Recently, Thrift Savings Plan officials announced that the retirement plan’s operating expenses have remained within budget in spite of unexpected costs associated with Hurricane Katrina. This is great news for participants, since the TSP’s costs are directly related to the returns they can expect to earn from their investments in the plan. But, just how low are the TSP’s expenses, and how important are these costs to plan participants?
The TSP’s investment expenses are so low — to me, astoundingly low — that they give TSP investors a significant edge over higher-cost alternatives like retail individual retirement accounts (IRAs). TSP participants are well-served to recognize this advantage when considering recommendations or offers to roll over their TSP accounts to IRAs after retirement.
All investors bear costs to own and manage their portfolios. Investment expenses for a diversified portfolio can vary widely, typically ranging from about 0.5 percent per year at the low end to 3 percent at the high end. The most widely used diversified investment vehicle is the mutual fund, which expresses its cost as an expense ratio — a percentage of invested assets regularly deducted from the returns generated by the fund’s activity. This cost directly reduces the returns credited to your account, so that if the fund’s investments earn 10 percent for the year and its expense ratio is 1 percent, you’ll only see a 9 percent return on your account statement for the period. These expenses are not sales commissions — commonly referred to as loads — they are unavoidable operating expenses that are relentlessly skimmed from your account and, consequently, your retirement savings.
According to Lipper, an independent firm providing information about mutual funds, the average expense ratio for all U.S. mutual funds is 0.96 percent, or 96 basis points, per year. The average cost of owning an actively managed, diversified domestic equity mutual fund — a subset of all U.S. funds — is 145 basis points, or 1.45 percent per year. While the cost of owning an individual fund can vary widely from these averages, the averages give you a feel for what to expect.
The corresponding cost of owning the TSP’s funds in 2005 was four or five basis points, depending on the fund. The income funds — G and F — cost four basis points to own, while the equity funds — C, S and I — cost five basis points. Owning a combination of funds, or the any of the L Funds, produces a weighted average cost of somewhere between four and five basis points, depending on the mix of funds. More aggressive portfolios will cost more than more conservative portfolios.
But, if we generalize, and assume that the average mutual fund portfolio costs about 100 basis points per year to own, then the cost advantage to owning a TSP portfolio instead of a mutual fund portfolio — in an IRA, for instance — is about 95 basis points per year, the difference between the cost for the two alternatives.
Over time, this small difference can produce large advantages in TSP account values. The difference — 0.95 percent per year – when compounded, is worth about 9 percent more TSP account value over 10 years, 19 percent more over 20 years and 30 percent more over 30 years.
In this scenario, for every $100,000 you have invested over 30 years, you can expect the TSP’s cost advantage to generate about $30,000 more in your account — serious money in anyone’s book.
The actual results will vary depending on alternative investments used in the analysis, but this example is a reasonable illustration of what to expect.
In general, the TSP’s cost advantage produces expected rates of return significantly higher than any other investment of comparable risk — that is, risk-adjusted expected rates of return. These higher expected rates of return are nothing to sneeze at, and will likely translate into a noticeably better standard of living in retirement for plan participants who take advantage of them for as long as possible.
Unlike prospective investment returns, the cost advantage is not speculative, but certain. You will save this money and it will contribute directly to your account’s value each year. I urge you to keep it in mind as you face the growing pressure from investment companies to roll over your TSP account to an IRA.
The attractiveness of a TSP rollover depends entirely on the character of the alternative being considered. The potential advantages of a new account should be carefully and objectively weighed against the cost disadvantage that will result from the rollover. Don’t be fooled by sales pitches disguised as advice. Far from the “smart move” investment companies may make it out to be, a TSP rollover is often nothing more than a sucker’s bet.
Written by Mike Miles
For the Federal Times
Publication October 2, 2006