November 19. Subject 
to the input from the Employee Thrift Advisory Council (ETAC), the 
Board authorized the Executive Director to put in place both interim 
and structural restrictions on frequent interfund transfer activity.
    The 15 members of the ETAC were advised that same day and presented 
with the information developed by Agency staff. Under longstanding 
custom, ETAC members were also provided an advance copy of the Agency's 
interim proposed rule. Two ETAC member organizations voiced some 
concerns, and the Agency decided to withhold publication of the 
proposed interim rule until a public meeting of the ETAC and the 
Executive Director could be conducted on December 19. After extensive 
discussion at the meeting, no ETAC member objected to the Agency's 
implementation of its interim plan. The proposed interim rule was 
forwarded to the Federal Register on December 21, where it was 
published on December 27. The rule took effect on January 7, 2008.
    On January 24, 2008, under the interim rule, the Executive Director 
sent letters to 3,775 TSP participants who had been identified as 
frequently requesting IFTs. The letters explained the need to reduce 
this activity and asked recipients to voluntarily reduce their IFT 
requests. The letters also warned each individual that a failure to 
practice self-restraint could result in the imposition of restrictions. 
Eighty-five percent of those who received a letter voluntarily 
complied. However, 549 individuals continued their frequent IFT 
activity during February. These individuals were subsequently notified 
by certified mail that they would be restricted to requesting IFTs by 
mail, effective April 1, 2008. Their option to request IFTs via the TSP 
Web site or over the Thriftline was suspended until plan-wide 
structural restrictions are implemented. However, some have appealed 
their restrictions, and, in appropriate cases, the Agency has approved 
their appeals.
    On March 10, 2008, the Agency published a proposed rule with 
request for comments in the Federal Register (73 FR 12665, March 10, 
2008). The Agency received comments from three Federal employees' 
unions and from 354 TSP participants. One comment purported to include 
the views of over 4,000 participants. Additionally, the Agency received 
and reviewed 110 comments prior to the Agency's publication of its 
January 7, 2008 interim regulation; these comments were reconsidered as 
a part of this rulemaking process.
Comment Summary
Summary
    Commenters raised a number of issues and a detailed response to 
each one is provided below. By way of summary, those individual 
respondents who have personally made frequent interfund transfers and 
oppose the proposed limits display a fundamental misunderstanding of 
the statutory TSP design. They also present two overarching arguments 
which deserve discussion at the outset, because they obscure the damage 
which their frequent IFTs inflict on other plan participants.
Misunderstanding
    By misappropriating language used in the capital markets (buys, 
sells, trades), some TSP participants give the impression that their 
frequent interfund transfers are trades in and out of the markets which 
affect only their own funds. This is incorrect. All TSP assets are in a 
pooled investment which is designated by statute as the Thrift Savings 
Fund.
    In this regard the TSP funds are like mutual funds regulated by the 
Securities and Exchange Commission (SEC). In 2005 the SEC took steps to 
reduce activity in mutual funds. It did so after finding that: 
``Excessive trading in mutual funds occurs at the expense of long-term 
investors, diluting the value of their shares. It may disrupt the 
management of a fund's portfolio and raise the fund's transaction cost 
because the fund manager must either hold extra cash or sell 
investments at inopportune times to meet redemptions.'
    Congress established the Thrift Savings Fund as a long-term, 
passive investment. The legislative history shows that active 
investments were considered, but rejected. The Federal Retirement 
Thrift Investment Board is required by law to develop policies under 
which four Thrift Savings Fund offerings--commonly known as the C, S, 
I, and F Funds--are invested to ``replicate' the performance of 
selected
[[Page 22050]]
market indexes at a low cost. Through careful and diligent management, 
these goals have been achieved for more than twenty years.
    Each day the Agency and its contractors tally new contributions, 
loan activities, disbursements, and IFTs to arrive at net amounts 
available for investment in each of the Thrift Savings Fund offerings 
that day. A similar netting process occurs in the TSP asset manager's 
commingled investment funds, which include the assets of many other 
institutional investors. Predictable cash flows and offsets due to 
netting minimize trading costs.
    This carefully designed structure, which optimizes achievement of 
the statutory goals, has been challenged over the past year by a 
noticeable increase of IFTs by a small group of participants. The 
Agency's analysis has demonstrated that fewer than 1 percent of TSP 
participants are engaging in this activity to the detriment of more 
than 99 percent of participants who are long-term investors (those who 
requested 12 or fewer IFTs in calendar year 2007).
    The actions by the small group have become less random, which 
suggests coordination and leads to fewer opportunities for cost savings 
due to offsets. The deleterious consequences of these activities in the 
TSP are the same as those which the SEC found occurring in mutual 
funds. Importantly, the clear intent of this activity--to ``beat' the 
market indexes--fundamentally conflicts with statutory mandates that 
the Board provide passive investments which replicate the performance 
of market indexes.
Claim That Frequent Interfund Transfers Do Not Significantly Increase 
Costs Is Misleading
    Commenters who oppose restrictions cite the very low TSP 
administrative expenses as evidence that their actions are harmless. 
Some concede additional costs, but argue that those additional costs 
are de minimus and only amount to $4 per year, per participant.
    While we neither accept this number nor the process by which it is 
derived, the view that exceptional costs generated by 1 percent of 
participants should be viewed as inconsequential if they can be charged 
off to 100 percent of plan participants is troubling. The resulting 
small average cost obscures a significant problem, i.e., the cost to 
other individual participants can be very high depending on how funds 
are invested on a particular day. This issue is discussed further 
below.
    Moreover, the Agency rejects the argument that $16 million in 
trading costs is small. The entire budget for the TSP in 2007 was just 
$87 million. In the context of how the TSP fiduciaries run the TSP, 
this additional $16 million is a very large number.
    Costs remain low in the TSP because the Board, exercising due 
diligence, looks behind broad averages. Indeed, diligent examination 
led to the discovery last summer of frequent interfund transfer 
activity by this very small but determined cohort of participants.
    As noted above, individual TSP interfund transfers are not 
``trades' and transferees are not ``traders.' However, frequent IFTs 
can and do generate expenses which include trading costs at the Fund 
level. The Agency and its asset manager endeavor to minimize trading 
costs through offsets, netting, and cost free ``cross-trading.' 
Ultimately, if the asset manager must go to the market to buy or sell 
securities, the associated transaction costs (including commissions 
paid to the brokers, transfer taxes, and market impact) are borne by 
all participants in the Fund. These costs are not reflected in the 
highly publicized and very low TSP expense ratio. Further discussion of 
transaction costs is featured below.
Recommendation That Interfund Transfer Restrictions Apply Only to the I 
Fund Obscures Significant Abuse
    A number of commenters acknowledge that the analysis presented by 
the Agency staff makes a compelling case to restrict interfund 
transfers in the I Fund. However, they argue that the analysis is not 
as compelling for the other TSP funds. The Agency has decided to apply 
the restrictions to all TSP offerings for two reasons:
    First, the Agency's analysis does demonstrate measurable and 
growing adverse effects of frequent IFT activity in the S Fund. 
Moreover, since the analysis was performed, interfund activity in the F 
Fund increased as well.
    Second, the G Fund has been subjected to a frequent transfer/market 
timing practice that is particularly insidious.
    The G Fund is invested in specially-issued Treasury securities 
which provide a fixed rate of return established monthly. It is 
considered the TSP ``stable value' fund, and is especially important 
to those cautious investors who seek security of principle and 
interest.
    Some of the frequent interfund transferors have determined that by 
making one-day round trips in and out of the G Fund three to five times 
each month, they are able to effectively collect a full month's worth 
of G Fund earnings for just three to five days of actual G Fund 
investment. The windfall they secure comes at the direct expense of 
long-term G Fund investors who never anticipated that their safe 
retirement investment would be subjected to such mercenary treatment by 
their fellow TSP participants.
    Practitioners visit a Web site in order to compare notes and 
calculations to assist each other in the execution of this scheme. They 
congregate at a message board which they have aptly titled ``G Fund 
Payday.' Indeed, like ghost workers, these individuals only show up in 
the G Fund on the days when their calculations show that G Fund shares 
will increase in value. With a finite amount of earnings to be 
allocated, these individuals unquestionably dilute G Fund value at the 
expense of long-term investors.
    This indefensible practice will be severely curtailed by the limit 
on interfund transfers. Additionally, the Agency will make a structural 
change beyond the purview of this rulemaking which will totally 
eradicate this particularly abusive form of frequent interfund transfer 
activity.
Union Comments
    The Agency received three comments from Federal employees' unions. 
All acknowledged that frequent IFT activity is detrimental to the 
performance of the funds and that some action to restrict it is 
necessary.
    One union supports the regulation as written.
    One union commented that changes that have already been made 
address the frequent transfer problem and no further changes are 
needed. This union is referring to the interim regulation implemented 
by the TSP in January 2008, whereby the Executive Director identified 
3,775 participants who were making excessive IFT requests, thus driving 
up costs for the participants who are using the TSP in the way it was 
intended, as a long-term retirement vehicle. Letters were sent to those 
participants requesting that they voluntarily restrict their IFTs to 
fewer than four in the month of February. The letter noted that, if the 
participant did not voluntarily comply, s(he) could be limited to 
making IFT requests by mail only. This limitation would remain in 
effect until the Agency implemented structural changes that would 
automatically apply to all participants.
    Thus, the Agency's actions so far were only approved as a temporary 
measure, to deal with an immediate problem, until the longer-term 
solution could be put in place. It was an extremely labor-intensive 
process to identify these individuals, notify them by mail,
[[Page 22051]]
identify those who did not voluntarily comply, send them certified 
letters, restrict their online access, and handle their appeals.
    Additionally, in all fairness to those individuals, the Agency 
would have to continue to apply that same labor-intensive process to 
all participants on a monthly basis.
    With this final regulation, the Agency will implement a structural, 
automated process. While the union asserted that the interim measure 
was less ``Draconian' than the proposed regulation, the Agency sees it 
as the opposite. Under the interim regulation, affected participants 
must submit IFT requests by mail and, as the Agency processes mail 
requests in the order received (not necessarily in the order mailed), 
participants have reduced control over what order their IFTs are 
executed. (One participant commented against the union proposal and 
noted that the interim regulation is ``Draconian.')
    This union also suggested that if a change is necessary, it should 
be ``to allow two transfers per month and after two transfers (if other 
than the G Fund), attach a fee for servicing the transfer.' ``While it 
may be `impossible to correctly assign the exact costs,' we can follow 
the leads of other such funds in arriving at a figure.'
    In its research, the TSP found no mutual fund or defined 
contribution plan which allows participants to make a certain number of 
free transfers and then charges a fee for additional transfers. In 
fact, fund managers who use trading limitations and fees, do so as a 
double deterrent, not as a way to accommodate more transfer activity. 
In recommending this approach at an ETAC meeting, the union noted that 
TIAA-CREF pursued a similar policy. The Agency contacted TIAA-CREF, and 
its policy is: A participant who transfers from any fund, transfers 
back, and then sells it within 60 days may not repurchase that fund for 
90 days and, if the transaction involves the international (similar to 
I Fund), high yield, or small-cap (similar to S Fund) funds, a 2 
percent fee is assessed. The TSP regulation is far less restrictive.
    The TSP also looked to Vanguard, the largest mutual fund index 
manager in the country. Holders who redeem shares in any Vanguard 
mutual fund must wait 60 days before repurchase. For some funds, 
including the fund that is similar to the TSP's I Fund, if the 
shareholder redeems a fund that has not been held for 60 days, the 
shareholder cannot repurchase the fund for 60 days, and must pay a 
redemption fee, which would be 2 percent for the international fund. 
Again, the TSP regulation is far less restrictive.
    The third union suggested two proposals. The first was addressed in 
the preceding paragraph. Alternatively, it proposed four instead of two 
unrestricted IFTs per month. TSP studies showed that allowing four IFTs 
per month would not result in any meaningful reduction in the dollar 
amount of the daily trades. Allowing three IFTs per month would result 
in a 31 percent reduction in the dollar value and two per month would 
result in a 53 percent reduction. Thus, the TSP is expecting a 
reduction in dollar value of between 31 percent and 53 percent, after 
factoring in some activity related to unlimited transfers to the safe 
harbor of the G Fund. TSP research has shown that less than 1 percent 
of participants make more than 12 IFTs per year. Therefore, the 
regulation will not affect 99 percent of participants. It will allow 
participants to rebalance their accounts twice per month, which, in the 
view of the Plan's two investment consultants, is more than adequate.
Participant Comments
Support for Proposed Regulation
    Thirty participants supported the regulation.
Opposition to Proposed Regulation
    Some participants suggested there should be a certain number of 
``free' IFTs per month and then a fee per transaction. This proposal 
was addressed under the union comments discussed above.
    Many participants commented that TSP expenses are already very low 
or that costs are going down. Some noted that TSP Funds are already 
outperforming their underlying indexes.
    TSP expenses are very low. The TSP's enabling legislation requires 
the Board to develop investment policies which provide for low 
administrative costs. 5 U.S.C. 8475. Due to efforts by the Board, the 
net expense ratio for the TSP Funds declined to 1.5 (0.00015%) basis 
points last year.
    However, the Funds also incur transaction costs, which are directly 
related to the dollar amount of IFTs requested by participants. These 
transaction costs are investment expenses that reduce investment income 
before deductions for administrative expenses and are not included in 
the expense ratio.
    TSP net administrative expenses in 2007 were reduced to 
$31,392,286. However, costs from trading activity were an additional 
$13,880,098. Although more than 99 percent of participants made 12 or 
fewer IFTs last year, all participants shared the full cost of 
executing the interfund transfers generated by those who made numerous 
IFTs.
    Numerous IFTs increase the dollar amounts of the orders that are 
given to the investment manager on a daily basis. The investment 
manager must therefore hold more cash to meet potential redemptions, 
leading to a greater chance of differences in performance from the 
indexes tracked by the funds. This difference (tracking error) can be 
positive or negative, but the TSP is charged by statute to keep this 
tracking error as low as possible since the funds must, by law, 
``replicate' their respective indexes. 5 U.S.C. 8438. It is 
indisputable that reducing the dollar amount of IFTs will lower 
transaction costs and the amount of cash the investment manager must 
hold and will, therefore, reduce tracking error.
    Several participants noted that ``there is no problem;' that 
trading costs are going down; that trading costs the average 
participant $3, $3.55, $3.56, $4, or $4.60. They asked ``Why does it 
cost $240 to trade a $300,000 account?' ``Why can't you determine the 
exact cost and charge participants accordingly?'
    The TSP has avoided using averages when averaging can obscure 
important distinctions. For example, over the years, some have 
suggested that the Agency develop an average cost per participant. One 
could devise a simple calculation, i.e., in 2007, net administrative 
expenses at approximately $32 million spread over approximately four 
million participants would yield an average annual cost of $8 per 
participant.
    However, this is misleading because costs are borne pro-rata, and 
increase based on account size. So in order to be precise, the Agency 
expresses costs in terms of basis points. Thus, with last year's net 
expense ratio of 1.5 basis points, a new participant with $1,000 on 
account can easily determine that his cost was 15 cents, while a 
veteran participant with $1 million on account can quickly know that 
her share of these expenses was $1,500.
    With regard to IFTs, because there are several moving parts each 
day, an average would obscure important distinctions. For example, on 
August 16, 2007, participants redeemed 22,219,762 shares of the I Fund. 
The price they received was $22.48 based on a 4 p.m. market pricing. 
When the securities were sold at the opening of the foreign markets 
later that evening and the following morning, they were sold for 
$9,554,497 less than the prices used to determine the $22.48 share 
price. This
[[Page 22052]]
equates to a $0.43 per share trading cost. That is, if the Agency could 
have determined this in advance, the share price would have been only 
$22.05. Instead, the $9,554,497 difference was charged to the remaining 
holders of the I Fund. That is in one DAY, not in one year.
    Each day is unique, and the timing of participants' redemptions 
affects how much of the cost is borne by any given participant. A 
participant who would have redeemed the day before would not have been 
impacted at all by this transaction. One who transferred funds into the 
I Fund just before August 16 and transferred out just after would have 
experienced the full effect.
    On August 16, almost half of the dollar amount of the trade was 
from participants who were requesting frequent IFTs. The Agency knows 
from its analysis that a large number of the participants who make 
frequent interfund transfers were moving $250,000 or more. Each 
participant who redeemed $250,000 on that day would have sold 11,121 
shares, and therefore would have made an extra $4,782. (11,121 shares 
sold multiplied by $0.43 per share trading cost.) These ``extra' funds 
did not come from the market. Rather, they came from the accounts of 
other participants who remained in the I Fund. When examined this way, 
it becomes clear why frequent IFTers would prefer to express this cost 
as an annual average spread over all participants.
    Additionally, because the investment manager's liquidity pool had 
been depleted on August 16, $452 million of that trade settled on 
August 21 instead of August 17. That cost the G Fund $235,000 in 
foregone interest.
    The Agency also cannot measure the cost to participants that 
results from increased tracking error because the investment manager 
has to keep a larger liquidity pool to meet frequent redemptions.
    Every day is different, and different participants are impacted in 
different ways depending on the timing of their interfund transfer 
activity. Stating an average cost per participant would be misleading. 
The goal of this regulation is to reduce IFT activity in order to 
control the costs borne by the other participants, costs which are 
different for every participant depending on what days they may be 
invested in, or not invested in, any particular fund and that are 
impossible to determine in advance.
    Several participants noted that money could be saved by eliminating 
mailed IFT confirmations and that the DVD for the L Funds was very 
expensive. Those costs are reflected in the already low expense ratio, 
which is assigned pro rata to all TSP participants. The trading 
expenses are not borne pro rata. In fact, a participant, who transfers 
out of a fund on a day when the cost to complete that trade is very 
high, bears none of the cost of that trade, while those who remain in 
the fund bear it all. It is the inequity of the allocation of the 
trading expenses which the TSP seeks to address, and which, as 
discussed in the proposed regulation (73 FR 12667, March 10, 2008), the 
SEC has identified as a problem for mutual funds.
    Several participants said (incorrectly) that the L Funds are 
responsible for the transactions costs and that these funds should also 
be limited. The dollar amount of trade activity attributable to the L 
Funds, especially when compared to the dollar amount of trading 
activity attributable to participants making frequent IFT requests, is 
very small. For example, in the I Fund, for September and October 2007, 
the average daily dollar amount attributable to the L Funds' 
rebalancing accounted for just 7 percent of the total daily trade, 
while the average daily dollar amount attributable to those making 
frequent IFTs (defined in this instance as participants who made IFTs 
into or out of the I Fund eight or more times in the prior 60 days) was 
63 percent. The impact of the L Funds' rebalancing is demonstrably 
minimal. The Agency monitors the L Funds, as it does all its funds, 
and, in the unlikely event that the dollar volume of the L Funds' 
rebalancing becomes costly, the Agency can take steps to reduce the 
frequency or amount of the rebalancings.
    Many participants requested that a fee be charged instead of 
limiting the number of IFT requests. Some of these participants 
recommended a ``$10 flat fee.' Others noted that the Agency charges a 
fee for loans, and therefore, should be able to charge a fee for 
interfund IFTs. This comment was addressed in the proposed regulation 
as explained below:
    Many fund families charge redemption fees for shares which are 
redeemed within 30, 60, or 90 days of purchase. T. Rowe Price, for 
example, levies fees on 27 funds, including a 2 percent redemption fee 
on shares of its International Index Fund (similar to the I Fund) and a 
0.5 percent fee on shares of its Equity Index 500 (similar to the C 
Fund) and Extended Equity Market Index Funds (similar to the S Fund), 
if they are sold within 90 days of purchase. TIAA-CREF (with $400 
billion of assets under management and 3 million participants) charges 
a redemption fee of 2 percent on shares of its International Equity, 
International Equity Index, High Yield II, Small-Cap Equity, Small-Cap 
Growth Index, Small-Cap Value Index or Small-Cap Blend Index Funds 
redeemed within 60 days of purchase. We noted particularly that the fee 
is a percentage of the dollar amount transacted, not a flat processing 
charge.
    When brokerage firms charge $10 to execute a stock trade, they know 
how much it costs them to make that transaction. Mutual fund managers 
(and the TSP) cannot determine the exact amount of costs to the plan 
from IFT activity for the following reasons. First, each day, a price 
for each fund is determined based on closing stock prices for that day. 
However, the fund manager does not execute every stock trade at that 
closing price. Any difference is market impact and is charged or 
credited to the fund, thus impacting the returns of the long-term 
holders. Second, to accommodate the large trades which result from 
frequent IFT activity, managers must keep a larger liquidity pool, 
which causes performance to deviate from that of the index. Lastly, for 
the TSP, when the liquidity pool is depleted as a result of a number of 
large trades in a row, cash due to the TSP is not received for up to 
three days, costing participants foregone interest. None of these three 
costs is calculable in advance, and all three are different every 
single day. Because it is impossible to determine how much to charge 
for each transaction, mutual fund families assess a percentage of the 
dollar amount transacted, which is then credited back to the Fund.
    Many fund families employ trading restrictions similar to 
Vanguard's whereby an investor may not repurchase any fund within 60 
days after a redemption.
    We would also note that both TIAA-CREF and Vanguard, among others, 
use a double-barreled approach by charging a fee on top of the trading 
restrictions for some funds. For example, if an investor sells the 
Vanguard Developed Markets Index Fund (similar to the TSP's I Fund) 
within 60 days of purchasing it, that investor is charged a 2 percent 
fee and cannot repurchase the fund for 60 days.
    In developing its recommendation, the Agency chose not to pursue 
redemption fees because it is impossible to correctly assign the exact 
costs to those who are making IFTs. Additionally, imposing a percentage 
fee would deny our participants the ability to go to the safe harbor of 
the G Fund at any time for no charge. The Agency considers that 
capability to be of paramount importance. A fee-based system would 
especially punish an
[[Page 22053]]
infrequent trader who may wish to redeem within 30, 60, or 90 days 
(depending on the policy) because the market is declining. In this 
situation, the participant could face losing 2 percent of his/her 
investment in addition to the market decline, a worst case scenario.
    The FRTIB is implementing a procedure to reduce costs to 
participants. The SEC recommends that all mutual funds take such 
actions, and according to a 2007 study by Hewitt and Associates, 73 
percent of defined contribution plans have adopted policies designed to 
minimize transaction activities in their funds.
    Several participants expressed wanting more than two (e.g., three, 
four, or more) IFTs per month. Others noted that the Agency should 
gradually implement its policy (e.g., have a ``trial period') and 
start with a limit greater than two. Further, several participants 
asked ``why two' trades and stated that the number seemed 
``arbitrary.' According to data compiled by the Agency, limits of four 
IFTs per month will have very little impact on the dollar volume of 
daily trades, three IFTs would reduce volume by just 31 percent while 
two IFTs would reduce volume by approximately half. The Funds in the 
Plan are index funds. Therefore, the Agency examined the trading 
policies of the largest index fund manager, Vanguard, and of numerous 
other mutual fund managers and defined contribution plans. An investor 
in any Vanguar