FEDweek

TSP G Fund Downside: Low Returns

The G Fund has arguably the best risk/reward ratio out of all investments issued by the U.S. Treasury, as I described in a recent TSP Investment Report article.

That doesn’t mean, however, that it is without risk, or that it’s the best fund in the TSP.  Although the G Fund is the least volatile, and protected on paper from losing any money at all, it does indeed have certain risks and downsides that investors should be aware of when deciding how much of their TSP to invest in it – namely low returns.

Many investors put 100% of their TSP into the G Fund, which is rarely a good idea, because it consolidates your risk with no diversification, and produces poor long-term returns.

Risk 1) Not Having Enough Money

The biggest problem and risk with the G Fund is that it offers low absolute returns.

Although there’s a degree of risk when it comes to taking on equities and other volatile investments, the hidden risk that the most conservative investments have is that you could end up in retirement with too small of a nest egg.  Not saving and growing enough money is a real concern.

If you put $1,000 per month into your TSP (including the part you receive in matching), here’s how your TSP could grow over a 40-year career at four different rates of return:

TSP could grow over a 40-year career at four different rates of return

If you adjust for 2% inflation, cut those final values in half.  And you have to pay taxes on your withdrawals.

So, if your TSP account grows at an average rate of 3% per year, you’ll wind up with a little over $1 million in the end, which will be worth about half of that in today’s purchasing power, and you still have to pay taxes as you draw the money out.

Meanwhile, someone investing in a more diversified manner, who reaches 5% or 7% per year over the long-term, can expect to have about $2 million or $3 million by the end, which still holds up well after inflation and taxes are taken into account.

Risk 2) Interest Rate Risk

Whether the G Fund gives decent or low returns, is almost entirely dependent on the federal funds rate set by the U.S. Federal Reserve.

That’s why the G Fund has produced better than 5% annual growth since its inception in 1987, but has given less than 2% over the last five years.

Here’s a long-term chart of the Fed’s interest rate, courtesy of the Federal Reserve Bank of St. Louis:

Long-term chart of Fed interest rate

We’re currently in a long-term interest rate drought.  There’s a decent chance that interest rates will remain low for a while, which means poor or mediocre G Fund returns compared to how well it did in the 80’s and 90’s.

Risk 3) Inflation Concerns

When you have all your money in bonds, including treasuries, you’re exposing all of your wealth to inflation risk.  The G Fund virtually guarantees that you can’t lose paper value, but it doesn’t guarantee that you can’t lose purchasing power.  Although the fund has historically grown at a pace that exceeds inflation, there’s no guarantee that it always will, especially if we hit a period of very high inflation.

Real estate and equities hold up better in inflationary environments, because they represent real assets that continue providing tangible value or cash flows.

Risk 4) Minor Default Risk

The G Fund is backed up by the full faith and credit of the United States.  It’s a common claim that the United States has never defaulted on its debt before, but that’s not exactly true.

In 1979, due to a combination of a political debt ceiling crisis, a back-office IT failure, and unusually high volume, the U.S. Treasury was unable to pay maturing T-Bills on time.   This was a period of peak inflation and interest rates, so a delay was a big deal.

They did pay the T-Bill holders after a delay, but initially refused to pay interest for the delay.  It took quite a while for the dust to settle and for the U.S. Treasury to agree to pay interest on its mistake and make investors 100% whole.

The debt/GDP ratio continues to rise, which makes the credit of the United States less and less sure.  This is partially offset by the fact that the United States controls its own currency, unlike countries that share in the Euro, which gives it quite a bit of flexibility.

The default risk on treasuries, including the G Fund, by an increasingly debt-burdened and polarized federal government, is small but non-zero.

Overall, the G Fund is a great low-volatility investment, but it’s best used in conjunction with the other more growth-oriented funds.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.