Federal employees are fortunate to be eligible to receive two types of pension income once they retire from federal service.
The first type of pension income is in the form of a guaranteed pension – a defined benefit plan – that is either a CSRS annuity or a FERS annuity. As a defined benefit plan, both the CSRS and FERS annuity have a guaranteed income stream that continues throughout a federal employee’s retirement years with some inflation protection until the death of the annuitant (or survivor annuitant in case a CSRS or FERS survivor annuity has been elected).
The second type of pension income that all FERS retirees and most CSRS retirees receive is from the Thrift Savings Plan (TSP). Unlike a CSRS or FERS annuity, the TSP is under the category of a defined contribution plan. As such, the TSP does not guarantee lifetime income once a federal retiree starts withdrawing from the TSP. In fact, a TSP account could be depleted before the TSP participant dies.
To prevent this from happening, there are certain actions TSP participants should perform with their TSP accounts and certain mistakes that employees will hopefully avoid when it comes to contributing to and investing in the TSP. The goal is to maximize growth in the TSP and to hopefully preserve an employee’s TSP account throughout the employee’s retirement.
This column discusses the actions, and the biggest mistakes employees will hopefully avoid with respect to their TSP accounts.
1 – Opting out of the automatic TSP enrollment
Newly hired federal employees are automatically enrolled in the TSP with 5 percent of their bi-weekly salary deducted and contributed to the TSP. By contributing 5 percent of their salary, the employee receives from his or her agency the maximum TSP contribution match of 4 percent.
Note the 5 percent automatic bi- weekly payroll deduction from a newly hired employee’s paycheck became effective October 1, 2020 and is a 2 percent increase from the automatic 3 percent bi-weekly automatic payroll deduction that had been in effect since 2010.
The only way an employee can opt out of the automatic TSP enrollment is for the employee to fill out Form TSP-25 (Automatic Enrollment Refund Request) requesting to cease TSP participation.
Opting out of the TSP is a mistake on a newly hired employee’s part. This is because the earlier an employee starts contributing to the TSP, the longer the TSP money has to grow, tax-deferred for the traditional TSP and tax-free for the Roth TSP.
2 – Staying with the default TSP contribution level
Some employees assume that the TSP’s 5 percent default contribution level will be sufficient to fund their retirement. According to most financial planners, a 5 percent contribution level, resulting with a FERS employee receiving a 4 percent agency match together with an agency automatic 1 percent of gross pay automatic contribution for a total 10 percent contribution level, is insufficient to fund a FERS employee’s future retirement.
Fidelity Investments recommend that individuals should aim to save at least 15 percent of their salary each year (divided between their contributions and employer matching contributions) for retirement. This means that FERS employees need to save at least 10 percent of their salaries each year in order to end up saving at least 15 percent (with a 5 percent contribution coming from the employee’s agency) for the year.
3 – Investing too conservative while young
While some federal employees getting close to retirement may attempt to accelerate the growth of their TSP accounts (by having all of their TSP invested in the three TSP stock funds), many younger employees often fail to take advantage of the growth potential of the three TSP stock funds – the C, S, and I fund.
The “rule of thumb” for a moderately aggressive portfolio is to take one’s age and subtract it from 120. The resulting number is the percentage that ideally will be invested in stocks and /or stock funds (that is, the C, S, and I fund), as opposed to more conservative assets such as bonds and bond funds (that is, the F and G funds). An employee who is 25 years old should therefore have a minimum 95 percent invested in the C, S, and I funds. A 35-year-old employee should have a minimum 85 percent invested in the C, S, and I fund and 10 percent invested in the F and G funds.
4 – Not diversifying within the TSP
The TSP offers three stock funds – the C, S and I funds – and two bond funds – the F and G funds. In an attempt to keep things simple, some employees may contribute to only one stock fund or to only one bond fund.
In doing so, the TSP participant’s investment portfolio likely lacks some diversification which is not good for a long-term investor. Having a balanced portfolio, a portfolio that includes stocks of different kinds and sizes, along with different types of bonds, helps to shield a TSP participant, from market volatility.
5 – Choosing and forgetting a life cycle (L) fund
Life cycle or L funds do not get much respect because they try to apply a “one-size fits all” approach to retirement savings. Many financial advisers are lukewarm on L funds but admit that L funds have their place in the long-term retirement savings world, especially for novice investors. L funds are a good place to start investing and certainly a better alternative than not saving at all.
Although L fund allocation is designed to change over time to more conservative funds (that is, the bond funds) as time goes on as an employee gets closer to his or her retirement date, a TSP participant’s personal tolerance for risk should still come into play. This is especially true if the TSP participant is getting close to retirement.
Over the last year, the TSP has expanded the number of L funds available to TSP participants, going from five L funds to 10 L funds (L lncome, L2025, L2030, L2035, L2040, L2045, L2050, L2055, L2060 and L2065).
6 – “Panicking” after a bad month or quarter
Switching from one stock fund in the TSP after the TSP tanks and switching to another TSP stock fund that is doing well sounds like a good idea, but the ultimate result is that a TSP participant who performs such a move will end up “selling low” and “buying high”, the exact opposite of basic investing principles.
The same is true when switching from stock funds to more conservative bond funds (such as the TSP G fund). During March 2020, when the stock market was in a downturn due to start of the COVID 19 pandemic in the US, many TSP participants transferred their money out of the C, S and I funds and switched their money into the “super safe” G fund. One of the reasons given by these participants was to “stop the bleeding” in their TSP portfolios.
But most of these same participants missed the start of the stock market recovery starting one month later in April 2020 and continuing for the rest of 2020. Even if some of these participants got back into the C, S and I funds three or six months after the market started turning upward in the spring of 2020, they made out worse than those TSP participants who “stayed the course” and remained in the C. S and I funds.
7 – Abandoning a 401(k)-retirement plan after leaving a job and entering federal service
With all of the upheaval that comes when switching from one employer to another, it can be understandable that a newly hired federal employee may not be aware that an employer-sponsored qualified retirement plan (such as a 401(k) plan) that the employee previously participated can be directly transferred into the employee’s TSP account. Leaving retirement fund assets in a 401(k) and not keeping track of those assets can have serious consequences. The funds themselves can change to the point where they no longer fit the owner’s investment goals.
8- Starting late in the TSP and trying to play “catch up”
Federal employees who start saving for retirement somewhat later in their careers such as mid-career, or who stop contributing to the TSP for a period of time, are often under the mistaken impression that they can make up for “lost time”. But the stock market does not work that way. A period of nonparticipation in the TSP deprives a TSP participant of the investment returns on the money had that money been invested.
9 – “Cashing out” one’s TSP account
In general, “cashing out” one’s traditional TSP account via a lump sum withdrawal is not a wise investment move for several reasons.
First, the withdrawn funds will be taxed at the participant’s marginal (ordinary) income tax bracket. If the participant has a sizeable traditional TSP account balance – for example, more than $500,000 -then withdrawing the entire account will likely result in the account being taxed at the highest federal marginal tax bracket, 37 percent.
In addition, if the participant lives in a state with an income tax, then state income taxes must be paid. This could be especially if the TSP participant lives in a state with high tax rates, such as California and New York. On top of this, the participant is withdrawing all of the money resulting in the cessation of tax-deferred growth. Withdrawal of one’s entire Roth TSP account results in the cessation of tax-free growth.
10 – Transferring one’s TSP to an IRA with high custodial and maintenance fees
There is no lack of financial planners and investment companies including banks, brokerages and insurance agencies who would like to have the opportunity of taking charge and investing a TSP participant’s TSP account. Many of these planners or companies suggest that the participant transfer their entire TSP account to them in order for them to manage the TSP account.
But the important information that most of these planners and companies do not fully explain to the TSP participant are the fees associated with the IRAs they want to manage. The one fact that all TSP participants should be aware of is that the TSP has the lowest administrative fees of all current defined contribution plans.
TSP participants pay no commissions or custodial fees with their TSP accounts. The same cannot be said of IRAs as every IRA has an annual custodial fee. In addition, IRA owners typically pay either a commission or higher administrative fees. These commissions and fees take away from the gross investment return that many IRA owners think they are earning but in reality they are not.