Avoiding Annuities

My column last week on the Thrift Savings Plan annuity option struck a nerve with readers. Many of the comments had a similar theme: Don't do it.

Let's look a little more closely at this option, examining why some people take advantage of it -- but many avoid it.

Opting Out

According to the Federal Retirement Thrift Investment Board, only a little more than 2,500 TSP annuities have been purchased during the past two years, at a time when the Office of Personnel Management has processed well over 50,000 federal retirements per year.

There are several reasons why most people don't take the life annuity option:

• Many people who are retiring today don't need to begin drawing on their TSP investments, because they have enough income from their other sources, such as civil service retirement benefits, military retirement and Social Security.
• Some people transfer some or all of their TSP account to an individual retirement arrangement and manage it themselves or with the help of a financial planner.
• The current interest rate index for the TSP annuity option is only 3.75 percent. That's down from 5.75 percent in 2007. The interest rate is locked in for the life of the annuity at the time of purchase.
• Many federal retirees move right into another job and don't need their investment income until they stop working later.

Cost

A central issue with annuities is the way they are paid out. If you purchase, for example, a $100,000 annuity, that's how much you pay. No additional fees or commissions are charged, and in the case of the TSP annuity option, your money is transferred to MetLife on a tax-deferred basis. The monthly benefit you then receive is computed on a combination of factors, including your life expectancy, how big the purchase was and the interest rate index that determines the benefit amount. The monthly payment from the annuity becomes your taxable income. There is no middleman between you and the annuity provider.

MetLife pays you a portion of your own money every month. If you live long enough, you will receive more than you paid in. If you die early, you "lose," in a sense -- although you would have had the peace of mind of receiving a monthly check throughout your lifetime.

One of the primary factors in determining just how big those checks will be is the interest rate index. Let's look at a couple of examples of how it can play out.

Suppose John bought an annuity in July 2006 at 70, when the interest rate index was 5.625 percent. Assume he used $500,000 to purchase a single life annuity with increasing payments and a cash refund. His initial payment was $2,862 per month. Assuming John receives 3 percent annual inflation adjustments, his annuity will be paying $3,735 in 2016.

Now suppose Phil bought an annuity in May 2009 at 70, when the interest rate index was 3.125 percent, and also used $500,000 to purchase a single life annuity with increasing payments and a cash refund. His initial payment was $2,156 per month. Assuming Phil receives 3 percent annual inflation adjustments, his annuity will be paying $2,813 in 2019 -- $922 less than John's payment after 10 years.

Safety

One of the main reasons for purchasing a life annuity is to receive a monthly income for life without the risk of losing money on investments. Still, many readers clearly are concerned that any insurance company offering annuities could go belly up in the current unstable economy.

The TSP doesn't guarantee annuities. The contract for the annuity is between participants in the program and MetLife. But the TSP does exercise extreme caution in making decisions about what company gets the annuity contract.

In the unlikely event that something happened to MetLife while you were receiving annuity payments, the state you live in will guarantee your annuity up to a certain dollar amount, varying from $100,000 to as much as $500,000. The TSP assures that the contract is awarded to a company that is licensed in all 50 states for this insurance guarantee.

Another Option

An alternative to the TSP annuity is to receive a series of monthly payments from your TSP investments. This can be done by designating a specific dollar amount or by letting the TSP compute the amount of the payment for you.

The specific dollar amount can be changed from one year to the next. So if you have a big expense coming up, you can increase your payout. Or if you're returning to work, you can reduce the amount of the payment to as low as $25 per month. If you want to take all of your money out later, you can change to a final single payment. But you can't stop payments to purchase a TSP annuity.

If you choose the option that allows the TSP to compute your monthly payment, your initial payment will be based on your age and your account balance. The payment will be computed by dividing your life expectancy into your account balance. Each year, on the anniversary date of your first monthly payment, the TSP will recalculate the amount of your monthly payments based on your age and your account balance at the end of the preceding year. Keep in mind that when the TSP switches life expectancy charts at around age 70, your payments will drop significantly each month.

As a comparison, let's go back to John and Phil in my previous example. They each had $500,000 that they used to purchase a TSP annuity at 70. Let's say they took the same money and chose a series of monthly payments. How long will their money last? How much will they receive each month?

The answer hinges on the way they manage their investments. Remember that while they are receiving their monthly payments, the balance of John's and Phil's TSP accounts remain in the G, F, C, S, and I Funds (or one of the life-cycle fund options).

The big difference between the monthly payment option and the life annuity is that John and Phil will have money in their TSP accounts even after payments begin. So, for example, if John starts out with $500,000 and takes out $18,248.16 (a little more than $1,500 per month) in the first year, he still has more than $481,000 left in his account. If we assume he can get a 4 percent return on his balance, he would end up with more than he took out. In year two, at age 71, John would start with more than $500,000. He wouldn't start using his principal for many years. His monthly payments won't start to decrease until he turns 93, unless he earns less interest or switches to a specific dollar amount for the monthly payment instead of using the life expectancy calculation.

If Phil chooses the specific dollar amount of $2,500 month, as long as his account earns an annual rate of return of 4 percent, his monthly payments will continue for 27 and a half years before he uses up the money in his account. He would be more than 97 years old.

Obviously, if the rate of return on John's or Phil's investments is higher or lower than 4 percent, this will affect monthly payments and the length of time their money will last. That's the risk in managing your investment yourself. But here are the benefits of electing to take the payments directly from your TSP account:

• You're are not locked into the monthly payment for life.
• When you die, your beneficiary will receive the remainder of your investments.
• You can still take advantage of the simplicity of the TSP investment options and the program's low administrative expenses.
• If you need a lump sum of cash later on, you can switch to a final single payment and take some cash out and transfer the remainder into an IRA where you could continue a monthly payout if you choose.
• This provides more flexibility than the annuity option.

Bottom Line

Decisions on TSP withdrawals come down to some very basic questions:

• How much money do you need to meet your monthly living expenses?
• What will inflation do to your buying power in the future?
• Is it important to you to leave an inheritance?
• Is there someone else who depends on you financially?
• How much risk can you tolerate?
• How well do you manage money?
• Are you willing to pay someone else to help you manage your money?
• How are your health and your family history going to play in to your life expectancy?
• How concerned are you that you will run out of money?
• How well do you understand your choices?

Remember, you have the option of splitting your withdrawal between the various options. And you'll have time after you retire to let the dust settle and make a choice regarding your investment income. You're not required to make a TSP withdrawal choice until you are older than 70 and a half and retired.

Tammy Flanagan is the senior benefits director for the National Institute of Transition Planning Inc., which conducts federal retirement planning workshops and seminars. She has spent 25 years helping federal employees take charge of their retirement by understanding their benefits.

For more retirement planning help, tune in to "For Your Benefit," presented by the National Institute of Transition Planning Inc. live on Monday mornings at 10 a.m. ET on federalnewsradio.com or on WFED AM 1500 in the Washington metro area.