After the frightening losses in value that many Thrift Savings Plan investors experienced over the past couple of years, it might be tempting for some near or in retirement to consider using part or all of their savings to buy a guaranteed life annuity. An annuity can be a great choice or a terrible mistake, depending on your circumstances. Since purchasing an annuity is an irreversible decision, it is critical that you understand the consequences before you buy.

A life annuity is an insurance policy that guarantees a stream of income over your lifetime, and possibly the life of a survivor. The allure, particularly in tough economic times, is that, once purchased, the annuity alleviates the kind of investment risk – that associated with volatility – that tends to make investors worry. But the payments you’ll receive during the life of the annuity are set based on interest rates when you make the initial purchase, so buying the annuity in a low-interest-rate environment locks in low payments for life.

You can buy a TSP annuity at any time – while in service using an age-based or financial hardship withdrawal, or after you separate – as long as you keep your money in TSP. Using all or part of your balance to purchase a life annuity avoids the 10 percent tax penalty imposed by IRS for early withdrawals – a plus for younger participants who are ready to receive a regular stream of income from their accounts. For example, a 50-year-old retiree can buy a TSP annuity without triggering the early withdrawal penalty.

A TSP annuity is not actually issued or administered by TSP or its governing body, the Federal
Retirement Thrift Savings Board. It is a private contract underwritten by a commercial insurance
company, currently Metropolitan Life. MetLife offers these annuity contracts to TSP participants under agreement with TSP. While it’s not considered as secure a source as the federal government, MetLife is one of the largest private insurers in the U.S. and the risk of default on one of its annuity obligations should be relatively small. Once the annuity has begun, however, your ongoing relationship – including any customer service you receive – will be with the insurance company, and not TSP.

As a participant, you may buy an annuity with payments guaranteed for your life or, if longer, for the life of a survivor. The survivor may be your spouse or another person with an “insurable interest.” The survivor benefit of the TSP annuity differs from that of the annuities under the Civil Service Retirement System or Federal Employees Retirement System. The TSP annuity offers either a 100 percent or a 50 percent survivor benefit, and that benefit is paid beginning when either the annuitant or the joint annuitant dies. This is an important distinction to recognize in planning future cash flows. Unlike a CSRS or FERS annuity, which pays the survivor benefit only when the retiree dies, the TSP survivor, no matter who it is, receives the survivor benefit.

Since the funds you are using to purchase a TSP annuity were deposited pretax and have never been taxed, 100 percent of each payment you receive is taxable as ordinary income in the year it is received. Again, this differs from a pension annuity on which there are some tax exclusions.

The amount of payment you receive, relative to the size of the premium you pay for the annuity is fixed when you make the purchase. While you may choose to purchase increasing payments as an optional feature, the base payment amount is determined at the time of purchase and is related to market interest rates. Future changes in interest rates, higher or lower, will not affect the base payment amount. This is important because purchasing an annuity in a low-interest-rate environment subjects you to the risk that interest rates will rise and the relative value of your payment will, by comparison, decrease. Purchasing your annuity in a high-interest-rate period generally will result in a larger payment relative to the size of the premium you pay.

You should also realize that the initial payment, as a percentage of your premium, does not necessarily correspond to the annual return on your investment. For example, $500 per month, or $6,000 per year, on a $100,000 premium is not equivalent to a 6 percent annual return on an investment. An investment returning 6 percent in the form of income payments will still be worth $100,000 after all payments have been made. When the annuity payments end, however, the value of the contract will be zero. The return on the annuity will always be less than the percentage represented by the payment amount. So, one way of considering the alternatives to the annuity is to compare the payout percentage with returns available on alternative investments.

Written by Mike Miles
For the Federal Times
Publication August 10, 2009