[Federal Register Volume 73, Number 47 (Monday, March 10, 2008)]
[Proposed Rules]
[Pages 12665-12669]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-4776]


 ========================================================================
 Proposed Rules
                                                 Federal Register
 ________________________________________________________________________
 
 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
 
 ========================================================================
 

  Federal Register / Vol. 73, No. 47 / Monday, March 10, 2008 / 
Proposed Rules  

[[Page 12665]]



FEDERAL RETIREMENT THRIFT INVESTMENT BOARD

5 CFR Part 1601


Participants' Choices of TSP Funds

AGENCY: Federal Retirement Thrift Investment Board.

ACTION: Proposed rule with request for comments.

-----------------------------------------------------------------------

SUMMARY: The Federal Retirement Thrift Investment Board (Agency) 
proposes to amend its interfund transfer regulations to limit the 
number of interfund transfer requests to two per 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: Comments must be received on or before April 9, 2008. Comments 
submitted in response to the interim regulation need not be 
resubmitted; they will be considered as part of this rulemaking 
process.

ADDRESSES: Comments may be sent to Thomas K. Emswiler, General Counsel, 
Federal Retirement Thrift Investment Board, 1250 H Street, NW., 
Washington, DC 20005. The Agency's Fax number is (202) 942-1676.

FOR FURTHER INFORMATION CONTACT: Megan Graziano on (202) 942-1644.

SUPPLEMENTARY INFORMATION: The Thrift Savings Plan (TSP) was 
established by the Federal Employees' Retirement System Act of 1986 
(FERSA). FERSA created a new retirement program for Federal employees 
which consists of a reduced defined benefit plan component supplemented 
by a defined contribution retirement savings and investment program 
commonly known as the TSP.

Statutory Basis and History of TSP Interfund Transfers

    After three years of study, the Congress determined that the TSP 
would be a passive, long-term investment vehicle. This approach is 
consistently reflected throughout the legislative history of the 
enabling legislation. The statute requires two opportunities each year 
for participants to transfer their investments among the TSP investment 
funds. 5 U.S.C. 8438(d). Additional opportunities may be provided under 
regulations issued by the Executive Director.
    This ``interfund transfer'' (IFT) program was first implemented in 
1988 under regulations which coupled two annual IFT opportunities with 
the then-statutory twice-a-year contribution open seasons. The March 
1989 booklet entitled Summary of the Thrift Savings Plan for Federal 
Employees introduced participants to the concept of interfund transfers 
as follows:

    You can transfer funds only twice a year, once in connection 
with each open season. Please consider this before you decide on the 
allocation of your contributions among the Funds. Your Plan 
contributions are invested for your retirement, and you should make 
your investment decision with this long-term goal in mind.

    This long-term investment strategy (as opposed to a short-term 
strategy of market-timing) remains an essential element of the TSP. The 
April 2007 TSP Fund Information sheets recommend a ``buy and hold'' 
strategy with periodic--as opposed to frequent--rebalancing.
    The enactment of legislation removing restrictions on TSP 
investments led to the first Agency review of the TSP interfund 
transfer policy. Until 1990, employees covered by the Federal 
Employees' Retirement System (FERS) were allowed to invest only a 
percentage of their own contributions outside the Government Securities 
Investment (G) Fund. All employer contributions and all contributions 
by employees covered by the Civil Service Retirement System could, by 
law, be invested only in the G Fund.
    The Agency asked Congress to ease these restrictions in order to 
simplify program administration. Congress ended the restrictions as 
part of the Thrift Savings Plan Technical Amendments of 1990. Going 
forward, all participants were to be allowed to invest or reinvest in 
any TSP fund. In preparing for implementation, the Agency reexamined 
the policy of two-a-year interfund transfers during open seasons due to 
the anticipated growth in the volume of IFTs.
    In conducting this review, the Executive Director identified four 
considerations:

--The practices of other plans;
--administrative/operational concerns;
--costs; and
--service to participants.
    The Executive Director recommended that the Agency's Board members 
approve de-linking IFTs from open seasons and allow up to four 
transfers a year. These transfers were linked to the TSP's then monthly 
valuation cycle, thus allowing a transfer in any month up to four times 
a year. This policy was based on the following findings: Other plans 
were liberalizing allowable IFTs; IFT request processing would be 
spread over more months, eliminating operational bottlenecks; trading 
costs would be reduced by processing smaller trades on twelve days 
rather than larger trades on two days each year; and, participants who 
missed an IFT deadline would no longer have to wait six months for 
another opportunity.
    In making his recommendation, the Executive Director cautioned that 
allowing more frequent transfers simply ``to satisfy the demand of a 
relatively small group of participants, could result in increases in 
administrative costs to all participants which would be difficult to 
justify. I would also be concerned that such a policy would be viewed 
as encouraging participants to focus on market conditions each month in 
making their asset allocations. Such a short term focus would not be 
consistent with the Board's policy of encouraging long term financial 
planning for retirement.''
    Thus, the initial two-a-year IFT regulatory requirement was 
liberalized, by regulation, but only after careful study and a clear 
restatement of the fundamental long-term investment policy.
    In 1995, the policy was again reconsidered. The goal was to ensure 
that any participant withdrawing an account balance be permitted to 
transfer to the G Fund while withdrawal processing was completed.
    The 1995 policy review examined the same elements as the 1990 
review. The Agency research found that, rather than allow one special 
withdrawal-based transfer, the trend among defined contribution plans 
was to allow at least

[[Page 12666]]

12 IFTs each year (this also happened to be the greatest number 
possible under the monthly-valued system then in place at the TSP). By 
that time, administrative/operational concerns were minimized for the 
TSP because IFT requests had largely migrated from paper processing to 
telephone keypad entry. After a thorough review, the Agency expanded 
IFT opportunities to one-a-month, twelve-a-year in April 1995.
    In October 1995, the Agency began designing a new TSP record 
keeping system. The initial plan anticipated that the new system should 
accommodate unlimited IFTs and have the capability to levy a charge if 
it was later determined that charges were necessary or desirable. 
However, by 1997, it was clear that frequent trading was still not a 
problem in the TSP. Further action on a design that would assess a 
charge for frequent trading was discontinued.
    A staff review regarding IFTs in 1998 found that the policy adopted 
in 1995 continued to achieve the intended policy goals. The review 
found that 91 percent of participants who made IFTs requested one (75 
percent) or two (16 percent) during the year. Just 42 participants 
requested the maximum of 12.
    From an administrative/operational perspective, IFT requests were 
processed without bottlenecks via the ThriftLine (telephone keypad) and 
were being migrated to an even more efficient processing environment on 
the new TSP Web site.
    From an investment perspective, transfers were netted each month, 
thus offsetting uncorrelated ``buys'' with ``sells'' before the monthly 
IFT amounts were forwarded to the asset manager for investment. 
Further, under Agency contracts, the asset manager executed ``cross 
trades'' with other institutional investors in its commingled funds, 
reducing trading costs and minimizing deviations from the indexes 
tracked by the TSP.
    Participants were satisfied with the level of service, which was 
comparable to what was being offered in private sector plans. Further, 
allowing 12 unrestricted interfund transfers a year--the maximum 
possible number under a monthly-valued system--had had no adverse 
effect on administrative operations or trading costs. Therefore, no 
restrictions were initially required when the TSP moved from its 
monthly-valued record keeping system to a daily-valued platform in 
2003. This had the effect of increasing interfund transfer 
opportunities from one per month, executed at month end, to one per 
business day.
    The Agency monitored interfund transfer activity by observing the 
overall number of transfers and periodically determining whether 
``frequent trading'' was becoming a problem. For example, in 2004, the 
Executive Director requested a check of 2003 data which disclosed 150 
participants were requesting frequent IFTs for the apparent purpose of 
short-term market timing. There was no apparent adverse consequence of 
this activity on other participants in the TSP.

The Problem

    This situation began to change in 2006. As the number of interfund 
transfers increased and as a small number of participants with 
relatively large account balances engaged in frequent interfund 
transfers, a pattern started to emerge. These participants began to 
focus on the International Index Investment (I) Fund, which tracks the 
Morgan Stanley Europe, Australasia, and Far East Index. The attraction 
may have been based on the notion that by the noon Eastern Time 
deadline for submitting an IFT request, a participant might anticipate 
whether overseas markets would open up or down. Since an IFT request is 
processed based on the closing price for the previous day, this was 
seen as an opportunity for arbitrage. Although ``fair valuation'' was 
introduced to eliminate the arbitrage potential, some participants, 
nevertheless, continued this behavior. Moreover, over the past year, 
this behavior has become more frequent and less random.
    This activity disrupts the Agency's carefully designed cost-
minimization efforts in three distinct ways: Increased transaction 
costs (including commissions paid to brokers, transfer taxes, and 
market impact); increased futures/cash position; and forgone interest.
    Market impact, which is impossible to calculate in advance, is a 
major problem generated by the correlated actions of those individuals 
attempting to actively manage their TSP investments based on 
anticipated short-term market movements.
    By statutory design, the TSP funds are passive, long-term 
``pooled'' investments required to replicate the performance of 
selected broad index funds. The intent of IFTs is to allow periodic 
rebalancing. There are many benefits inherent in this arrangement 
established by the original statute. However, the vast majority of 
participants who follow this long-term strategy are subjected to 
greater risk when a determined cohort of participants frequently moves 
funds in anticipation of market movements.
    Simply stated, when this small cohort rapidly removes funds in 
anticipation of short-term market losses, any losses which in fact 
materialize are spread over fewer remaining participants and are 
therefore more severe for those who maintain the long-term approach. 
Those who rapidly shift out secure the higher value based on the 
closing price for the day, while the remaining investors bear the 
losses when the shares are sold at the lower opening price on the 
following business day.
    An extreme example would involve a large, highly-correlated Friday 
afternoon transfer by market timers wishing to eliminate their exposure 
in the I Fund based on anticipated market losses due to world events. 
If those events come to pass, in particular during a three-day U.S. 
weekend, world markets could fall dramatically, and the smaller number 
of remaining investors would bear the totality of the losses.
    Defenders of this practice argue that the market timers might guess 
wrong, and, in such a case, positive earnings would be spread over a 
smaller investor base. They also argue that they are only controlling 
their own funds.
    This rationale, however, ignores the fact that, by their actions, 
these market timers are exposing passive, long-term investors to a risk 
they never agreed to accept. These bystanders are simply using the TSP 
in the passive, long-term method for which it was designed.
    Additionally, the market timers are forcing the fund manager to 
take extraordinary measures to mitigate the adverse impact of an 
investment behavior for which the TSP was not designed. These 
extraordinary measures generate costs borne by all participants and 
adversely affect the plan manager's ability to precisely replicate the 
performance of the selected indexes.
    Frequent rapid fire transfers in the TSP reached a zenith in 
October, 2007. One example:

--On October 19, $371 million was transferred into the I Fund.
--On October 24, three business days later, $391 million was 
transferred out of the I Fund.
--;$295 million of those transactions was attributable to 2,018 
participants who purchased on 10/19 and redeemed on 10/24.
--323 of these participants transferred $250,000 or more for a total of 
$110 million on each day.
--In the previous 60 days, these 323 participants had completed 5,804 
exchanges of the I Fund for a total dollar amount of $1.9 billion. Two

[[Page 12667]]

hundred and seventy-eight of those participants with large accounts 
went on to repurchase the I Fund two days later on October 26.
--1,656 participants bought the I Fund on October 19, sold it on 
October 24 and repurchased it on October 26.

Limits Established by Other Funds/Plans

    The Agency is not alone in recognizing the problems caused by 
frequent traders. Indeed, there are supplemental plans offered by some 
U.S. Government agencies, which have taken measures to reduce interfund 
transfer activity. The FDIC Savings Plan charges a 2 percent redemption 
fee on shares of the international stock fund which are not held for at 
least 90 days. The Thrift Plan for the Employees of the Federal Reserve 
System does not allow participants to redeem shares of any fund for 14 
days after purchase.
    Beginning with the ``late trading'' scandal of 2003, the mutual 
fund industry began to place limits on trading. Trading limits imposed 
by major mutual fund groups include:

------------------------------------------------------------------------
      Mutual fund group            Trade limit           Time frame
------------------------------------------------------------------------
AIM Funds...................  4 exchanges.........  1 calendar year.
Ariel Capital Management....  4 round trip          1 year.
                               exchanges.
Federated...................  2 trades............  30 days.
Harbor......................  3 round trips (in/    12 months.
                               out within 30 days).
Hotchkiss and Wiley.........  1 round trip........  12 month period.
ING.........................  4 trades............  360 days.
Janus.......................  4 round trips.......  12 months (may
                                                     reject even before
                                                     this limit is
                                                     reached.)
Neuberger and Berman........  1 trade.............  60 days.
Northern....................  2 trades............  90 days.
PBHG........................  4 trades............  360 days.
Royce.......................  1 trade.............  30 days.
Van Eck.....................  6 trades............  360 days.
Vanguard....................  After sale cannot     60 days.
                               repurchase.
------------------------------------------------------------------------

    Defined contribution plans which offer mutual funds as their 
investment choices can pass on the funds' restrictions or impose more 
stringent restrictions of their own. The Hewitt survey entitled Trends 
and Experience in the 401(k) Plans 2007 found that 73 percent of 
surveyed plans have placed restrictions on some or all of their funds.
    While the Securities and Exchange Commission (SEC) has no direct 
oversight authority with respect to the TSP, its views on frequent 
trading and specifically its directive to mutual fund board members is 
instructive.
    The SEC's rule 22c-2(a)(1) under the Investment Company Act of 
1940, which authorizes mutual funds to impose redemption fees when it 
is determined that such fees are in a fund's best interest, took effect 
in October 2006. In the release adopting this rule (Inv. Co. Ac Rel. 
No. IC-26782, March 11, 2005), the SEC noted, ``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 costs because the fund 
manager must either hold extra cash or sell investments at inopportune 
times to meet redemptions.''
    According to the SEC: ``Under the rule [22c-2], the board of 
directors must either (i) approve a fee of up to 2% of the value of 
shares redeemed, or (ii) determine that the imposition of a fee is not 
necessary or appropriate. Id. A board, on behalf of the fund, may 
determine that the imposition of a redemption fee is unnecessary or 
inappropriate because, for example, the fund is not vulnerable to 
frequent trading or the nature of the fund makes it unlikely that the 
fund would be harmed by frequent trading. Indeed, a redemption fee is 
not the only method available to a fund to address frequent trading in 
its shares. As we have stated in previous releases, funds have adopted 
different methods to address frequent trading, including (i) 
restricting exchange privileges; (ii) limiting the number of trades 
within a specified period; (iii) delaying the payment of proceeds from 
redemptions for up to seven days (the maximum delay permitted under 
section 22(e) of the Act); (iv) satisfying redemption requests in-kind; 
and (v) identifying market timers and restricting their trading or 
barring them from the fund.''
    In its review of the best practices of the mutual fund industry's 
efforts to curb frequent trading, the Agency learned that the exact 
mechanisms funds employ to deter frequent trading are many and varied 
depending on unique circumstances, but they share two common themes: 
Fees or transaction limitations.
    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 and a 0.5 percent fee on 
shares of its Equity Index 500 and Extended Equity Market Index Funds, 
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 
exactly 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 interfund transfer 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

[[Page 12668]]

up to three days, costing participants forgone interest. None of those 
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.
    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% fee AND 
cannot repurchase the fund for 60 days.

Proposed TSP Solution

    The hallmark of the TSP is simplicity. Although the problem 
described above may not be amenable to a single solution (as evidenced 
by the multi-layered restrictions including monthly limits/no-buyback 
rules/redemption fees imposed by various private sector funds and 
plans), the Agency is currently proposing a straightforward rule that 
will allow two unrestricted transfers each month, followed by unlimited 
opportunities to transfer amounts to the Government Securities 
Investment (G) Fund. Our analysis on the effect of such a limitation 
shows that it would have reduced the historic levels of November 2007 
trade dollar volumes by 53%.
    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 interfund transfers. 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 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 two percent of his/her investment in addition to the market 
decline, a worst case scenario.
    Further, our approach is more liberal than most, if not all, of the 
restrictions reviewed. It allows participants to rebalance up to twice 
a month. Indeed, our two investment consultants, Mercer and Ennis 
Knupp, have conducted studies showing that rebalancing an account more 
than monthly or quarterly is ineffective. We therefore consider our 
approach to be more accommodating than necessary for optimal 
rebalancing frequency and demonstrably more liberal than the policies 
of 40 record keepers which use the same processing system as the TSP.
    The advantages of our current approach include ease of 
understanding by the 3.9 million TSP participants as well as 
administrative simplicity. In fact, the Agency's proposal will affect a 
very small number of TSP participants. Our review of 2007 data shows 
that more than 99% of participants requested 12 or fewer interfund 
transfers. The Agency expects that, when coupled with our educational 
and outreach efforts, this structural limit of two per month will 
virtually eliminate the problems associated with frequent interfund 
transfer activity.
    The Executive Director has sent a letter to every one of the 3.9 
million participants explaining the situation and reminding all 
participants that the TSP was designed by Congress to be a passive, 
long-term vehicle designed to replicate the selected indexes.
    Participants whose frequent transfer requests reflect an effort to 
time the markets (i.e., those who request interfund transfers in 
reaction to, or anticipation of, short-term market conditions) might 
still affect the returns of others in the pooled investments, as well 
as the Plan's ability to replicate the indexes, through less frequent 
yet more determined activity. This has the potential to become a 
significant problem as account balances grow over time. If participants 
with large account balances request large interfund transfers in a non-
random manner, the Agency may reconsider imposing the more restrictive 
limitations employed by other plans and mutual funds. If additional 
restrictions prove necessary, the Agency will announce additional 
rulemaking at a future date.

Regulatory Flexibility Act

    I certify that this regulation will not have a significant economic 
impact on a substantial number of small entities. It will affect only 
Thrift Savings Plan participants and beneficiaries. To the extent that 
limiting interfund transfers is necessary to curb excessive trading, 
very few, if any, ``small entities,'' as defined in 5 U.S.C. 601(6), 
will be affected by the final rule. This is because the Thrift Savings 
Plan is sponsored by the U.S. Government and because the interfund 
transfer limitations are likely to affect primarily federal employees, 
members of the uniformed services, and an insubstantial number of 
financial advisors who may provide advice in connection with the Fund.

Paperwork Reduction Act

    I certify that these regulations do not require additional 
reporting under the criteria of the Paperwork Reduction Act.

Unfunded Mandates Reform Act of 1995

    Pursuant to the Unfunded Mandates Reform Act of 1995, 2 U.S.C. 602, 
632, 653, 1501-1571, the effects of this regulation on state, local, 
and tribal governments and the private sector have been assessed. This 
regulation will not compel the expenditure in any one year of $100 
million or more by state, local, and tribal governments, in the 
aggregate, or by the private sector. Therefore, a statement under 
section 1532 is not required.

Submission to Congress and the Government Accountability Office

    Pursuant to 5 U.S.C. 810(a)(1)(A), the Agency submitted a report 
containing this rule and other required information to the U.S. Senate, 
the U.S. House of Representatives, and the Comptroller General of the 
United States before publication of this rule in the Federal Register. 
This rule is not a major rule as defined at 5 U.S.C. 814(2).

List of Subjects in 5 CFR Part 1601

    Government employees, Pensions, Retirement.

Gregory T. Long,
Executive Director, Federal Retirement Thrift Investment Board.

    For the reasons set forth in the preamble, the Agency proposes to 
amend 5 CFR chapter VI as follows:

PART 1601--PARTICIPANTS' CHOICES OF TSP FUNDS

    1. The authority citation for part 1601 continues to read as 
follows:

    Authority: 5 U.S.C. 8351, 8438, 8474 (b)(5) and (c)(1).

    2. Amend Sec.  1601.32, by revising paragraph (b) to read as 
follows:


Sec.  1601.32  Timing and Posting Dates.

* * * * *
    (b) Limit. There is no limit on the number of contribution 
allocation requests. A participant may make two unrestricted interfund 
transfers (account rebalancings) per account (e.g., civilian or 
uniformed services), per calendar month. An interfund transfer will 
count

[[Page 12669]]

toward the monthly total on the date posted by the TSP and not on the 
date requested by a participant. After a participant has made two 
interfund transfers in a calendar month, the participant may make 
additional interfund transfers only into the G Fund until the first day 
of the next calendar month.

 [FR Doc. E8-4776 Filed 3-7-08; 8:45 am]
BILLING CODE 6760-01-P