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TSP annuity options

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The last post talked about the TSP’s withdrawal options, including penalty-free ways to tap into your account before age 59.5. It also includes the TSP’s draft of their rules for the 2012 Roth TSP.

Before we get into the “how” of a TSP annuity, let’s ask “Why?”

If you’re retired from the military then you already have an annuity: your military pension. It includes a COLA, a survivor benefit plan, and the world’s most reliable payment agency. You just can’t buy a better annuity than your pension, and another one might not be worth the money.

As annuities go, the TSP annuity is a bargain. However if your military pension meets your bare-bones spending needs, then you may want to keep control of your TSP assets. Even the most conservative financial advisers recommend annuitizing only a portion of your retirement income, not all of it. A TSP annuity is safe but you surrender control over the money.

When you withdraw your TSP funds you can choose nearly any combination of a single payment, monthly payments, and an annuity. If you buy a TSP annuity then you give up a lump sum that you could have spent on other essentials (like long-term care) or passed on to your heirs. Instead of being able to dip into your TSP funds for large expenses like a new roof, caring for a loved one, or a fantasy vacation, you’d have to save the money out of monthly annuity payments. Better still, if you use the TSP’s other withdrawal methods then your account funds will continue to grow and will probably outperform an annuity.

If you have a military pension then there may be still be a few reasons to opt for a TSP annuity– you could have spendthrift concerns or you may prefer to shield assets from litigation. But before you decide to take this option, it’s worth spending an hour or two with a financial adviser (or on Early-Retirement.org!) to explore other options.

If you won’t have any other pension income then a TSP annuity is one of the world’s best safety nets. (The other, believe it or not, is Social Security.) However you still don’t want to go overboard on annuitizing your income. For most retirees, your annuity (plus Social Security) should cover an absolute minimum standard of living– one cut above cat food. Even if you’re highly risk-averse, you can invest most of your remaining funds in assets like TIPS or I bonds that will afford inflation-fighting income while minimizing the risk of losing principal. If you later decide that you’re not comfortable with this approach then you can always buy more annuities. Once you purchase a TSP annuity, however, it’s an irrevocable decision.

The timing of your annuity purchase has a big impact on its amount. Annuity providers use an “assumed interest rate” to determine the discounted value of an annuity. It works just like a mortgage: when interest rates are high, your payment is high. When interest rates are low, your payment is low. If you buy a TSP annuity in April 2011, the interest rate is 3.625%. This is actually up from last November’s record low of 2.625%.

Now let’s move on to “how”.

You can start your TSP annuity anytime after age 59.5. (TSP withdrawals before then are subject to early withdrawal penalties, although there is a complex 72(t) loophole to avoid the penalties.) The IRS requires you to start your TSP annuity before 1 April of the year after you turn 70.5 in order to comply with the required minimum distribution rules.

You can buy your annuity for just yourself (with or without a survivor option) or jointly with another annuitant. Typically that’s your spouse, but it could be an immediate family member or business partner with an “insurable interest”.  Survivor options include “100% payment” and “50% payment”. Of course the size of the survivor benefit that you’d like to pass on will reduce the amount of your own annuity payment. There are additional rules for survivor annuity options which are summarized on this page  or on page 9 of this booklet.  Once again, if you have a military pension then its Survivor Benefit Plan is probably a better deal than a survivor option on your TSP annuity.

The annuity can be paid with or without a COLA. The COLA option will raise your annuity payment each year by the amount of inflation measured in the Consumer Price Index (CPI) up to a maximum of 3%. This option will also reduce the amount of your initial annuity payment, but that reduced amount will preserve its purchasing power for much longer.

The annuity options are quite complex, and their interactive effects on the monthly payment are hard to assess. The TSP annuity calculator  can help sort through the choices to see how each one would affect the amount of the payment during your life expectancy and (if a survivor option is selected) your survivor’s remaining life expectancy.

If your TSP account includes tax-exempt contributions (from a combat zone), the annuity vendor will track the taxable and tax-free proportions and report those amounts in your annual tax statement.

Once you apply for your annuity, the TSP purchases it from a major vendor like Metropolitan Life. The federal government buys a large volume of annuities for its retirees and the vendors don’t have to spend money marketing them, so the vendors are expected to offer their annuities at lower prices and commissions. However this bargain-basement price comes at a cost: the decision is irrevocable. Once the TSP has bought your annuity for you, you can’t cancel or change its option or change its joint annuitant. It’s hypothetically possible to exchange an annuity for an annuity from another company, or to sell the continuing stream of payments to a third-party buyer, but a TSP-funded annuity includes a number of restrictions that may render it ineligible for the secondary annuity market.

Remember: if you’re receiving a military pension, its survivor and COLA benefits are probably a better deal than the TSP annuity. If you decide to buy a TSP annuity then purchase the absolute minimum amount you need, and consider the impact of interest rates. It’s always difficult to time an investment decision, but you get a higher annuity payment when interest rates are higher. It may be wise to delay your TSP annuity as long as possible or to purchase smaller annuities (from other companies) over several years.

Related articles:
TSP withdrawal options
TSP booklet: “Withdrawing Your TSP Account”
TSP booklet: “Tax Information About TSP Withdrawals and Required Minimum Distributions”

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