Changing military pensions

I’ve been discussing, researching, and thinking about military pensions ever since the Defense Business Board released their draft study on retirement.  Although the data used for the study was reasonable, their conclusions were provocative and the release of the study was a public-relations disaster. However the DBB did an excellent job of discussing evidence that the current retirement system is financially troubled and not very fair to servicemembers who separate before 20 years. They released a trial balloon that was immediately shot down by angry veterans (and their elected representatives), but now DoD can quietly begin to suggest changes that seem reasonable by comparison.

I’m no expert, but I can recognize the process. It’s beginning to look as though pension evolution is inevitable.

I usually blog to explain a concept or deliver the news, but this post is mostly conjecture based on a few links. It comes from my conversations with other military veterans, Department of Defense Congressional testimony, a U.S. Naval Institute PROCEEDINGS article, and over 30 years of watching the pendulum swing.

Here’s the summary of my personal opinions:

  • The military will be shifting to a defined contribution pension system by 2020.
  • Current retirees will continue under the existing system.
  • Current servicemembers can switch to the new system.
  • New servicemembers will be enrolled in the new system.

First, here’s some background: pensions have been making news at corporations and all levels of governments. However the accounting changes that put a spotlight on these problems haven’t been considered so newsworthy. Until the 1990s there was wide discretion to account for pension funding, and many corporations abused the privilege. Some companies made ridiculous assumptions on stock-market returns while state & local governments assumed short retiree longevity, low service multiples, and cheap healthcare. Even worse, many organizations “borrowed” from their pension plans by underfunding them (and presumably expecting to catch up later).

The accounting tightened in 1997 when the Governmental Accounting Standards Board required governments to report their pension liabilities.  A few years later governments were required to report their retiree health care liabilities, and suddenly many discovered that they weren’t adequately funding their obligations. The GASB is still “fixing” the system, and as the accounting standards get tighter the issues will only be more visible.

Let me emphasize that last paragraph: the funding deficiencies of pensions and healthcare have always been there, even before 1997. The accounting changes are just bringing more transparency to a complex problem. Now governments have to clearly state their liabilities, and then presumably figure out how to fund them. It’s the first time since WWII that some of these governments have had to realistically assess their expenses.

The GASB has been accused of instigating governments to “solve” their funding problems by ditching defined-benefit pension plans for defined-contribution plans. However the new accounting rules have shown that the defined-benefit plans weren’t even funded enough to pay their liabilities in the first place. Shifting to a defined-contribution plan still requires governments to show that their pension liabilities are funded, and not just by taking them off their balance sheets. Governments can no longer assume that optimistically high stock-market returns will enrich their employees’ retirement accounts. They also have to realistically account for longevity, employee service years, and healthcare expenses.

Now, nearly 15 years later, the Department of Defense is grappling with the same issues. For current retirees, the system is stable. In October, the Principal Deputy Undersecretary of Defense for personnel and readiness testified to Congress “the department acknowledges the military retirement system appears expensive [but] it is neither unaffordable nor spiraling out of control as some would contend.”

However the military’s demographic trends are working against the current pension system. The DoD’s requirement for a 20-year military pension was set in 1949. Since then, the life expectancy for men has risen by 10-12 years.  What that means to DoD is a 20-year pension now has to pay out more than 40% longer for most retirees, and in some cases more than 60% longer. Early retirees at are familiar with this problem: most financial studies expect a retirement of up to 30 years, while today’s early retirees are trying to push the envelope to longer than 50 years.

“Luckily” for DoD, the percentage of military retirees isn’t rising. Only 17% of servicemembers actually vest in a 20-year retirement, and the burden of service is carried unevenly across those two decades. Today, some four-year veterans leave the service with more combat than some 20-year retirees who were in similar duties. The current pay system offers cash and tax benefits for combat duty, but I think both types of veterans would agree that they’re not adequately compensated for the risk.

DoD’s bigger problem is their legal mandate to fund military pensions by investing in U.S. government securities.  These securities are used by government agencies to earn interest for their pension funds, but they’re not much better than Treasuries and they’re currently earning record-low returns. DoD has spent a lot of money growing the military over the last decade, and now the accounting standards require DoD to realistically project their growing pension liability while earning very little to pay for it. They have to sequester money now to pay pensions later– even if today’s troops decide not to actually hang around for them. Legally, DoD can’t change their benefits & pension projections until after they actually draw down the troop numbers.

DoD has estimated that they have to save at least 27% of a servicemember’s pay in the current defined-benefits pension system to fund future pensions. (Pension accountants consider 10% to be more reasonable for corporations.) One problem is that there are more troops who might stick around long enough for that pension. Another problem is DoD’s current low yield on their government securities.

You can see where this is going. DoD has to reduce the number of troops who’ll qualify for a pension, and they have to boost the return on their pension accounts. The drawdown is already underway, and the defined-benefit pension system is under scrutiny.

At this point a certain minority of readers are harrumphing and grumbling about commitments and promises and honoring our sacrifices. Yes, there were promises. Yes, we signed up for a commitment and we expected our covenant leadership to honor their side of the commitment. However, a new system would only affect the new recruits. Retirees would be grandfathered, and servicemembers would have the opportunity to go either way. In the government’s view, the commitment has been honored. In my opinion, a reasonable promise backed by actual funding is better than a generous promise which is fiscally empty. Today’s commitment will be empty tomorrow. Get over it. We can help shape the new system or we can be left behind to waste our time defending the old one.

One way for the DoD pension funds to earn a higher return would be to get Congressional approval to invest them in other securities, including the stock market. Unfortunately this sounds a lot like the early 2000s campaign to privatize Social Security, and I’m not sure that DoD would be able to sell this proposal– no matter how strong the stock market economy seems to be.

Another way for military pension funds to earn a higher return would be to get Congressional approval to give them to the servicemembers to invest in other securities (including the stock market). The proposal wouldn’t be worded this way, of course– it would be explained as “giving the military more control over their money” and “teaching the troops to save for retirement”. The most convenient way to do this would be plagiarizing the government’s existing bureaucracy: the Federal Employee Retirement System and the Thrift Savings Plan.

FERS participants make an automatic TSP contribution of at least three percent of gross pay. These funds are matched dollar-for-dollar by employers like the U.S. Postal Service or the Justice Department. Higher employee voluntary contributions up to five percent of gross pay are matched at a rate of 50 percent; above that not at all. Military servicemembers only have to make voluntary contributions to the TSP, and DoD does not currently contribute any matching funds.

Here’s one way a military defined-contribution pension would work. As soon as recruits get their first paychecks, they’d be enrolled in the TSP and a default contribution would be deducted from their pay. It would be some minimum (3%?) matched by their service (up to 5%?). The entire amount would be invested in the TSP’s “L” fund with the longest date (at least 20 years). If recruits wanted to change the amount or the asset allocation then they would have to log on to their TSP accounts and request the changes on their own. If they wanted to boost their contributions or invest more aggressively, of course, they’d be able to do that too.

Once they reached retirement eligibility (20 years for almost everyone) they’d have a choice. They could cash in their entire TSP account to buy an inflation-adjusted single-premium immediate annuity. (That’s the investment equivalent of a military pension.) The annuity would be backed by the federal government but would actually be funded by one of the insurance companies currently used by the TSP. Or they could leave their funds in the TSP to grow until they’re ready to start drawing that annuity (which would probably be larger by then). Or they could roll their TSP account into an IRA– that investment would have higher expenses but would be totally under the control of the servicemember for other early-withdrawal options. Or the servicmember could completely cash out their TSP, including paying taxes and penalties. That sounds like a dumb idea, but it’s no dumber than the current retirement system’s REDUX/Career Status Bonus decision that gives up decades of pension benefits.

Although this new plan protects the minimum benefits of today’s pensions, it offers many more “force shaping” opportunities. For example, during a drawdown the services could offer to deposit an additional $100K in the TSP accounts of those who agree to separate voluntarily. Veterans wouldn’t be able to tap into their TSP funds without making some sort of rollover under the IRS’ existing IRA rules, but they’d be getting a tax-deferred incentive to support the reduction in end strength. If one specialty was overcrowded and another one was under strength, DoD could pay volunteers $50K in their TSP accounts to re-train for the new skill.

The services could also offer incentives to stay on active duty. Re-enlistment bonuses could be deposited into the TSP (or a smaller amount could be taken in cash). The TSP matching contributions could double for those who stay beyond 20 years, and even start rising after 10 or 12 years. Reservists and Guard members could earn a higher TSP match for volunteering for “hot fill” orders. Additional bonuses or matches could be contributed for special technical skills or leadership billets or specific ranks or for combat duty.

But there you go: the military’s “new” defined-contribution retirement system could look a lot like the existing FERS and TSP structures, with a few changes to make the pension payout equivalent to today’s retirement benefits. I’m not sure that 3% is the correct default contribution, and I’m not sure what the matching would be, but DoD would be able to fund a more realistic pension plan instead of racing head-on into a bankruptcy brick wall. Instead of having to set aside 27% (or more) for every servicemember’s possible pension, they’d be able to allocate DoD contribution funds at an acceptable accounting standard of 8-10%. Veteran’s advocacy groups and thousands of financial advisers would keep the system highly visible and transparent. More importantly, servicemembers would vote with their feet if the system didn’t adequately compensate them for their sacrifice.

We thought military pay was complicated now. Wait until Reservists need a financial calculator to decide whether to volunteer for overseas orders. Wait until active-duty mid-grade enlisted have to try to decide between a smaller re-enlistment bonus or a cash incentive to convert to another specialty. Wait until a retiree has to try to decide whether to buy their annuity now (at what seems to be a good interest rate) or whether to wait a few years until its balance grows larger (but when interest rates might be lower).

Today’s servicemembers and retirees learned how to adapt from a “final pay” pension system to “high three” and REDUX. We learned how to handle specialty pays and bonus contracts. We have far more support from financial advisers and accountants and veteran’s groups. I think tomorrow’s servicemembers and retirees will learn to adapt to a new retirement system. Most importantly, DoD will actually be able to start keeping their pension promises.

Related articles:
Military retirement: the latest overhaul
The military drawdown and benefits cuts

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About the Author Doug Nordman

I retired in 2002 after 20 years in the Navy's submarine force. I wrote "The Military Guide to Financial Independence and Retirement" to share the stories of over 50 other financially independent servicemembers and veterans.

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