What will you do if Congress raises the amount you must contribute to your pension? That’s a question that many of you should be prepared to answer — just in case. In the current environment, every federal employee should be considering the most likely threats to his or her financial plan.
One threat that should be on your radar is a bill the House passed May 10 to raise employees’ pension contributions by 5 percent of their pay. I thought I’d take a stab at quantifying the impact of this bill on an individual employee.
I considered a hypothetical employee, and assumed she had come to me for advice. This means that the results presented here are based on my assumptions, analysis and methods. This doesn’t imply that I have some unique magical abilities, but that the results you should expect, and that you ultimately enjoy, depend entirely on the decisions you make along the way.
My analysis considered a recently hired Federal Employees Retirement System employee earning $50,000 per year, before taxes. She plans to contribute 10 percent of her gross pay, per year, to her Thrift Savings Plan account from now until her retirement, 35 years from now at age 67. Her income and other tax factors bring her combined marginal income tax rate to 30 percent. After accounting for her TSP contributions and income taxes, she is left with $31,500 per year to live on. This is her current standard of living (SOL).
When she retires, she’ll be eligible to receive $21,000 per year, in today’s dollars and before taxes, in Social Security income and $19,250 per year in FERS benefits. If she makes her planned savings contributions and manages her TSP account prudently, she can expect to enjoy a retirement SOL equivalent to about $56,000 per year, in today’s dollars, for as long as she lives. In this case, the increase in her SOL between now and her retirement does not come from increases in pay beyond the rate of inflation, but from the growth in her savings and investments in the TSP, which I expect to exceed the general rate of inflation.
In other words, the expected return on her TSP investments, which I based on the current matching formula and an investment allocation of 60 percent equities, 37 percent bonds and 3 percent cash, produced a 78 percent increase in her retirement SOL.
If the required contributions to FERS rise, she has two possible methods to compensate: She can reduce her pre-retirement standard of living by 5 percent so that she can maintain her expected retirement SOL, or she can reduce her expected retirement SOL to maintain her current standard of living. In a nutshell: She can pay now or pay later — or some combination of these two.
To fully absorb the increase by reducing her pre-retirement SOL, without affecting her savings rate, she’ll need to cut her current spending by 5 percent, from $31,500 to $29,000.
But, what if, instead, she decides to maintain her current SOL and offset the entire increase by reducing her TSP contributions — the “pay tomorrow” alternative? Because her TSP contributions are taken from her pay, before taxes, the impact is less obvious. In this case, the tax deferral that is usually considered an advantage of saving to the TSP becomes an additional burden. To recover the $2,500 in net income lost to the higher FERS contributions, she’ll have to reduce her TSP savings by $3,571 per year. Since she was saving 10 percent of her pay, or $5,000 per year, this will reduce her TSP savings rate by more than 71 percent. In addition, the reduction to her payroll deferrals will also reduce the matching contributions she receives.
Based on my rather conservative projections, this reduction in TSP contributions will reduce her expected retirement SOL from $56,000 per year, after taxes, to $49,000 per year, in today’s dollars. That’s a reduction of nearly 13 percent for the duration of her retirement.
While the exact impact of an increase in the FERS contribution rates will vary from case to case, I hope that this example helps you to understand the kind of analysis that should guide your financial decision-making.