One of the most important rules of investing is to keep your fees low.
Until index funds became popular in the last few decades, high investment fees were almost unavoidable. You’d have to pay 1-2% or more of your assets every year to an actively managed fund.
That doesn’t sound like much, but a simple example can illustrate just how tremendous of an impact that is. If you invest $10k per year at an annual rate of return of 7%, then you’ll have approximately $1 million after 40 years and after adjusting for 2.5% inflation. However, if you pay 1.5% in fees each year, then your effective annualized rate of return is only 5.5%, and your inflation-adjusted net worth after 40 years would only be a little bit over $720k. In other words, that fee costs you almost $280,000.
Unless a fund can give an outsized rate of return over an extended period of time (and very, very few manage to do that), the higher fee is not worth it, and enriches the fund manager rather than the investors.
TSP Expense Ratio Compared to Other Investment Platforms
Fortunately, the TSP has among the lowest fees of any investment platform in the world. For 2016, the average net expense was just 0.038%. Even over the course of 40 years, that has a nearly negligible impact on your net worth, and in the previous example would still leave you with over $1 million by the end.
However, TSP investors have a choice. After you put in the obvious 5% of your salary for matching, you can continue to put in more money without added matching (up to $18k per year currently), or you can put money elsewhere, such as in a Roth IRA, or another type of brokerage account. So, it’s worth comparing the TSP to other investment platforms to see how it stacks up. After all, although index funds are generally far less expensive than their actively managed counterparts, not all index funds are created equal.
Vanguard’s Balanced Index Fund Admiral Shares invest in stocks and bonds, and thus are a somewhat comparable investment to the TSP. Their expense ratio is among the lowest in the world at 0.07% per year, which is still almost double what the TSP charges. Vanguard’s cheapest stock-only fund charges just 0.04%, and their target date funds charge as high as 0.16%.
Fidelity index funds have expense ratios ranging from 0.045% to 0.14%, which is still decent but higher than the TSP.
A company called Motif lets you buy a collection of 30 stocks for $9.95. If you do that once per month, it would come out to $119.40/year. Since the fee is a fixed amount rather than a percentage of your assets, the expense ratio would therefore depend on how much assets you have invested. If you only have $50k, then the expense ratio would be 0.23%. If on the other hand you have $1 million, then the expense ratio would be only 0.01%. However, if you invest more frequently (such as every two weeks like the TSP), then the expense ratio would be a bit higher. This method takes a bit more time to manage than a pure index fund.
Overall, the TSP has virtually the lowest fees in the world, and is tax-advantaged similarly to a 401(k) plan. Most 401(k) plans, however, charge higher investment fees than the TSP, even for index funds. Both the TSP and Vanguard have cost advantages because they are extremely large in scale and are run without a profit motive, since the TSP is a federal service and Vanguard is owned by its own funds. This allows them to have the lowest fees possible.
The TSP has a few downsides, like the limited selection of funds. For example, the I-Fund has some problems, and although it’s useful for rounding out your TSP account, it’s perhaps not the best type of international index available. In addition, a Roth IRA is more flexible than the TSP while also being tax advantaged, and can be a useful place to put some money in alongside your TSP.
Still, the TSP is flexible enough in its limited options to cover pretty much all your bases, and since it’s combined with the lowest fees in the world in a 401(k)-like tax-advantaged platform, it is one of the best defined contribution retirement systems available anywhere.
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.