personal finance

Change in Catch-Up TSP Contributions and Finance Friday Articles

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Here’s a cut/paste from the TSP announcement about a change for catch-up contributions:

Catch-up contributions will soon get easier

Starting in January 2021, we will make the catch-up process easier: if you’re turning 50 or older, you’ll no longer need to make two separate elections each year in order to take advantage of catch-up contributions.

Instead, your contributions will automatically count toward the IRS catch-up limit if you meet the elective deferral limit and keep saving. If you’re eligible for an agency or service match, contributions spilling over toward the catch-up limit will qualify for the match on up to 5% of your salary. Your election will carry over each year unless you submit a new election.

For 2020 catch-up contributions, you do still need to complete the current process and make a separate election. Check current contribution limits to make sure you’re on track this year.

Here are this week’s articles:

What is an Expense Ratio?

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Whether you are managing your investments by yourself or getting help, you need to understand one critical concept, the expense ratio of your investments. Every mutual fund and exchange-traded fund (ETF) that you invest in has an expense ratio, and keeping it as low as possible is key to your long-term financial success.

What is an expense ratio? An expense ratio is the percentage of a fund’s assets that is used for expenses. In other words, if you invest in a mutual fund with a 1% expense ratio and that fund makes 10% in 2020, you’ll only get a 9% return on your investment because 1% goes to pay expenses. The less of your return you use to pay expenses, the more you get to keep.

What is an average expense ratio? An average stock mutual fund has an expense ratio of 0.6% in 2019, but the expense ratios for mutual funds that are similar in their composition can vary wildly. For example, if you look at a list of Standard & Poor 500 index funds offered by investment companies, you’d find expense ratios as low as 0.04% (like the TSP C Fund) and as high as 2.43% (ticker RYSYX). While 2.39% does not seem like that large of a difference, keep in mind that costs last forever and that small differences compounded over years will cost you a lot of money.

Let’s pretend that when you are 25 years old your grandparents give you $10,000 to invest in an S&P 500 index fund for 50 years, during which you earn a 9.5% return. If you invested in an average mutual fund with a 0.6% expense ratio, you would have $683K. If you invested in the Vanguard index fund (another low cost S&P 500 index fund like the TSP C Fund) with a 0.05% expense ratio, you would have $902K. That 0.55% difference in the expense ratios cost you $219K! Small differences in expenses can make huge differences in long-term investment returns, so you need to pay attention to the expense ratios of your investments.

This difference is even more dramatic when you compare actively managed funds to passively managed index funds. Because actively managed funds have higher expense ratios than index funds, it is very difficult for an active manager to beat his/her comparative index over the long-term. This is why I invest 100% in index funds.

When you are picking your investments, keep in mind that you can’t control what happens to the market, but you can control which investments you choose and the expenses that they charge. Any time you are looking to invest in a mutual fund or ETF, you should search for similar funds and compare expense ratios, which you should try to keep below 0.5% (or even 0.25% if possible). Make sure that at a minimum you take a look at the Vanguard version of the investment you are considering since their expense ratios are among the lowest in the industry and they never charge extraneous fees, like loads. There is no reason to pay more expenses for what is essentially the same investment product. It could cost you A TON of money over the long-term.

Finance Friday Articles

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It takes a LONG TIME to compile all the articles for Finance Friday, and not that many people click on them, so I’m going to just start listing my favorites instead of my favorites plus the rest of the articles. Here are my favorites this week:

Overconfidence in Investing

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Jonathan Clements was a longtime personal finance columnist for The Wall Street Journal, and he offers great advice at the best price you can get (free) on his blog Humble Dollar. Here is one piece of advice from his site:

OVERCONFIDENCE. Most of us believe we’re above-average drivers, smarter than most and better looking. This overconfidence is often a good thing—it can boost happiness and help us in our career—but it’s terrible for investment results. As they seek market-beating gains, overconfident investors trade too much, take unnecessary risk and buy costly investments.”

I’m smarter than most but probably an average driver. When it comes to my looks, my crowning achievement is that I was once told by a patient that I was “extremely handsome.” A few minutes later she told me that one of her medical problems was that she was legally blind. You can’t make this stuff up…

If there was a common fault among military members, overconfidence is probably it. It has boosted my happiness and helped me in my career, but it has caused me to take unnecessary risk. I don’t think I trade too much because I never sell anything. I simply rebalance to my desired asset allocation with my end-of-the-month investments.

Avoiding the pitfalls associated with overconfidence is one of the reasons I use a financial advisor despite my obvious interest in personal finance. While I execute the financial plan myself and don’t pay any ongoing fees to a financial advisor, getting the plan from Vanguard’s Certified Financial Planners was eye opening. While I had a 100% stock portfolio, they recommended an 80% stock and 20% bond portfolio with a gradual transition to 60% stock and 40% bond when I retire in 5-11 years, depending on how long I stay in the Navy.

Probably more than 90% of my readers could benefit from a financial second opinion from a trusted advisor. If it was me, I’d get that opinion from Vanguard.

2 Quick TSP Investing Tips for Beginners (and Maybe Not-So-Beginners)

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Here are two tips for investing in the Thrift Savings Plan (TSP) that frequently trip up beginners and not-so-beginners:

  1. Strive to always base your TSP contribution off of your basic pay because it is the most stable and predictable pay you have. If you prefer to contribute from bonuses (or some other type of pay) you can, but realize that they tend to be less predictable. During my career I’ve seen the Navy’s pay structure changed and my special pays get hosed up due to the variable timing of the special pay NAVADMIN release. If I would have been contributing to the TSP from my bonuses, my TSP contributions would have been screwed up. TSP contributions from base pay, though, wouldn’t have missed a beat because my basic pay stayed the same.
  2. If you are in the Blended Retirement System (BRS), make sure you don’t fill your TSP early. If you fill it in September, you won’t get a match for the rest of the year. You have to contribute each month to get the monthly match.

Throwback Thursday Classic Post – Thrift Savings Plan Fund Deep Dive – The C Fund

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There are only five investments available in the Thrift Savings Plan (TSP), so let’s take a detailed look at them one at a time. First, we’ll cover the C Fund, which would probably be the fund you would pick if you were only allowed to pick one.

Inception Date

29 JAN 1988

Fund Management

The Federal Retirement Thrift Investment Board currently contracts BlackRock Institutional Trust Company, N.A. (BlackRock) to manage the C Fund assets. The C Fund remains invested regardless of the performance of the securities markets or the overall economy.

Investment Strategy

The C Fund is invested in a stock index fund that fully replicates the Standard and Poor’s 500 (S&P 500) Index, a broad market index made up of the stocks of 500 large to medium-sized U.S. companies. The C Fund’s objective is to match the performance of the S&P 500. Also, some of the money in the C Fund is temporarily invested in the G Fund and earns the G Fund return.

The C Fund is a passively managed fund that remains invested according to its indexed investment strategy regardless of stock market movements or general economic conditions.

What is the Risk?

Your investment in the C Fund is subject to market risk because the prices of the stocks in the S&P 500 Index rise and fall. You are also exposed to inflation risk, meaning your C Fund investment may not grow enough to offset inflation.

What is the Benefit?

Historically, this increased risk has been rewarded with an increased return. It offers the opportunity to experience gains from equity ownership of large and mid-sized U.S. company stocks. Here is all the performance data as of 3 OCT 2020:

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Types of Earnings

The C Fund changes in value as the market price of its stocks change. In addition, the C Fund makes money for its investors when those stocks pay dividends. Unlike a traditional mutual fund, though, income from dividends is included in the share price calculation. It is not paid directly to participants’ accounts.

It also makes some money on interest on short-term investments and securities lending income.

BlackRock credits interest and dividend income each business day. This income is then reflected in the TSP share prices.

Share Price Calculations

The value of your account is determined each business day based on the daily share price and the number of shares you hold. At the end of each business day, after the stock and bond markets have closed, the total value of the funds’ holdings (net of accrued administrative expenses) is divided by the total number of shares outstanding to determine the share price for that day. The daily change in TSP share prices reflects all investment income (interest on short-term investments, dividends, capital gains or losses, and securities lending income) net of TSP administrative expenses.

Expenses

The net expenses paid by investors is 0.042% or 4.2 basis points, which like all the TSP funds is ridiculously low and is a major benefit of the TSP. It cost $0.42 for each $1,000 invested.

How Should I Use the C Fund in my TSP Account?

The C Fund can be useful in a portfolio that also contains stock funds that track other indexes such as the S Fund (which tracks an index of small US company stocks) and the I Fund (which tracks an index of international stocks). The C, S, and I Funds track different segments of the overall stock market without overlapping. This is important because the prices of stocks in each market segment don’t always move in the same direction or by the same amount at the same time. By investing in all segments of the stock market (as opposed to just one), you reduce your exposure to market risk.

The C Fund can also be useful in a portfolio that contains bonds. Again, it is because the prices of stocks and bonds don’t always move in the same direction or by the same amount at the same time. So a retirement portfolio that contains a bond fund like the F Fund, along with other stock funds, like the S and I Funds, will tend to be less volatile than one that contains stock funds alone.

Advice from My Favorite Short Investing Book

Here is what my favorite investing book, The Elements of Investing: Easy Lessons for Every Investor, says about S&P 500 index funds like the C Fund:

The best-known of the broad stock market mutual funds and Exchange Traded Funds (ETFs) in the US track the S&P 500 index of the largest stocks. We prefer using a broader index that includes more smaller-company stocks…Funds that track these broader indexes are often referred to as ‘total stock market’ index funds. More than 80 years of stock market history confirm that portfolios of smaller stocks have produced a higher rate of return than the return of the S&P 500 large-company index. While smaller companies are undoubtedly less stable and riskier that large firms, they are likely – on average – to produce somewhat higher future returns. Total stock market index funds are the better way for investors to benefit from the long-run growth of economic activity.

If you want to follow their advice, you just combine the C Fund with the S Fund in a 3:1 ratio. To see how I use the C Fund, read the Crush the TSP series.

Check Your Fund Expenses

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Jonathan Clements was a longtime personal finance columnist for The Wall Street Journal, and he offers great advice at the best price you can get (free) on his blog Humble Dollar. Here is one piece of advice from his site:

CHECK YOUR FUND EXPENSES. If you own index funds, aim for weighted average annual expenses below 0.2%. If you own actively managed funds, you’ll pay more—but allocate enough of your portfolio to index funds to keep your average below 0.4%. By holding down costs, you’ll keep more of what you make, plus low-cost funds typically outperform high-cost competitors.

In the military, we’re blessed with the Thrift Savings Plan (TSP) and its industry leading low expenses. Outside of the TSP, if you want to keep your costs down you should just invest with Vanguard. Their unique structure makes them a non-profit, unlike their competitors, so no matter what you invest in you know it will be among the lowest cost investments available. Admittedly, though, there is a price war and you can find the same funds for even lower costs at Schwab and Fidelity.

Whatever you invest in, take the time to look up the investments at Morningstar. Just type your investment in the search bar at the top and check the expense ratio. As an example, I typed in VTI, which is the Vanguard Total Stock Market Exchange Traded Fund (ETF). The expense ratio of 0.04% is circled in red:

As Mr. Clements mentions, if the expense ratios for index funds are more than 0.2% then you are paying too much. You should try to keep the total expense ratio of all your investments less than 0.4%.

Throwback Thursday Classic Post – Step 6 to Crush the TSP – Rebalance Annually

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We’ve talked about steps 1-5 to crush the Thrift Savings Plan (TSP). Now we move on to the final step (unless I think of more), step 6 – rebalance annually.

What is Rebalancing?

Let’s say that your desired TSP asset allocation is 70% stocks and 30% bonds. After the last year, though, stocks earned more than bonds and now you’re sitting at 85% stocks and 15% bonds. In order to rebalance back to your desired asset allocation, you’d sell approximately 15% of your stocks and buy bonds, restoring your desired asset allocation. It’s that simple.

Why Should You Rebalance?

If you don’t, you may be assuming more or less risk than you desire.

Also, by rebalancing you force yourself to sell what has overperformed and buy what has underperformed. Although this seems counter-intuitive because you are selling what has given you the largest return, by doing this you are systematically selling high and buying low. When left to themselves, investors typically buy high and sell low, the opposite of what you want to do. Rebalancing forces you to do it right.

How Often Should You Rebalance?

Vanguard has researched this, and you can read their full report here:

Best Practices for Portfolio Rebalancing

Their conclusion is:

We conclude that for most broadly diversified stock and bond fund portfolios (assuming reasonable expectations regarding return patterns, average returns, and risk), annual or semiannual monitoring, with rebalancing at 5% thresholds, is likely to produce a reasonable balance between risk control and cost minimization for most investors.

In other words, you rebalance annually or semiannually (twice per year) whenever your current asset allocations are off by 5% or more from your desired allocations. If the current and desired allocations are within 5% of each other, you do nothing.

How Do You Rebalance in the TSP?

You just log on and do what they call an “interfund transfer” or IFT. You can read all about it on this page from the TSP website.

Because you are doing it in a tax-advantaged retirement account, there are no expenses, fees, or taxes associated with rebalancing (unlike if you were rebalancing a taxable account).

You can only do it twice per month without restrictions, but since you are smart you are only doing it once per year anyway.

Do You Need to Rebalance With Lifecycle Funds?

No, you don’t. This is one of the major advantages of the L funds. If you are hitting the easy button on your TSP and just using a Lifecycle fund, you don’t need to rebalance…EVER!

That’s It. Crush the TSP!

That’s the final step to crush it in your TSP account. Read the whole series, maximize your TSP contributions, and get rich in the military.