Beware Of Huge Flaws In The Military Blended Retirement System
History still repeats itself, but we’re still not learning from it. Now we have the Military Blended Retirement System on the horizon…
The existing military retirement system has been in place since the end of the last millennium when REDUX ended and the High Three pension was signed into law. The REDUX system was modified to offer a lump-sum Career Status Bonus of $30K in exchange for the reduced pension.
Only a few people remember why this 1999 change was implemented: REDUX was one of the factors killing retention. Back then the Cold War had ended and the wars in Afghanistan and Iraq were “over”.
The World Wide Web had been added to the Internet, and the economy was booming. The peace dividend was finally paying off and the federal budget was actually running a surplus! The military had just finished the biggest drawdown since WWII (over 25% of the force).
In the mid-1990s thousands of servicemembers were being paid to leave active duty, and not enough people were willing to stick around past 20.
Retention was so dire that the chiefs of all four services jointly testified to Congress: the drawdown was over and we’d cut too deep.
The marginal performers and the short-timers were long gone but now the lifers were leaving as soon as they finished their service obligations. The Internet was making everyone else rich!
Nobody wanted to settle for a measly 40% pension at 20 years (let alone stick around for a 75% pension at 30) when they could jump into a New Economy career.
Today those Baby Boomer and Generation X attitudes seems pretty silly to Millennials. But when you’re living through history and you don’t know how it turns out, its movies can have a surprise ending.
A Video Explanation
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REDUX and the Career Status Bonus
The Career Status Bonus seemed like a great deal when it started in 1999. After 15 years of service, you could get $30K (before taxes), just for sticking around to 20!
Servicemembers had lots of great plans: paying off debt, or starting a business, or making a down payment on a “forever” home. A few were even buying hot tech stocks on sale and planning to grow their investments faster than the parts of the pension & COLA they’d given up. I’m pretty sure that a few other plans turned into new pickup trucks too.
Nearly 17 years later, the CSB is still $30K. Meanwhile, inflation has cut the CSB’s buying power down to $20,988 (before taxes) and the original pension-cutting provisions are still in effect.
People realize that a 40% pension at 20 years is a lot smaller than it sounds, and years of reduced COLAs took a huge toll on its spending power. The CSB calculators make optimistic assumptions about future investment returns— just over 7% APY before taxes– which have proven to be difficult for typical investors to achieve.
Servicemembers (and their families) finally did the math and recognized that giving up years of future payments for a lump sum could be a bad deal. It all depends on how much that lump sum could earn over the years, and those future payments depend on the assumed average returns of the lump sum. In technical terms, the net present value of a lump sum payment depends on its estimated future value and the discount rate.
Now a new generation is being asked to make the same decision.
Lump-sum math and the discount rate
Once again, the amount of a lump-sum payment depends on how big everyone expects it to grow in the future.
For example, a pension of just $100/day ($3000/month) could be paid out for a military retiree’s remaining life expectancy of 35 years. That’s $1.26M in today’s dollars because the pension is adjusted for inflation.
However, nobody knows how long an individual retiree will live. A lot more Americans are surviving to their older years (lower mortality) and longevity has been rising slowly during the last century. A handful of today’s military retirees are over 100 years old, and that number is bigger today than it was a decade ago.
Nobody truly knows how much DoD has to set aside today to pay that pension. If inflation is low and investment returns are high then it’s easy to fund a long retirement with a relatively small amount of money. That works out to a high discount rate because a small amount of money grows to a much larger final value. However, if inflation spikes or future investment returns are lower then we’re going to need a lot more to pay for retirement. That works out to a small discount rate because a large sum of money grows very slowly to a slightly larger final value.
Over the last two decades, American businesses and state/municipal governments have learned some harsh lessons about pension accounting. Accountants and actuaries have refined their statistical models of retirement, and pension accounting is much tighter than its previous 75 years.
Many municipal pension funds (and some airline pensions) have assumed that inflation will stay low (for decades) and investment returns will be high (forever). They decided to use high discount rates and only set aside a small amount in the pension fund.
When their employees retired and the payments started rolling out, it turned out that those estimates were wildly optimistic and the pensions were horribly underfunded. Cities and companies have frozen retirement plans, raising contributions to their pension funds, and even declaring bankruptcy– all because accountants finally have decent tools to analyze their predictions.
When everyone applied these new tools to their pension funds, they finally had to face up to realistic financial obligations and use much lower discount rates.
Ironically, DoD pension funds are in great shape today because Congress forced similar accounting changes on the military over 30 years ago. DoD has to set aside funding every year for expected pension expenses, and those funds are invested in special-purpose Treasury securities which pay a very low (but very safe) rate of return.
In today’s pension math, DoD has to use a very low discount rate and has to set aside a large sum of money to pay for a military retirement.
DoD’s lump-sum pension payouts and their discount rate
One of the features of the new blended military retirement system is an optional lump-sum payment. Retirees could give up some of their pension (until age 67) in exchange for an immediate lump-sum payment at retirement. The specific amounts of this lump sum would depend on the retiree’s age and the size of their pension, but once again the discount rate is the critical factor.
Nobody knows exactly how this lump sum will be calculated. The new retirement law allows a lump sum to be paid but it doesn’t specify the calculation or the amount. DoD will be able to set their discount rates by their own policies under the Congressional legislation, and the lump-sum choice is up to the retiree.
However, the lump sum is already looking like a bad deal. The American Academy of Actuaries is concerned about DoD’s potential accounting for the lump-sum payouts. The Academy’s decades of experience has shown that an appropriate discount rate for today’s economic forecasts is roughly 2%-4%. (That’s a low discount rate.) However, when DoD was analyzing the value of a military pension, they were using a discount rate of 8%-12%. That’s a high discount rate for any corporation, and for DoD it’s stratospheric.
This means that once again retirees will be tempted by what appears to be a huge sum of money, but which will only eviscerate their pensions until they reach age 67. We’ll hear stories about paying off student loans, buying a home, or starting a business. Once again, a few will be absolutely positive that they can invest their lump sum in hot stocks or leveraged rental properties and grow it faster than the discount rate.
This looks a lot like REDUX and the CSB all over again… on a new generation of unsuspecting recruits.
Think ahead: ask yourself why DoD would be so nice to you at retirement. If you’re not sticking around for longer or doing a tougher job, then why should they give you a lump sum at all? Now do the math. If those discount rates are still being used against you then you’ll know that DoD has learned to apply the lessons of REDUX and the CSB for their own benefit.
New changes to the new military retirement system
In early 2015 the Military Compensation and Retirement Modernization Commission released the most comprehensive study of the military’s pension system since WWII. They heard the testimony of tens of thousands of servicemembers and families. The commission’s work was closely tracked by dozens of veteran’s organizations, and the government even extended the reporting deadline to allow for additional research and analysis. The MCRMC report was considered so important that the Commander In Chief actually canceled the latest quadrennial review of military compensation so that the Pentagon staff could support the MCRMC’s research.
The legislation for the military’s new blended retirement system was drafted by DoD, approved by Congress, and signed into law. It’s supposed to take effect in January 2018. The Defense Finance and Accounting Service and the Thrift Savings Plan have a lot of computer networks to reprogram by then, and thousands of military pay clerks have to be trained on the new system. Hundreds of thousands of servicemembers (and new recruits) have to be educated on the plan and their options. You’d expect that DoD would be hustling to implement the new pension’s details before the deadline, right?
Not so fast. DoD actually wants Congress to change the new retirement system before it’s even been implemented. They want to cut back on their matching contributions to the servicemembers’ Thrift Savings Plans.
When the MCRMC was taking testimony from the military, the most overwhelming complaint was that the pension only “cliff vests” at 20 years. 83% of today’s servicemembers leave before vesting the military pension, and they get zero pension benefits. Meanwhile, tens of thousands of civilian 401(k) pension plans (and the federal civil service system) include matching of their employee contributions.
The MCRMC listened. The original plan for the new retirement system (the legislation already passed by Congress) starts making matching contributions to TSP accounts at the beginning of the third year of service. Recruits typically obligate for contracts of 4-8 years, so for at least half of their enlistment, they’d receive a match of up to 5% of their pay. At the end of the contract, they’d be able to leave the service and keep that balance. Ideally, they’d be inspired to stay for another obligation, partly because of the TSP matching.
TSP matching begins in the fifth year?!?
DoD has apparently changed their mind. Even though the legislation has already been signed into law, DoD has asked Congress to delay the start of the matching to the beginning of the fifth year of service. In other words, a few military recruits could serve an entire enlistment and never see a single matched dollar in their TSP. Even those who stick around longer would still lose an additional two years of contributions and compounding. Instead of at least giving the 83% a bit more in their TSP, DoD wants to wipe out most of the TSP matching for the first enlistment.
DoD’s theory is that the TSP matching should be a retention incentive for the second service obligation. They seem to think that they’re already getting enough recruits and they don’t want to give anyone more incentive to join. They want to hold back until the second enlistment.
You servicemembers (and veterans) know what’s been done to retention bonuses over the last five years. Instead of giving away thousands of dollars for each new contract, DoD’s new retention incentive would be the TSP match.
A 5% match on an annual contribution of $18K is… $900. Per year. A 5% match on an annual salary is a lot less than a bonus. For an E-3 earning $1963/month that’s about $1178/year. For an O-2 earning $3900/month it’s about $2340/year. Assuming that the servicemember makes the contribution in the first place.
(Thanks to alert reader Charles for noting my conceptual error in calculating the match!)
As always, nobody should sign a military contract just for the money. Everyone should stay on active duty only if they’re feeling challenged and fulfilled and maybe having a little fun.
But it stings a little when DoD decides to cut back on the promised reforms after the law has been enacted. It’s even worse when DoD tries to circumvent the entire MCRMC process (and everyone’s hard work) by quietly sliding their change into a subcommittee request. They’re not only breaking faith with today’s servicemembers and everyone they hope to recruit over the next few years. They’re also subverting the work invested by Congress to fulfill their commitments to their constituents.
Again, this is just a budget proposal. Nobody has changed any laws yet. I have not seen any indication that Congress plans to give in to DoD’s request. But apparently DoD cares just as much for its “valued headcount” as any other large corporate bureaucracy cares for its employees.
I’ll post occasional updates on the implementation of the blended retirement system. I’m also seeking calculators to help analyze which retirement system works out best for today’s servicemembers.
If you entered the military after roughly 2010 then you will probably benefit from switching over to the blended retirement system— especially if you don’t plan to stick around for 20 years and you want to have DoD matching in your TSP account. My daughter and her spouse started active duty in 2014, and I’m advising both of them to switch to the blended retirement system.
While you’re waiting for the 2018 rollout, get ready for TSP matching. This is a great reason to sign up, and if you’re already signed up then now is the time to maximize your contributions. By the time DoD starts offering a match, you’ll already have your finances and your contributions in autopilot. You won’t miss out on a single dollar of the match.