Journal of Financial Planning: June 2017
Francis E. Laatsch, Ph.D., is a retired professor of finance at The University of Southern Mississippi. He received a doctorate degree in finance from the University of Oklahoma.
If you are a financial planner who serves U.S. military service members, many of those clients will need to choose between the military’s current retirement system and the new “Blended Retirement System,” which goes into effect January 1, 2018.
The U.S. military currently has 20-year cliff vesting in its defined benefit (DB) plan. According to the Joint Chiefs of Staff, only about 19 percent (and only 15 percent in the National Guard and Reserve) of those who join the military qualify for retirement benefits. However, this is about to change. As required by the fiscal year 2016 National Defense Authorization Act, a modernized retirement system will go into effective January 1, 2018.
Active Duty High-3 System
Under the current retirement system, members of the U.S. Army, Navy, Air Force, Marines, and Coast Guard qualify for retirement benefits after 20 years of service. The monthly benefit is calculated as 2.5 percent times the years of service times the average of the member’s highest 36 months of basic pay (hence the “high 3” referring to the highest three years of basic pay). A member retiring with 20 years of service would therefore receive 50 percent (2.5 x 20) of basic pay as the defined benefit. No benefit is paid to those members who serve fewer than 20 years of service.
Reserve Component High-3 System
Reservists and National Guard members qualify with the rough equivalent of 20 years of service, but do not actually receive a retirement benefit until age 60. Reserve Component (RC) service members earn points for drill periods or periods of active duty.
Most weekend drill periods are worth four points, and most reservists serve 12 weekends a year in addition to 15 days of active duty for training. Such a “typical” reserve schedule would generate 78 points (48 drill weekend points, plus 15 points for days of active duty for training, plus 15 points for being in the Reserve Component).
A “good” year is defined as earning 50 or more retirement points. To qualify for a retirement benefit, a RC member needs 20 good (or “creditable”) years. Benefits are based on the same 2.5 percent multiplier, but years of service for a reservist are defined as retirement points earned divided by 360. For example, suppose a RC member of 46 years of age has 20 years of creditable service and 2,600 retirement points. Dividing 2,600 by 360 yields 7.22 “years.” The member would qualify for 2.5 percent times 7.22 equaling 18.06 percent of his or her basic pay.
Active Duty Blended Retirement System
Beginning January 1, 2018, individuals joining the U.S. Army, Navy, Air Force, Marines, and Coast Guard, along with those joining the Public Health Service Commissioned Corps and the National Oceanic and Atmospheric Administration Commissioned Officer Corps will be covered by the new Blended Retirement System (BRS). Members with 12 years of service or more will be grandfathered into the existing high-3 system. Members with fewer than 12 years of service (4,320 points for reservists) will need to choose between the BRS and high-3 approaches.
The BRS is part defined benefit and part defined contribution. The defined benefit part is reduced, relative to high-3, using a multiplier of 2 percent rather than 2.5 percent. Years of service are calculated in the same manner as high-3. The defined benefit part is paid only after 20 or more years of service. Thus, a 20-year service retiree would receive 40 percent of the average of his or her highest 36 months of basic pay, not the 50 percent as in the high-3 plan.
The defined contribution part of the plan uses the government’s Thrift Savings Plan (TSP). Members joining after January 1, 2018 will be automatically entered into TSP at the 3 percent individual contribution level. Members can change this contribution level by making a request to do so. The BRS will be like a 401(k) with an “opt-out” provision, rather than an “opt-in” choice.
After 60 days of active service, members will receive an automatic 1 percent contribution from the government. After two full years of service, members will be eligible for government-matching contributions up to 5 percent. All individual contributions are fully and immediately vested. Government contributions are vested at the beginning of three years of service. Government contributions end at retirement, separation, or 26 years of service, whichever comes first.
Under the BRS, if a member leaves military service prior to 20 years of service, that member will keep his or her vested contributions. This should increase the percentage of military members who receive at least some retirement benefit from the current 19 percent to more than 85 percent, according to the Joint Chiefs of Staff.
Other features of the BRS include continuation pay and lump-sum payment of retirement benefits. Continuation pay will be provided to service members who reach “mid-career” status (eight to 12 years of active duty) and who commit to an additional three or more years of service. The amount of continuation pay is a minimum of 2.5 months up to a maximum of 13 months of basic pay.
A lump-sum payment option will be available for the defined benefit portion of the BRS. At retirement, a service member may choose 50 percent or 25 percent of the discounted defined benefit portion payable until the member reaches normal retirement age under Social Security, usually age 67. Monthly benefits until age 67 will be proportionately reduced. At age 67, the retiree will begin to receive the full, original defined benefit portion. The discount rate is to be set by the Secretary of Defense.
RC Blended Retirement System
Under the new Blended Retirement System, years of service for RC members is calculated as it is in the current system. As is true for active duty members, the defined benefit multiplier is reduced to 2 percent from the high-3 multiplier of 2.5 percent. Reservists must continue to wait until age 60 to apply for and receive defined benefit payments. Automatic, matching, and individual contributions into TSP are the same as for active duty under the new BRS. Reservists who leave service prior to reaching 20 creditable years do retain those defined contribution amounts they are vested in. Retirees, of course, also keep the defined contribution benefits they are vested in.
The BRS for reservists differs from that of active duty members in that continuation pay is based on a minimum of 0.5 months to six months of basic pay (basic pay determined as if serving on active duty) in exchange for a three-year-or-more service commitment. The lump-sum option for the defined benefit portion is not available for retired reservists until age 60, and it is either 25 percent or 50 percent of the discounted value of benefits payable from age 60 to Social Security normal retirement age. Matching contributions for reservists start after two creditable years.
The “Opt In” Decision
Active duty service members with fewer than 12 years of service as of December 31, 2017 will have the option of choosing the BRS or staying in the high-3 retirement system. Reserve component members will have the option to join the BRS if they have fewer than 4,320 points as of December 31, 2017. The decision, once made, is irrevocable. The decision must be made during calendar year 2018. Members reentering service after 2018 will have a limited time to choose the BRS or stay with the high-3 system.
Scenarios
Let’s look at three issues affecting the decision to opt-in to the BRS:
What’s the rate of return on TSP? What interest rate would one need to earn on their TSP investments to equal the defined benefit reduction in the BRS versus the high-3, assuming 20 years of service?
Consider an active duty E4 aged 30 with 10 years of service as of December 31, 2017, who is contemplating opting in to the BRS. If he does, he will put 5 percent of his basic pay into the TSP in order to receive the maximum matching contribution from the government. He will retire in 10 years as an E8. His monthly pay in this example is taken from the 2017 military pay scale and not adjusted for inflation.
His high-3 retirement benefit would be 20 times 2.5 percent times $4,856, which equals $2,428 per month. His defined benefit under the BRS would be $1,942 per month, $486 per month less than the high-3 benefit. If we assume this service member has a life expectancy of 90, he has 50 more years of retired life. Using a discount rate of 6 percent, the present value of 50 years of the difference in monthly benefits is approximately $92,248. The question is: will the TSP part of the retirement plan grow to equal this figure?
Using Excel, I ran a simulation calculating the deposits into TSP using a 10 percent contribution rate (individual plus matching) for each month remaining in active service. The simulation assumed that the soldier will receive 2.5 months of basic pay as continuation pay at the end of 12 years of service and that he deposits the full amount of continuation pay into the TSP. The simulation then sought the rate of return that would make the future value of these deposits equal $92,248. The answer was a monthly rate of 0.8292 percent, which is an annual rate (ignoring compounding) of about 9.95 percent.
How many years must the TSP account grow? A second issue affecting this choice is: how many years must one’s TSP investments grow, at a presumed rate of return, to equal the defined benefit reduction if one opts in to the BRS?
As of December 2016, the TSP lifecycle fund, L 2050, has averaged about 3.95 percent annual return. Assuming, then, a monthly return on the L 2050 of 0.329 percent and further assuming the hypothetical service member is fully invested in the L 2050 fund, how long would it take for the DC portion of the BRS to equal or exceed the reduction in defined benefit from choosing to opt in?
The simulation assumed the service member had only recently entered active duty. Using the same assumptions as above, the BRS would provide an equivalent future value after 20 years of service if the soldier had five years and seven months of service or less. That is, the TSP portion of the BRS needed 14 years and five months of compounding (at the assumed rate of 3.95 percent, monthly compounding) to provide an equivalent benefit to the high-3 system
What’s the impact of continuation pay? A third issue to consider is: how large must the continuation pay bonus be to make the BRS a more attractive choice, given 20 years of service and an assumed rate of return on TSP?
In the previous examples, the service member would receive continuation pay under the BRS at 12 years of service. The simulations assumed the continuation pay would be the minimum for active duty members (2.5 months of basic pay), but what if the continuation pay is more?
Return to the first example where the service member has 10 years of service and is deciding whether to opt in to the BRS. Assume an annual rate of return on the L 2050 fund of 3.95 percent and that the soldier is 100 percent invested in L 2050. To make the future value of the BRS equal to the high-3 value at year 20, the Excel solution indicated that continuation pay needed to be 8.34 times basic pay.
In Closing
During 2018, many service members will need to choose between the current high-3 retirement system and the new Blended Retirement System. Although the three examples shown here may make the decision look simple, consider the simplifying assumptions made to make the problem tractable. Now take away those assumptions and instead of solving for one variable at a time, solve for all elements that impact this choice simultaneously. That is why clients that face this decision will be seeking guidance from their financial planners.