Thrift Savings Plan: Adding a Socially Responsible Index Fund Presents Challenges
Published: 2012-06-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Socially responsible investmentinvestment made on the basis of environmental, social, religious, or corporate governance criteria in U.S.-based mutual funds exceeded $300 billion in value in 2010. TSPa $308 billion retirement plan with more than 4.5 million participantscurrently offers five distinct low-cost investment options, and is authorized to offer a service that enables direct participant investment in mutual funds outside TSP. GAO was asked to consider the value of adding an SRI option to TSP. GAO examined: (1) What challenges might TSP face in adopting an SRI option? (2) How would the addition of an index fund tracking an SRI index have affected past TSP stock portfolio performance? (3) How do the performance and costs of SRI mutual funds compare to those of non-SRI mutual funds?
To analyze the challenges surrounding SRI, GAO interviewed federal officials, SRI experts, and representatives of public retirement plans that had considered SRI adoption. To examine the impact of adding an SRI fund to the existing TSP funds, GAO analyzed monthly benchmark return data. To examine mutual fund performance trends and costs, GAO analyzed historical summary data on US-based mutual funds.
GAO provided a copy of this draft report to the Board, the Department of Labor, and the Department of the Treasury for review and comment. None of the agencies provided formal comments on the report.
section_title: What GAO Found
paragraphs: Officials at the Thrift Savings Plan (TSP) and the other public retirement plans that had considered socially responsible investment (SRI) associated a number of common challenges with SRI adoption. While none of these plans were identical to TSP in scope or demographics, many plan officials shared similar challenges and concerns with TSP. For example, they identified participant demand, SRI screening criteria, and costs as the most common challenges. Officials at public retirement plans that had adopted SRI cited some short-term benefits of SRI, such as providing participants an opportunity to invest in accordance with their values, but said that the long-term benefits were unknown.
When compared to the past performance of the TSP stock portfolio, the addition of a hypothetical SRI index fund tracking the best-performing U.S.-based SRI stock index would not have both increased returns and lowered volatility in any allocation scenario that GAO tested. Specifically, over the last 20 years, if TSP had included such an SRI index fund in its existing stock portfolio, it could have resulted in (1) lower returns and lower volatility, (2) lower returns and higher volatility, or (3) higher returns and higher volatility, based on GAOs analysis of evenly distributed portfolio allocations. The managers of the SRI index explained the difference in the indexs performance over the last 20 years was a result of having different sector weightings than the overall market to align with the funds SRI strategy. Moreover, the addition of this SRI fund would have resulted in overlap with the TSP stock portfolio, and would not have provided a substantial opportunity for additional portfolio diversification.
Looking more broadly at SRI mutual fundsthe most common form of SRI in the United StatesGAO found the comparative performance of SRI and non-SRI mutual funds to vary by asset class while costs were nearly the same. Regarding performance, SRI bond mutual funds had better risk-adjusted performance than their non-SRI counterparts over the last 15 years, while SRI stock and balanced funds did not. However, after controlling for various factors such as fund size, SRI stock mutual funds had better estimated performance as well. Regarding costs, in fiscal year 2010, the costs of SRI institutional grade mutual funds were similar to their non-SRI counterparts. Although TSP participants cannot currently invest in mutual funds through TSP, the Federal Retirement Thrift Investment Board (Board) is authorized to offer a mutual fund window if it determines that it is in the best interests of participants.
section_title: What GAO Recommends
paragraphs: This report contains no recommendations.

section_title: Letter
paragraphs: Since its inception in 1986, the federal government’s Thrift Savings Plan  (TSP) has become a central component of federal employees’ retirement  savings. Intended to resemble 401(k) pension plans in the private sector,  TSP allows employees to contribute a portion of their current  compensation through payroll salary deductions and to allocate their  contributions and any associated earnings among the available  investment options. As of February 2012, TSP held about $308 billion in  retirement assets and had more than 4.5 million participants, making it  one of the largest retirement savings plans in the United States.
The Federal Employees’ Retirement System Act of 1986 (FERSA)  established TSP and the Federal Retirement Thrift Investment Board  (Board), an independent agency in the executive branch, to administer it.The five-member, presidentially appointed Board must manage TSP  prudently and solely in the interest of the participants and their  beneficiaries and cannot exercise the voting rights associated with  ownership of securities in TSP. FERSA also established three TSP  investment funds: the Government Securities Investment Fund (G Fund),  Common Stock Index Investment Fund (C Fund), and Fixed Income  Investment Fund (F Fund). In 1996, Congress authorized TSP to broaden  its offerings with the International Stock Index Investment Fund (I Fund)  and Small Capitalization Stock Index Investment Fund (S Fund). Since  August 2005, TSP participants also have had the option to choose one of  five lifecycle funds, which diversify participant accounts among the G, F,  C, S, and I Funds using investment mixes tailored for different retirement  time horizons.
Congress has proposed legislation to require TSP to offer additional  investment options in an effort to give participants and beneficiaries  greater investment choice. Several of these proposals have sought to  require TSP to include a responsible investment index fund that would  track a market index comprised of stocks that were prescreened for  corporate governance, environmental practices, workplace relations and  benefits, product safety and impact, international operations and human  rights, involvement with repressive regimes, and community relations.  Commonly referred to as socially responsible investment (SRI), this kind  of investment strategy seeks to generate long-term competitive financial  returns while realizing positive societal impact by investing in accordance  with one’s values or certain environmental, social, or corporate  governance criteria. Investment in SRI mutual funds—the most common  SRI vehicle—exceeded $300 billion in 2010. Congress asked us to  examine the value of adding an additional investment option to TSP in the  form of an SRI index fund. In response to this request, we examined the  following questions:
What challenges might TSP face in adopting an SRI option?
How would the addition of an index fund tracking an SRI index have  affected past TSP stock fund portfolio performance?
How do the performance and costs of SRI mutual funds compare to  non-SRI mutual funds?
To determine the challenges associated with SRI, we reviewed relevant  federal laws and regulations related to FERSA and TSP, and literature. We  also interviewed officials from TSP, the Employee Thrift Advisory Council  (ETAC), investment management or consultant firms, and a  nonrepresentative sample of 15 public pension plans. To identify our  sample, we contacted plans that were signatories of the United Nations’  Principles for Responsible Investment and employed a snowball sampling  technique based on recommendations of interviewees. To assess how the  addition of an index fund tracking an SRI index would have affected past  TSP stock fund portfolio performance, we identified the best performing  U.S.-based SRI stock index based on 10-year risk-adjusted performance  data, and analyzed its potential impact on the TSP stock portfolio over the  past 20 years (1992 through 2011). Because this analysis is strictly based  on past performance, this result does not guarantee or imply that the  addition of an SRI index would have the same effect on future TSP stock  fund portfolio performance. To determine how the performance and costs  of SRI mutual funds compared with those of non-SRI mutual funds, we  analyzed historical performance data for several time periods over the past  15 years (dating back from December 2011)—the longest time period for  which data were available—and cost data from fiscal year 2010. We  focused our analysis exclusively on three share classes of mutual funds— institutional, front-load, and no-load—of U.S. domiciled open-end mutual  funds, which experts identified as the most common form of SRI funds. To  better demonstrate the full range of performance and costs trends between  SRI and non-SRI mutual funds, we analyzed funds by subcategories such  as share class, and also ran regressions to control for factors such as fund  asset size and investment strategy.
We assessed the reliability of the quantitative data used in this  engagement by reviewing related documentation, interviewing  knowledgeable officials, reviewing related internal controls, comparing to  published data, and tracing a selection of data to source documentation.  Based on this evaluation, we determined these data were reliable for the  purposes of this report. Additional details regarding our methodology can  be found in appendix I.
We conducted this performance audit from July 2011 to June 2012 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: The Thrift Savings Plan
paragraphs: FERSA created TSP to provide options for retirement planning and  encourage personal retirement saving among the federal workforce. Most  federal workers are allowed to participate in TSP, which is available to  federal and postal employees, including members of Congress and  congressional employees and members of the uniformed services, and  members of the judicial branch. TSP is structured to allow eligible federal  employees to contribute a fixed percentage of their annual base pay or a  flat amount, subject to Internal Revenue Service limits, into an individual  tax-deferred account. Additionally, Federal Employees’ Retirement  System (FERS) participants are eligible for automatic 1-percent  contributions and limited matching contributions from the employing  federal agency. TSP provides federal (and in most cases, state) income  tax deferral on contributions and their related earnings, similar to those  offered by many private sector 401(k)-type pension plans. As is typical in  defined contribution (DC) plans, TSP allows participants to manage their  accounts and conduct a variety of transactions similar to those available  to 401(k) participants, including reallocating contributions or account  balances, borrowing from the account, making withdrawals, or purchasing  annuities.
Administration of TSP falls under the purview of the Board, an agency  established by Congress under FERSA. The Board is composed of five  members appointed by the President, with the advice and consent of the  Senate. They are authorized to appoint the executive director who hires  additional personnel, and ETAC—a 15-member council that provides  advice to the Board and the executive director on the investment policies  and administration of TSP. policies for the investment and management of TSP, as well as  administration of the plan. The executive director and Board staff are  responsible for implementing the Board’s policies and managing the day- to-day operations of TSP, prescribing regulations to administer FERSA,  and other duties. The Board members and the executive director serve as  plan fiduciaries. FERSA has other investment policy provisions, such as  who can exercise voting rights associated with the ownership of stocks  held by TSP. For example, the Board and the executive director may not  exercise voting rights associated with the ownership of TSP securities.
5 U.S.C. § 8473. sponsors have greater discretion in choosing which investment options to  offer participants. In addition, Congress must amend FERSA to approve  a change in TSP investment options offered to participants. TSP’s  authorizing statute specifies the number and types of funds available to  participants, and requires that some of these funds track indexes, which  are broad, diversified market indicators. The Board may select the  particular indices for the funds to follow as well as review the investment  options and suggest additional funds. The Board has developed  investment policies for each TSP fund. These policies, which the Board  reaffirms quarterly, provide the rationale for selecting the fund’s  investments. Table 1 shows FERSA requirements and Board policies  regarding each fund and its underlying index.
Members of Congress have introduced bills calling for new investment  options to be added to TSP. In the past four sessions of Congress, a  number of bills have been proposed to add investment options to TSP,  including a corporate responsibility stock index fund, a precious metals  investment fund, a real estate stock index fund, and a terror-free  international investment option. In addition, Congress passed the Federal  Retirement Reform Act of 2009, which among other things, authorized  TSP to offer a service that would enable participants to invest in mutual  funds outside TSP, if the Board determined that such a mutual fund  window was in the best interests of participants. The law stipulated that  the Board had to ensure that any expenses charged for use of the mutual  fund window would be borne solely by the participants who used it. The  Board has not implemented the mutual fund window. According to TSP  officials, both the Board and ETAC were similarly split on whether to  include a mutual fund window and the Board tabled the discussion of the  mutual fund window to address more immediate issues, such as adding a  Roth TSP option. They also noted that while TSP has not moved  forward with adding a mutual fund window, it may at some future point.
FERSA also requires the Board to defray reasonable expenses of  administering TSP. TSP’s administrative expenses include management  fees for each investment fund; the costs of operating and maintaining  TSP’s recordkeeping system; the cost of providing participant services;  and the printing and mailing of notices, statements, and publications.
section_title: Socially Responsible Investment
paragraphs: SRI—investment made on the basis of environmental, social, and  corporate governance (ESG) criteria—is a global phenomenon and is  growing in popularity in the United States. In 2006, the United Nations  issued Principles for Responsible Investment that maintained a belief that  ESG issues can affect the performance of investment portfolios and  therefore must be given appropriate consideration by investors if they are  to fulfill their fiduciary duty.investors commit to better align investors with broader societal goals  while acting in the best long-term interests of their beneficiaries.  Specifically, signatories agreed to   By supporting the principles, institutional  incorporate ESG issues into investment analysis and decision-making  processes, be active owners and incorporate ESG issues into their ownership  seek appropriate disclosure on ESG issues by the entities in which  they invest, promote acceptance and implementation of these principles within the  investment industry to affect the performance of investment, work together to enhance the effectiveness of the principles, and  report on their activities and progress in implementing the principles.
In 2012, there were more than 1,000 asset owners, investment  managers, and professional service partners that had committed to these  principles worldwide—136 of them in the United States, according to the  United Nations’ website.
section_title: Officials Identified Several Challenges to SRI Adoption and Said the Long-term Economic Benefits of SRI Were Unknown
subsections: section_title: Challenges
paragraphs: Officials at TSP and the other public retirement plans that had considered  adding an SRI option associated a number of common challenges with  the implementation of SRI. While none of the plan officials that we  contacted had plans that were identical to TSP in terms of its federal  scope or participant demographics, many of them shared similar  challenges and concerns with TSP. As shown in figure 3, participant  demand, SRI screening criteria, and costs were the most common  challenges identified by public retirement plans.
TSP and most other public plan officials we contacted identified low  participant demand for SRI as a challenge to adopting SRI. TSP officials  told us that based on the results of their participant surveys and the  experiences of ETAC there was little demand for an SRI fund among TSP  participants. Specifically, they noted that the results of periodic participant  surveys have consistently indicated that there was no overwhelming  demand for any new investment options, including an SRI option. In  addition, ETAC members told us that they were unaware of demand for  SRI among TSP participants. They said that they would respond if  demand ever presented itself. While consultants and fund managers that  we contacted reported a growing demand for SRI in the United States,  public plan officials that we spoke with generally reported low participant  interest in SRI adoption. Officials at several plans noted that continued  pressure and repeated demands from small vocal groups of participants  in support of SRI had been a principal driver in the plans’ decision to have  an SRI option. However, officials at several of these plans said that, while  the SRI option did attract a small percentage of participants, overall  participation in the SRI funds ranged from less than 0.5 percent (in one  plan with 20 investment options) to about 10 percent (in a plan that  offered 9 investment options).
TSP and most other public plan officials we contacted identified the  difficulty of finding broadly acceptable SRI criteria as a distinct challenge to  adopting SRI. According to TSP officials, different interpretations of what  social criteria to apply to an SRI fund could lead to the need to develop  multiple funds to satisfy participants. Officials also noted that it would be  hard to reach agreement on what values an SRI fund should endorse.  Moreover, officials at most of the other plans we contacted said that the  lack of a common definition of SRI and the selection of SRI criteria was  challenging. For example, officials at one plan noted that social issues were  difficult to incorporate into an investment approach because, while some  basic social issues, such as child labor, imprisonment, and forced slavery,  were generally acceptable screens, reaching broad consensus on other  issues, such as labor laws, workers’ rights, weapons, guns, and tobacco,  was more difficult. An official at another plan noted that it was incumbent  upon participants to tell them what social policy they wished to pursue.  Officials at the plans we contacted that considered selection of screening  criteria to be a challenge overcame this challenge by either using an off-the  shelf SRI fund, or relying on the expertise and experience of the SRI fund  managers, or educating participants on why fund managers selected the  investments they did.
TSP and other public plan officials we contacted had varied opinions on  the degree to which the costs associated with the creation and  administration of an SRI index fund presented a challenge to adopting  SRI. According to TSP officials, the costs to create a new index fund  would be considerable. In addition, they said an SRI index fund would  cost more because it requires additional screening and monitoring. Under  TSP’s current cost structure, any costs associated with a new SRI index  fund would be borne by all participants whether or not they chose to  invest in the SRI index fund.had varied opinions on the degree to which these costs presented a  challenge. While there would be certain upfront costs associated with  adding an SRI fund, which could include member communication and  manager selection, officials at several plans said that adding a new fund  to its existing portfolio would not adversely affect administrative costs.  According to some investment managers we contacted, the key factors  affecting cost of any fund are (1) its asset size—the larger the asset base,  the better the economies of scale and the lower the overall cost ratio— and (2) whether the fund’s investment strategy requires active  management or passively tracking of a market index.
Other public plan officials we contacted  While TSP and some public plan officials we contacted asserted that their  role as fiduciary was a challenge in that it precluded the adoption of SRI,  officials at other public plans with an SRI option said there were no  fiduciary concerns surrounding the inclusion of an SRI option in a DC plan.  According to a 1990 memorandum sent from the TSP executive director to  the Board, Congress considered and rejected the concept of social  investment when creating TSP. The memorandum noted that the strict  fiduciary provisions of the law, which require the Board to discharge its  responsibilities solely in the interest of participants, excluded the possibility  of social investing, and that any authorization outside the realm of interest  of all participants would be inconsistent with the notion of employee  ownership of TSP assets. Officials at all of the public plans that had not  implemented an SRI option considered fiduciary issues a challenge to  adopting SRI, while officials at other plans did not. For example, an official  at one plan with an SRI option stated that fiduciary duty was not a  challenge when adding an SRI fund to the investment options to a DC plan  because participants have individual account ownership, are free to choose  how they invest, and must assume responsibility for any risks associated  with the underlying investments. One plan official noted that the fiduciary  responsibility of a DC plan extends to exercising due diligence in the  selection of a fund manager, providing appropriate participant  communications about the fund, offering enough investment options, and  acting in the best interest of the majority of participants.
TSP and some public plan officials that we contacted asserted that  investment decisions made on any basis other than the economic welfare  of participants could present a challenge in that it would expose the plan  to potential political interference. In its 2006 investment option review, a  consulting firm hired by TSP eliminated SRI from consideration in part on  the grounds that identifying screening criteria that all could agree to would  be difficult to find and likely draw attention from opposing parties of  interest. According to the 1990 memorandum from the TSP executive  director, the laws that established the current TSP funds prevent the  political manipulation of TSP funds, and officials told us that TSP has  taken steps in the past to avoid political interference. Officials at the  public plans we contacted had different views on the extent to which  political interference was a challenge. For example, officials at some  public plans that did not implement SRI identified political interference as  one of the reasons they chose not to do so. On the other hand, officials at  other public plans that had implemented SRI said that political  interference was not a challenge. For example, officials at one public plan  noted that the state’s legislative mandate to maximize returns and  improve levels of risk prevented political interference. An official at  another public plan that adopted SRI told us that although they had  anticipated political interference by state officials following their decision  to divest from alcohol or tobacco companies, it had not materialized.
Officials at TSP and some other public plans identified SRI fund  performance as a challenge to adopting an SRI fund. According to TSP  officials, participants who allocated assets to an SRI fund instead of a  standard fund that included all relevant companies would narrow the  number of companies in which they were indirectly investing, thereby  limiting their exposure to the performance of the broader, more diversified  market. While officials at some public plans that we contacted believed  that SRI funds had lower performance than other funds, other officials  had mixed views on whether the performance of SRI funds was any more  challenging than the performance of non-SRI funds. Officials at several  plans, which had considered but not implemented SRI, cited SRI  performance as a reason for not incorporating SRI in their plans. Officials  at one plan said they would reconsider offering an SRI fund if it  demonstrated better long-term performance than non-SRI funds.
However, officials at several other plans that implemented SRI told us  that the SRI fund produced comparable and sometimes better returns  than other funds in their portfolio. Officials at one plan said the plan would  terminate its working relationship with an external fund manager if its SRI  investments did not perform as well as other funds.
While TSP officials considered the lack of peer implementation of SRI as  a challenge to adopting an SRI fund, officials at other public plans we  contacted said that it was not a challenge. As part of its investment  options review in 2006, a consulting firm advised TSP that SRI funds  were not a common practice among TSP’s peers and identified this  criterion as a reason for eliminating SRI from further consideration.  According to TSP officials, the fact that similar plans had not adopted SRI  was a challenge in that TSP had no precedent to follow. We found a  number plans similar in asset size and membership to TSP that applied  SRI principles through investment screening. Officials at several plans we  contacted said that peer implementation of SRI did not factor in their  decision to incorporate SRI into their investment strategy.
Officials at most of the public plans we contacted had no restrictions  regarding investment overlap between funds and thus did not view such  overlap as a challenge to adopting SRI. According to TSP officials, the  Board is permitted to suggest legislation to address any gaps in  investment options as long as there is no evident overlap. In the past, for  example, TSP proposed legislation authorizing the addition of the S Fund  and the I Fund to provide participants with options for greater  diversification of investments in the small capitalization and international  markets. According to TSP officials, each of the current funds tracks  different companies in different segments of the overall financial market  without overlap, helping to reduce the risk of incurring large losses on a  broader portfolio. Officials at other public plans, which did not face the  same restrictions as TSP, said that overlap was not a consideration, and  that certain amount of overlap with existing investments was both  expected and accepted. Some officials noted that the purpose of SRI was  to select companies that met certain criteria and provided an alternative  investment choice.
section_title: Benefits
paragraphs: Officials at some of the nine public plans we contacted that offered an  SRI option cited some short-term benefits associated with SRI but said  that the long-term benefits were unknown. For example, officials at  several plans noted that the greatest benefit of having an SRI option is  giving participants broader investment choice and an opportunity to make  a statement in the way they invest. Officials at other plans said that  having an SRI option could serve as a recruiting tool for the plan in that it  encouraged more eligible employees to join the plan. Regarding the long- term benefits of SRI, officials at two of the public plans stated that it was  still too early to judge the benefit of SRI. As one plan official noted,  responsible investment involves making investment decisions that are  important to the long-term value and profitability of a company over time.
section_title: Adding an SRI Index Fund Would Not Have Improved Past TSP Portfolio Performance in Most Allocation Scenarios
paragraphs: When compared to the past performance of the TSP stock portfolio (the  C, S, and I Funds), the addition of a hypothetical SRI index fund tracking  the best-performing U.S.-based SRI stock index would not have both  increased returns and lowered volatility in any allocation scenario we  tested. Specifically, over the last 20 years, if TSP had included such an  SRI index fund (SRI Fund) in its existing stock portfolio, it could have  resulted in (1) lower returns and lower volatility, (2) lower returns and  higher volatility, or (3) higher returns and higher volatility, based on our  analysis of evenly distributed portfolio allocations containing the SRI Fund  against the TSP stock portfolio alone (a C, S, and I Funds combination).  For example, as shown in figure 4, adding the SRI Fund to the existing  TSP stock funds (an SRI, C, S, and I Funds combination) would have  resulted in lower returns and lower volatility; substituting the SRI Fund for  the C Fund (an SRI, S, and I Funds combination) would have resulted in  lower returns and higher volatility; and substituting the SRI Fund for the I  Fund (an SRI, C, and S Funds combination) would have resulted in  higher returns and higher volatility.based on past performance, this result does not guarantee or imply that   Because this analysis is strictly  the addition of an SRI index would have the same effect on future TSP  stock fund portfolio performance.
Overall, portfolio performance is directly tied to the individual fund  performance, which varied by time period. A comparison of the underlying  indices of these four funds shows that, while the SRI Fund had higher  cumulative returns than the I Fund over the last 20 years, it had lower  cumulative returns than all three of the TSP funds over the last 10 years.  Figure 5 shows the funds’ annual and cumulative returns and highlights  their performance during market cycles.
The managers of the SRI index explained the difference in the index’s  performance over the last 20 years in comparison with the Standard &  Poor’s 500 Index (the C Fund index) was a result of having different  sector weightings than the overall market to align with the fund’s SRI  strategy. For example, they told us that, in the late 1990s, the index was  relatively overweighted in technology, consumer, and finance stocks and  underweighted in energy and utilities, resulting in higher performance in  the “dot com” boom of the late 1990s and lower performance in the 2001  recession. Moreover, the SRI index also excludes companies involved in  the production of military weapons, which may have contributed to lower  returns over the past decade while the country has been at war.
In addition to providing less return overall than the C Fund over the 20- year period, the inclusion of this SRI Fund would have resulted in overlap  with the C Fund and not have provided a substantial opportunity for  additional portfolio diversification. By law, holdings in TSP stock funds  may not overlap. Fifty-seven percent of the companies included in the  SRI Fund index, which includes large, mid, and small capitalization  stocks, overlap with companies included in the C Fund index. In part, as  a result of this overlap, the SRI Fund and the C Fund are highly  correlated in their returns, and thus adding this SRI Fund would not  provide a substantial opportunity for additional portfolio diversification.  Portfolio diversification aims to reduce risk by investing in various  financial instruments and markets so that market events will not affect all  assets in the same way. Diversification opportunities exist if investments  have independent price movement, and therefore, independent returns.  The price movement between these two funds over the last 20 years was  1.94 percent independent, suggesting that the same external causes  affected their returns to nearly the same degree. By contrast, over the  same time period, the independence in price movement between the S  Fund and C Fund was 17.27 percent, and between the I Fund and C  Fund was 42.19 percent.
section_title: SRI Mutual Fund Performance Varied by Asset Class, but Had Similar Costs to Non-SRI Mutual Funds
subsections: section_title: After Controlling for Fund Size and Strategy, SRI Bond Mutual Funds and SRI Stock Mutual Funds Outperformed Their Non- SRI Counterparts
paragraphs: Looking more broadly at SRI mutual funds, the most common form of SRI  in the United States, we found that the comparative performance of SRI  and non-SRI mutual funds over the last 15 years varied by asset class.  While TSP participants cannot currently invest in mutual funds through  TSP, the Board is authorized to offer a mutual fund window if it  determines that it is in the best interests of participants. Specifically, our  analysis of institutional-grade mutual funds over the last 5, 10, and 15  years (dating back from December 2011) found that SRI bond mutual  funds had better risk-adjusted performance than their non-SRI  counterparts. In contrast, SRI stock funds and SRI balanced funds— which hold bonds and stocks—had worse risk-adjusted performance than  their non-SRI counterparts over these time periods. Because this  analysis is strictly based on past performance, these results do not  guarantee or imply that these asset classes would perform similarly in the  future.
After controlling for fund size and investment strategies (other than SRI  approaches), we found that the performance gap between the SRI and  non-SRI mutual funds narrowed significantly for stock funds but not for  balanced funds. Moreover, our regression estimates showed that SRI  stock mutual funds performed better than their non-SRI stock  counterparts in the 5- and 15-year timeframes, after controlling for  differences in asset size, share class, and investment strategies. (See  appendix I for additional information on the regression analyses.)
section_title: SRI and Non-SRI Mutual Funds Had Similar Costs
paragraphs: In fiscal year 2010, the costs of SRI institutional grade mutual funds were  similar to their non-SRI counterparts. It is important to note that our cost  analysis included only the most recent year of data available (fiscal year  2010) for three share classes of institutional grade mutual funds, and it  did not look at all SRI product types such as variable annuities or  exchange traded funds, which may have had higher costs. In addition,  fiscal year 2010 cost data are not indicative of past or future costs. As  shown in figure 7, there was considerable overlap in the costs associated  with these funds, as measured by their annual net expense ratio—the  actual percentage of assets deducted each fiscal year for fund  expenses.
While non-SRI mutual funds had a broader range of costs than SRI mutual  funds, the vast majority of SRI and non-SRI funds reported expense ratios  from 0.12 to 1.81 percent. On average, the reported expense ratios for SRI  mutual funds were 0.2 percentage points higher than non-SRI mutual  funds. When asset size and investment strategy were taken into account,  SRI mutual fund cost ratios were estimated to be only 0.06 percentage  points higher than non-SRI mutual fund cost ratios. For additional details  on our regression analysis on cost ratios, see appendix I.
section_title: Concluding Observations
paragraphs: Adoption of an SRI index fund would present challenges for TSP.  Currently, the law limits the types of funds that TSP can offer, prohibits  overlap among existing funds, and charges TSP to keep its costs low.  First, TSP would have difficulty finding an SRI index fund that did not  overlap with the existing TSP funds, limiting opportunities for additional  portfolio diversification. However, officials at other DC plans, which do not  face the same restrictions as TSP, said that a certain amount of overlap  with SRI and other investment options was acceptable and the purpose of  SRI was to provide an alternative investment choice. Second, TSP would  have difficulty selecting SRI screening criteria that all participants and the  Congress would find acceptable. While challenging, a number of plans  have a long history of SRI in their plans. Finally, under TSP’s current  structure, the costs of adding a new fund would be distributed among all  participants regardless of whether they participated in that fund. We note  that the Board has the authority to open a mutual fund window for  participants to invest in mutual funds managed outside TSP. If the Board  decides to act on this authority and allow the mutual fund window,  participants seeking other forms of investment, including SRI, could invest  in mutual funds and would bear the costs associated with this investment.
section_title: Agency Comments
paragraphs: We provided a copy of this draft report to the Federal Retirement Thrift  Investment Board, the Department of Labor, and the Department of the  Treasury for review and comment. None of the agencies provided formal  comments. The Department of Labor provided technical comments, which  we incorporated in the report, as appropriate.
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section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: To determine the challenges associated with socially responsible  investment (SRI), we reviewed relevant federal laws, regulations, and  literature. For example, we reviewed the Federal Employees’ Retirement  System Act of 1986, the Federal Retirement Reform Act of 2009, and the  2006 United Nations’ Principles for Responsible Investment. We also  interviewed officials from the Thrift Savings Plan (TSP), the Employee Thrift  Advisory Council, investment management and consultant firms, and 15  selected public pension plans. Our nonrepresentative sample of pension  plans included 9 domestic defined contribution (DC) and defined benefit  (DB) plans that incorporated SRI, and 6 plans that considered but did not  adopt an SRI component. To identify our sample, we contacted plans that  were signatories of the United Nations’ Principles for Responsible  Investment and employed a snowball sampling technique based on  recommendations of interviewees. We analyzed interview responses of  pension plan officials and other SRI experts on the challenges and benefits  associated with SRI, and how these experiences might affect TSP.
To determine how the addition of an SRI index fund to a TSP stock portfolio  would have affected past TSP stock portfolio performance, we identified the  best performing U.S.-based SRI index and assessed its potential impact on  the TSP stock portfolio based on historical performance data of the three  TSP stock fund underlying indices. To identify the best performing U.S.- based SRI stock index (SRI Fund) we (1) identified all U.S.-based SRI stock  indices with at least a 10-year history, and (2) selected the index with the  best 10-year Sharpe ratio (dating back from December 2011). To determine  how the SRI Fund would have affected TSP stock portfolio performance from  1992 to 2011, we analyzed monthly total return data for the SRI Fund and  the underlying indices of the three TSP stock funds provided by Morningstar,  Inc.—a leading independent financial market research firm. We used these  data to analyze changes in annual returns and volatility, in a manner similar  to past analysis conducted by TSP when considering whether to add funds  to the TSP portfolio. An important element of any performance statistic is the  unit of time measurement. Our analysis measures returns on an annual  basis, and measures risk based on the variation in year-to-year returns.  Using a different unit of time, such as a month or even a multi-year period,  could give a different picture of the risk/reward tradeoff. We calculated the  compound rates of return and standard deviation based on annual rates of  return from 1992 to 2011 for an annually rebalanced, evenly distributed  portfolio of the three existing TSP stock fund indices (a distribution of 33  percent, 33 percent, and 33 percent). We then calculated the change in  compound rates of return and standard deviation of annual returns for the  following evenly distributed portfolios: a four-way combination (25 percent, 25 percent, 25 percent, and 25  percent) of the SRI Fund and the three TSP stock funds indices, all of the three-way combinations (33 percent, 33 percent, and 33  percent) of the SRI Fund with two of the TSP stock fund indices, all two-way combinations (50 percent and 50 percent) of the SRI Fund  with one of the TSP stock fund indices, and  the SRI Fund alone (100 percent).
Another decision in any performance assessment is whether to do the  analysis on a time-weighted or a dollar-weighted basis. A time-weighted  basis gives equal weight to each unit of time; thus, the annual rate of  return in 1992 gets just as much weight in the analysis as the annual rate  of return in 2011. A dollar-weighted basis gives greater weight to the  periods when more money is at stake. For example, for a TSP participant  who made regular contributions to the plan during the 1992 to 2011  period, the overall rate of return would be more influenced by particular  performance in the later years, when more contributions are at stake,  than in the earlier years. We used a time-weighted basis for our analysis,  in order to focus on investment performance itself, rather than on the  particular economic consequences in the time period under study.
To further assess the performance of the SRI Fund, we compared annual  rates of return and compound cumulative rates of return for the three TSP  stock fund indices over various time periods. Specifically, we reviewed  performance over the 20-year period (1992 to 2011), the 10-year period  (2002 to 2011), and periods of market weakness. Because this analysis is  strictly based on past performance, this result does not guarantee or  imply that the addition of an SRI index would have the same effect on  future TSP stock fund portfolio performance. In addition, we analyzed the  overlap of holdings of the SRI Fund and the C Fund as of April 2012. To  analyze the diversification potential of the SRI Fund for the TSP stock  portfolio, we analyzed the correlation coefficient, common variance, and  independence of price movement between the SRI Fund and the C Fund  over the last 20 years.
To determine how the performance and cost of SRI mutual funds compare  with those of non-SRI mutual funds, we compared performance over the  past 15 years (1997 to 2011)— the longest time period for which data were  available—and costs as of fiscal year 2010 provided by Morningstar. To  identify the universe of SRI mutual funds, we included mutual funds from  Morningstar considered to be SRI mutual funds based on ethical screen  employed and data on SRI mutual funds maintained by US SIF. analyze performance and cost of SRI and non-SRI mutual funds active as  of December 2011, we focused our analysis exclusively on three  institutional grade share classes—institutional, front-load and no-load—of  U.S. domiciled open-end mutual funds, which experts identified as the most  common form of SRI funds. We did not examine other forms of SRI, such  as exchange traded funds, hedge funds, or variable annuities. Because this  analysis is strictly based on past performance, these results do not  guarantee or imply that these asset classes would perform similarly in the  future. Performance statistics include measures of risk-adjusted returns  over 5-, 10-, and 15-year time periods dating back from December 2011.
US SIF was formerly the Social Investment Forum (SIF). US SIF is a U.S. membership  association for professionals, firms, institutions and organizations engaged in sustainable  and responsible investing.
Some mutual funds had more recent inception dates, thus limiting the  number of funds in longer-term performance comparisons. Risk-adjusted  return statistics include the Sharpe and Sortino ratios. Cost measures  include fiscal year 2010 annual report net-expense ratios.
To investigate why SRI and non-SRI mutual funds differed in  performance, we ran regressions with and without controls for fund size,  share class, and investment strategy not inherently related to SRI. We  used the risk-adjusted performance measures, Sharpe and Sortino ratios,  as the dependent variables. Table 2 summarizes the results of 24  regressions for U.S. stock funds. The numbers in the columns labeled  “Outcome Variable 1” and “Outcome Variable 2” are coefficient estimates  on a flag indicating that a fund was non-SRI.
As shown above, the Sharpe ratio served as the outcome variable for the  first set of regressions (second column of the table). The Sortino ratio  served as the outcome variable for the second set of regressions (third  column of the table). The last column shows the average impact on the  non-SRI flag coefficient of inclusion of the control variables for the row. For  each outcome variable, inclusion of the control variables generally reduced  the estimated performance premium of non-SRI funds versus SRI funds.  The fund size and strategy variable sets both had substantial impacts on  the estimated difference in SRI and non-SRI fund performance.
The rows of the table show regression results for the 5-, 10-, and 15-year  time frames. The rows indicating no control variables included only the  non-SRI flag. The rows indicating “with fund size” included fund size,  along with the SRI variable as explanatory variables. The row indicating  “with strategy categories” include controls for whether a fund is actively  managed or passively tracks an index, the broad investment category of a  fund based on portfolio statistics and composition (e.g., natural resources,  real estate, or financial), the more narrowly defined institutional  investment category of a fund based on portfolio statistics and  composition (e.g., materials, domestic energy, technology, or utilities),  and the market capitalization and type of stock (value, blend, and growth).  The row indicating “with all controls” provides results for regressions with  share class as an explanatory variable in addition to the fund size and  strategy variables.
Table 3 shows results from 24 regressions for balanced funds. The  methodology for these regressions was the same as that used for the  regressions in table 2. Accounting for covariates did not have a consistent  impact on the estimated difference in performance between SRI and non- SRI funds for these funds, with the addition of control variables to the  regressions sometimes increasing the estimated difference in  performance and sometimes decreasing it.
Table 4 shows results for 24 regressions for bond funds. The  methodology for these regressions was the same as that used for the  regressions in table 2 except that one field (equity style box) was not  included as an explanatory variable because it was not populated for 90  percent of these funds. Accounting for covariates generally decreased the  estimated difference in performance between the SRI and non-SRI funds.
To investigate disparities between SRI and non-SRI mutual fund costs,  we ran regressions that controlled for fund size, share class, and  investment strategy. The coefficient for a flag indicating SRI status is  reported for four regressions in table 5. The regression reported in the  third column used fund size categories along with the SRI variable as  explanatory variables. The strategy variables used in the regressions  reported in the fourth and fifth columns were the same as those used for  the performance regressions reported above. Once the fund size and  investment strategy variables are taken into account, the estimated  difference in cost between SRI and non-SRI funds falls to 0.06 percent.
We assessed the reliability of the quantitative data used in this engagement  provided by Morningstar by reviewing related documentation, interviewing  knowledgeable officials, reviewing related internal controls, comparing to  published data, and tracing a selection of data to source documentation.  Based on this evaluation, we determined these data were reliable for the  purposes of this report. We supplemented our quantitative analysis with  qualitative data obtained from our interviews.
section_title: Appendix II: Variation of Annual Compound Rates of Return and Standard Deviation among Evenly Distributed Allocations of the Best Performing SRI Stock Index and Existing TSP Stock Index Funds, 1992 through 2011
paragraphs: Appendix II: Variation of Annual Compound  Rates of Return and Standard Deviation among  Evenly Distributed Allocations of the Best  Performing SRI Stock Index and Existing TSP  Stock Index Funds, 1992 through 2011 Allocations  Existing TSP Funds (C, S, I)  (baseline)
section_title: Appendix III: Additional Information on the Performance of SRI and Non-SRI Mutual Funds by Asset Class
paragraphs: σ= the Greek letter commonly used to denote standard deviation  rt= expected return on the series or portfolio  = the arithmetic mean of the return series r  n= the number of periods    Sortino ratio. The Sortino ratio is a risk adjusted return ratio that  considers excess return over a designated target return and the risk of  not achieving that target return. Excess return is defined as the series’  return less the target return; risk is considered to be the semi- standard deviation below the target return. The Sortino ratio therefore  tells you how well you are being compensated by a series for each  unit of shortfall risk you are incurring.
The formula for the Sortino ratio:  SD= the target semi-standard deviation of the return series in  question over the period in question. This is the square root of the  target semi-variance, with T as the target return   the arithmetic average return of the return series in question over  the period in question  The following tables provide additional information on risk-adjusted  performance of SRI and non-SRI mutual funds by asset class.
section_title: Appendix IV: GAO Contact and Staff Acknowledgment
subsections: section_title: GAO Contact
section_title: Staff Acknowledgment
paragraphs: In addition to the individual named above, Kimberley Granger, Assistant  Director; Jonathan S. McMurray, Analyst-in-Charge; James Bennett; and  Sarah Kaczmarek made significant contributions to this report. Kenneth  Stockbridge, Roger Thomas, and Jack Wang also made key  contributions.