One of the tricky things about defined-contribution retirement plans is that although you know how much you’re putting in, you can never be sure how much you’ll get out in the end.
The Thrift Savings Plan is one of the world’s best retirement systems due to its extremely low fees and index options, but it still can’t tell you for sure what rate of return your savings will compound at and how much retirement income your portfolio will be able to produce.
That can make retirement planning challenging, which is why talking to a professional for personalized advice to plan your future can help.
So what are your realistic expectations from the TSP over the next 10-to-20 years in terms of growth? I take a stab at predicting that based on historical data and through experts like John Bogle, the founder of Vanguard.
The C Fund has grown at about a 10 percent compounded rate of return since its inception in the late 1980s, according to the information sheet for that fund on the TSP website.
Going back further, the S&P 500 (which the C Fund is based on) has produced about 9-to-10 percent annual returns since its inception in the late 1920s.
The G Fund, meanwhile, has produced a little over 5 percent per year since its inception in the late 1980s, although this rate of return has deteriorated slowly over time as the Federal Reserve has lowered interest rates for decades from their peak in the early 1980s. Returns over the last 10 years were less than 3 percent per year, and returns over the last five years were just above 2 percent, which barely stays ahead of inflation.
The S Fund historically keeps pace with the C Fund in terms of long-term performance.
The F Fund is a bit riskier than the G Fund and compensates by giving a little more than 1 percent extra per year than the G Fund since inception. Like the G Fund, its rate of return has deteriorated over time due to lower interest rates.
The I Fund, as discussed here, has been the worst-performing fund of the group at less than 5 percent growth per year since inception.
Why TSP returns may be lower going forward
Bogle, the founder of Vanguard and the inventor of the index fund, predicts about 4-to-5 percent S&P 500 returns on average over the next decade, and even lower than that when considering an appropriately balanced stock/bond portfolio. He has continued to support that number in recent months.
A report by McKinsey & Company from 2016 echoed the same sentiment, and predicted 4-to-6.5 percent S&P 500 average annual returns and 0-to-2 percent government bond average annual returns over the next 20 years.
Why would these esteemed sources forecast such mediocre or pessimistic results? The answer lies in valuation; the ratio between price and value for shares on the market, as well as low-interest rates.
Equities are currently highly valued
There’s no perfect way to measure valuation of the S&P 500, but there are several good methods that give us useful information to work with.
One way is to look at the cyclically adjusted price-to-earnings (CAPE) ratio of the market. This metric was introduced by Robert Shiller during the Dot-com Bubble to point out how overvalued the market was. Shiller is a professor of economics at Yale, and a Nobel laureate.
The way the metric works, is you take the current price of the S&P 500, and you divide it by the average inflation-adjusted earnings of the companies from the S&P 500 over the last 10 years.
It’s not critical to follow the detailed math; the takeaway point is that it’s a way of dividing average share price by average earnings in a more reliable way than just using the earnings over the past year, which can be volatile.
Here’s the current and historical chart of the CAPE ratio for the S&P 500 based on Shiller’s data, which he makes freely available on his Yale homepage:
As the chart shows, the current value is over 28, which is higher than any period in history except for a brief five-month period in 1929 and the five-year period between 1997 and 2002.
The reason this is important is because Shiller demonstrated with his research, via 130 years of back-testing, that the CAPE ratio is highly predictive of S&P 500 returns over the next 20 years from any point in time.
It doesn’t tell you what will happen over the next year or even several years, but historically whenever the CAPE ratio was quite high, returns over the next 20 years were poor. This makes intuitive sense, because when the price-to-earnings ratio of the market is already very high, there’s not much room for the stock market to expand other than through corporate earnings growth, and there’s plenty of room for a stock market crash or correction.
A shortcoming of the CAPE ratio is that it can be skewed by changes in accounting laws, since it’s based on reported corporate earnings. So, a second metric I like to look at is one popularized by no one other than Warren Buffett himself: the Market Capitalization/GDP ratio.
This Cap/GDP metric takes the price of all shares of all publicly traded companies in the country, and divides that figure by the country’s gross domestic product. It’s another way to come up with an approximate idea of the price of the market divided by the real output of the market.
Buffett has suggested that a ratio above 1 is overvalued, and a ratio below 1 is undervalued. Currently, we’re at over 1.27.
I won’t chart it here, but this second ratio correlates very closely with the CAPE ratio, and thus together they are in my opinion, and based on over a century of data, a reliable way to determine market valuation and sketch out a rough idea of what long-term forward returns might be.
Both Bogle and the report by McKinsey & Company cite high current market valuation as the specific reason they expect long-term returns to be rather low. And Shiller’s research agrees with them.
Another thing I like to do is analyze the discounted cash flows of major companies, because that provides one of the most hands-on ways to check how stock prices compare to the estimated value of a company based on the cash flows it could reasonably produce.
The short answer is that a lot of companies do appear expensive when measured by that method.
Bond interest rates are low
The second issue is that bonds are not well-positioned for good returns either, since their interest rates are so low.
The main driver of bond interest rates is the Federal Reserve funds rate that they control, and this is a chart of their rate over the past several decades:
Until interest rates come back up from near-zero, the G Fund is positioned to keep producing less than 3 percent annual returns. The Federal Reserve has begun slowly increasing interest rates over the past year, but there’s no way to know for sure how fast or to what extent they’ll increase rates.
It may take a long time to ever get back up to the 5 percent returns or better that the G Fund used to produce.
Playing it safe
Obviously, nobody knows what the future holds.
Nobody, regardless of their credentials or track record, can tell you what the short-term or long-term rate of return will be for any stock or market with certainty.
However, over a century of data does suggest that current high stock valuations are not well-positioned for producing great returns over the next decade or two. And low-interest rates have been crippling bond returns and may continue to do so.
Bogle, who is famous for arguing that trying to beat or predict the market is fruitless, is nonetheless comfortable pointing out the high probability that long-term U.S. stock returns will be low based on current broad valuation metrics, because they’re historically very reliable as an indicator.
The prudent thing to do is for investors to assume lower rates of return in their retirement calculations. The last thing you want to do is assume 9 percent-to-10 percent S&P 500 returns and 4 percent-to-6 percent bond returns for your TSP, and turn out to have been too optimistic with a portfolio at retirement that is smaller than you expected.
Instead, it may be wise to assume 4 percent-to-7 percent long-term returns for the C Fund, and 2 percent-to-4 percent long-term returns or from bonds, until we see a reason to expect otherwise. Err to the side of modest growth assumptions, and invest extra money accordingly.
If returns turn out better than that, you’ll have saved extra money and will have more than you need when you retire.
Lyn Alden has a background in electrical engineering and engineering management, focusing on engineering economics, financial modeling and resource management. She shares investment strategy on her website, LynAlden.com.