Three proposals to help reduce the nation’s deficit could reduce the standard of living of retirees covered by the Federal Employees Retirement System:
- Computing the pension benefit with the average of the highest five years of salary, instead of the highest three.
- Reducing cost-of-living adjustments.
- Increasing the employee’s share of contributions to FERS before retirement.
Changes like these could affect the life you enjoy for many years after you stop working, so it is important that you understand what they mean to you. I analyzed the case of a hypothetical employee near the top of the pay scale, but the results are illustrative of the effects that any FERS-covered employee can expect.
Consider Jane, who intends to retire in two years, at age 62, with 20 years of FERS service. Her high-three will be $150,000 and she is entitled to maximum Social Security benefits when she claims them. She has $500,000 in her Thrift Savings Plan account and $100,000 in taxable savings, and plans to contribute $22,000 to her TSP account during each year she remains at work. She expects to have no accumulated sick leave at retirement.
If she came to me for help, I would advise her that she can plan to spend about $72,000 per year, after taxes, for life, during retirement. This amount would be supported by FERS pension payments that begin at about $33,000 per year, before taxes, and are adjusted annually for inflation by cost-of-living allowances (COLA). In addition, she would be entitled to Social Security benefits that begin at about $21,000 per year, before taxes.
I would be responsible for managing her remaining invested assets in a way that would produce withdrawals of the amount needed to make up the difference, after taxes of about $12,400, to $72,000 each year. In the first year of retirement, these withdrawals are equal to about $30,400, but they will have to increase over time because the FERS COLA will not keep pace with inflation. My goal would be to manage her invested assets to produce a 10 percent return each year.
The first proposal, to shift to a high-five, reduces the salary factor in the annuity calculation by varying amounts, depending on how rapidly your pay increased during the years used in the calculation. It turns out that the reduction in the result, and in the resulting FERS pension, is about equal to the pay growth rate. If your pay increased 3 percent per year, switching to a high-five will reduce your annuity by about 3 percent.
For the test case, I assumed a 5 percent reduction in the annuity amount, so Jane’s high-five average pay is $142,500 and her initial annuity income falls by $1,650 per year, to $31,350. This reduces the safe spending from $72,000 to $71,000, or by about 1.4 percent. Additional testing reveals that Jane could compensate for this loss by shifting to a more aggressive investment strategy to increase her expected annual return to 11.75 percent; by adding $25,000 to her portfolio by the time she retires; or by delaying her retirement by seven months to increase her annuity payment.
The second proposal, to reduce COLAs, might be a bigger threat. If the COLA were eliminated, for example, my analysis concludes that Jane’s retirement spending would be reduced by about 6 percent — to $68,000 per year, after taxes. It would take an additional $90,000 in after-tax saving, or a delay in retirement of at least a year, to compensate for this loss. She could not likely make it up by adjusting her investment strategy alone.
The third proposal, to increase employee contributions to FERS, is harder to nail down. Its impact would depend on how employees handle the reduction in take-home pay, which has been estimated to be about 5 percent. If Jane’s planned savings contributions continue until retirement, then there would be no effect on her retirement spending.
But if she saves less, then every $10,000 she hasn’t saved at retirement will reduce her retirement spending by about $1,000 per year. For example, if Jane took the entire 5 percent reduction in her gross pay, which would be $7,500, from her TSP contribution each year over the two years pending her retirement, she would save $15,000 less than now planned.
With investment earnings over these two years, I expect that reduction in contributions to cost about $17,000 in her TSP account’s value at her retirement. This would reduce her expected retirement spending by about $1,700 per year, to $70,300, after taxes.
The effect of each of these scenarios on your retirement income will depend largely on how much of your planned income will come from your FERS pension and how your investments are managed. Hopefully, this gives you a feel for what you may be up against if one of these plans becomes reality.