Following is a rules proposal from the TSP to reduce the maximum inflation adjustment on annuities purchased with withdrawals from 3 to 2 percent, a change that it says is more in line with actual inflation of recent years and that will result in higher initial annuity amounts.
A TSP participant has a variety of withdrawal options to choose from when electing to receive a post-separation withdrawal of some or all of his or her account balance.
One such option is an annuity with an increasing payment option based on an annual cost-of-living adjustment (COLA) calculation. Under this increasing payment option, the amount of the monthly annuity payment can increase each year on the anniversary date of the first payment.
Current Cost-of-Living Adjustment
Currently, when a TSP participant elects to receive an annuity with an increasing payment option, the increase in the amount of his or her monthly annuity payment each year is based on the annual change in inflation, as measured by the Consumer Price Index (CPI). Increases cannot exceed 3 percent per year.
When a TSP participant elects to receive some or all of his or her account balance in the form of an annuity with an increasing payment option, the TSP purchases the annuity for the participant from its annuity vendor.
Although the actual change in inflation varies from year to year, the annuity vendor’s pricing for this variable increase rate assumes an annual increase of 3 percent when calculating monthly annuity payments even when the calculated COLA turns out to be below 3 percent.
Proposed Cost-of-Living Adjustment
The FRTIB is proposing to change its COLA from the variable rate described above to a fixed rate of 2 percent per year. The Federal Open Market Committee (FOMC) has set an inflation target of 2 percent and implements that target over the medium term. Indeed, over the last 20 years, inflation, as measured by the CPI, has averaged 1.95 percent annually, which is the expected result given the FOMC inflation target.
Using a fixed rate of 2 percent offers two benefits. First, the FRTIB anticipates that fixing the rate at 2 percent will result in a higher initial monthly annuity payment on average. Assuming an inflation rate of 2 percent, a participant’s initial monthly annuity payment will, on average, likely be 10 to 15 percent higher than it would have been under the variable rate. Although this increase comes at the expense of a smaller amount of inflation protection (i.e., protection only up to 2 percent per year as opposed to 3 percent), using a fixed rate makes it less likely that participants will pay for more inflation protection than they need.
Second, a fixed rate produces a predictable rate of increase allowing participants to have a predictable pattern of income. Annual changes in a COLA based on the annual change in inflation can vary from year-to-year. This volatility can lead to participant uncertainty about how much, if any, their benefit will increase each year. However, the fixed rate has the added benefit of producing a predictable pattern of income.
As with all contract provisions, the FRTIB will regularly review the COLA to ensure that it continues to be beneficial for TSP participants.