Servicemembers who enter the military after Jan. 1, 2018, may receive retirement payouts that are as much as 18% lower than current servicemembers', according to a white paper released Wednesday by First Command Financial Services.
That decline is due to the new retirement system that will affect future servicemembers. Troops who join before 2018 may opt in to the modernized plan, or be automatically covered under the current system. The December 2015 First Command Financial Behaviors Index found about 30% of troops who plan to serve to full retirement want to opt in to the modernized plan.
The 2016 National Defense Authorization Act adopted several of the recommended changes to the military retirement system that were put forth by the Military Compensation and Retirement Modernization Commission (MCRMC) in January 2015. One of the biggest changes is a switch from a cliff vesting system where participants are eligible for retirement benefits after 20 years of service — and nothing before — to a system that combines participation in the Thrift Savings Plan and lump sum payouts.
First Command compared the switch to the modernized plan from the cliff vesting plan to the private industry’s move to defined contribution plans rather than defined benefits.
“Certainly it was a successful trade for many employers, who were able to transfer the uncertainty of long-term financial risk from their company balance sheets to the household finances of their employees,” the report said, referring to employers’ preference for defined contribution plans. “But for a good portion of American workers, the trade hasn’t worked nearly as well.”
A December report from the Center for Retirement Research at Boston College found that defined benefit plans outperformed defined contribution plans by 0.7%, regardless of plan size and allocation.
The modernized retirement plan will benefit servicemembers who don’t serve 20 years; with the cliff vesting plan, they would leave the service with no retirement benefits at all. However, as First Command noted in the white paper, “those who serve out a 20-year career will see smaller pensions and be required to make up the difference through a greater reliance on their own savings and investment behaviors.”
That could be a problem, as a March 2015 report by First Command found financial literacy was falling among military families.
The New Retirement Plan
The modernized plan is based on four components. One is a reduced multiplier to calculate retirement pay, from 2.5% per year of service to 2%, which reduces pensions by 20%, according to First Command.
However, one of the biggest changes is the focus on participation in the 401(k)-style Thrift Savings Plan available to federal employees. Servicemembers have only been eligible to participate in this plan since 2001, and until now, there’s been no automatic deduction or matching contribution to encourage enrollment. First Command found in January that even among military families who work with a financial advisor, just 53% participate in TSP.
The modernized retirement plan introduces a minimum 1% automatic contribution to TSP. In the private sector, the average default contribution rate is 2.8%, according to the Bureau of Labor Statistics.
Troops can also earn a 100% matching contribution from the Department of Defense on the first 3% and a 50% match on the next 2%, for a total 4% match. Total contributions are maxed out at 5% of basic pay.
The MCRMC report that recommended these changes assumed troops would invest their TSP contributions in the Lifecycle L2050 fund with a constant 7.3% return. However, First Command noted that assumption doesn’t match current participants’ behavior, as 43% of account balances were invested in the G Fund (government securities) and F Fund (fixed income securities) as of 2012.
At 12 years of service, active duty servicemembers will be eligible for a continuation pay bonus if they commit to another four years. They can receive between 2.5 and 15.5 months of basic pay, as determined by their service department, either in a lump sum or spread over four payments. If they retire before the four years are up, they’ll have to pay back a portion of the bonus.
If they take the full four years of continuation pay, that puts them within four years of retirement, when servicemembers may decide to take either 25% or 50% of their pension as a lump sum with a corresponding reduction in their pension until they reach full retirement age. At that point, the pension will increase to its original value with cost of living increases.
According to the Congressional Research Service, the average enlisted servicemember is only 43 when he or she retires, and the average officer is just 47. That leaves a very long retirement to fund, and although most begin second careers, “that is not the case for all,” First Command wrote. If the enlisted servicemember takes the 50% lump sum, the paper theorized, and loses it for any number of reasons, he “could find himself with $1,180 in monthly income ($1,180 less than full retired pay), until age 67, which could be nearly 30 years away.” The officer could lose $2,239 per month.
Enlisted, Officer Scenarios
First Command tried to put some numbers to what all these changes mean for troops’ retirement savings. The paper is based on two hypothetical servicemembers: one who enlisted as an E-1 (an enlisted servicemember at the first pay grade) and serves 20 years before retiring as an E-7, and an officer who starts as an O-1 and retires after 20 years as an O-5.
Using the 2016 military pay chart and assuming pay raises of 1.5% a year, First Command found the enlisted servicemember could expect retirement pay of $2,951 per month under the current system, compared with $2,361 under the new system. The officer would have an even bigger decline, from $5,599 to $4,479 a month.
It is possible for troops to fill those gaps and even come out a little ahead with the new system, according to the paper. If both servicemembers contribute at least 5% of their basic pay to earn the full match, and invest in TSP’s L2050 fund with the higher rate of return, and invest 15.5 months of continuation pay in an investment with the same return, the enlisted servicemember can increase his or her monthly payout to $3,013, for a 2.1% gain. The officer’s payout increases by 1.4%.
By including the servicemembers’ TSP contributions and projected investment gains, the enlistee and officer can increase their retirement payouts by 12.5% and 11.8%, respectively.
Without that “preferred behavior,” though, servicemembers can do much worse, First Command found. If they don’t save enough to get the matching contribution, the enlisted servicemember suffers a shortfall of 5.4%, and the officer loses 6.3%. Without the matching contribution and with only 2.5 months of continuation pay invested, both the officer and the enlisted servicemember have a shortfall of 16%.
If they don’t take any continuation pay, the shortfall drops to 18% for both servicemembers. In that worst-case scenario, the enlisted service member receives only $2,422 per month for retirement, and the officer receives $4,595.
“These examples clearly demonstrate the importance of service member contributions in the new retirement system,” according to the paper. “Earning matching funds and saving continuation pay is critical to success. If a servicemember chooses not to participate in the TSP, or cannot afford to participate, they forgo matching contributions made by the DoD. Without those matching contributions, they accept a less valuable retirement plan.”
The above calculations assume investments in TSP are allocated entirely to the Lifecycle 2050 fund, but a 2013 survey of TSP allocations by Aon Hewitt found that as of 2012, the largest portion of military participants’ portfolios were allocated to government securities or fixed income. Thirty-six percent was allocated to stocks, and 20% to the L2040 fund. First Command found that allocation would result in a 5.6% rate of return. Recalculating the above scenarios with the more conservative return, the best-case scenario for the enlisted servicemember is a 0.8% loss, and a 1.4% loss for the officer.
Including personal contributions increases those payouts by 8% for the enlisted servicemember and 7.4% for the officer, according to the paper. “In short, any behavior by the service member that is less than ideal will result in reduced retired pay in the long run.”
“Military families, like their civilian counterparts, are being asked more and more to accept responsibility for their retirement outcomes,” according to the paper. “Certainly lump sum bonuses and 401(k)-style contributions seem very appealing at first glance. But do these service members understand what they may be giving up? Do they understand that the up-front dollars may not be large enough to justify a smaller lifetime pension? And if not, who will help them understand?”
Part of the implementation plan for the NDAA includes a financial literacy program, according to the paper. However, First Command said education alone is not enough, as it’s too general to apply to a servicemember’s situation. Working with an advisor has a significant impact on retirement confidence. First Command’s year-end 2015 study found 59% of servicemembers who have an advisor reported high levels of retirement confidence, compared with 31% who are investing on their own.
“Those with a financial advisor also report greater financial security and greater confidence that their financial situation will improve in the next year,” according to the paper. “The value of working with a professional financial coach is clear.”
--- Check out Advisors Focus on Financial Planning Needs of U.S. Military Members on ThinkAdvisor.