In today’s modern workforce pensions are out and 401Ks are in. Most people do not have an employer who offers them a pension. Oh how the world has changed from what it used to be.
Those employers who do still offer pensions to their employees are often no longer offering the benefit at same level at they once were. If at all. If you are a federal employee of the U.S. government, you are lucky enough to be offered a pension as part of your benefits package. As with the rest of the private sector, the “deal” has changed from what it once was. Having said that, it is still a very good deal.
Pensions Can Equal Stability
For those that retire with a pension, it can provide a tremendous amount of stability in your retirement years. The combination of having a pension from an employer, social security benefits, and retirement savings can be a home run.
In today’s post I will be providing an overview of how the federal pension works for many federal employees. Oh, how I wish I could sum up all of the pension information in one 800 word post.
So even with a slightly longer post than normal, I will only be able to touch upon some of the information out there. Hitting the wave tops so to speak.
The Higher The Salary, The Larger The Benefit
The average salary for all federal employees nationwide reported in 2016 was $75,578. Washington, DC, area feds topped the list at $112,601 with South Dakota at the bottom with an average of only $65,782. The difference in salary is impacted by the type of work being performed and the locality pay applied to the base pay of each employee.
Federal employees’ total salary is made up of two portions. There is a base salary plus a locality pay that when combined create the total salary for a federal employee. For example in Washington, DC, Baltimore, and Virginia the locality pay is 27.10% of one’s base salary.
Where You Live Matters
There are some areas of the country where the locality pay is only 15%. So where you live matters when it comes to being a federal employee. This also matters when it comes to pensions because the higher your salary, the larger your pension (also called annuity) will be in retirement.
Federal Employee Retirement Pension
Note: Today I am only going to discuss pensions under the FERS (Federal Employee Retirement System).
Explaining the federal retirement plan is complicated. In fact, it’s so complicated that the government holds 2-day classes in order to explain it all and help employees plan for their retirement.
In general, it’s fair to describe the system as being tiered. Meaning, the longer you are in, the higher your payout will be. If you are a federal employee for 5 years, you are entitled to a pension when you meet the required age. That’s on the low side. The next tier is 10 years of service, then 20, then 30 -each year adding to your benefit. Those tier milestones provide you slightly more options and benefits.
On the higher side of the benefit is someone who has served at least 30 years and walks out the door at their minimum retirement age (MRA). MRA for anyone born after 1969 is age 57.
They would be leaving with an immediate pension, meaning it starts right away, and would be allowed to continue to buy health insurance at full time employee premium rates (HUGE BENEFIT) until age 65. They would also qualify for something called an “annuity supplement,” which mimics your estimated social security benefits that would start at age 62.
Thank You For Your Service, But Please Retire
This annuity supplement gives incentives for feds to leave service prior to age 62. This benefit goes away starting at age 62. For many feds this supplement could be upwards of an extra $15,000 a year on top of your pension until you hit age 62.
As I mentioned, I was only speaking towards something called FERS. But there are also all sorts of other programs, exceptions, and caveats with pension benefits for federal employees working for specific agencies and career fields. Federal employees who have jobs like air traffic controllers, and with the FBI and Department of Corrections all have unique rules. There is also a legacy system called CSRS, but that is being phased out. They are all similar, but not exactly the same. The type of benefits in terms of the required years of service and how the benefit is calculated or when it will be paid out is different.
Also, I’m also not speaking towards the military pension plan which is an entirely different set of rules for those active duty military federal employees.
If You Are Still Reading You Should Get Some Sort Of Participation Award
There are also very specific rules for gaining access to health insurance after you retire, which is one of the biggest benefits of all.
How Does FERS Pension Get Calculated?
Federal employees’ pensions under FERS are calculated based on your length of service and a person’s “high-3” average salary. The high-3 is the average of your three highest years of salary. If you pay close attention to federal legislation, Congress oftentimes discusses possible changes this calculation to a “high-5” in order to reduce the overall payout. If changed, this would most likely be phased in over time. The formula for actual payout is below.
Under age 62 at separation OR age 62 and older with less than 20 years of service your formula = 1% of your high-3 average salary for each year of service.
Age 62 or older at separation with 20 years or more years of service = 1.1% of your high-3 average salary for each year of service.
As you can already tell, it starts to get complicated real quick. Don’t worry, it gets worse!
It is also worth noting that federal civilian service can also include active duty military time if a federal civilian buys back their years of service. For example, if you’ve served 10 years in the military and take a job as a civilian worker, you have the option of “buying back” your years of service, which in this case would get you 10 years closer to that 20 or 30 year mark – whatever you are shooting for. With over 25% of the federal workforce claiming a veteran’s preference this can be a big boost to your accumulation of years of service. All that is required is to make a deposit into the pension plan for the years you were active duty.
It is a more complex calculation than I care to discuss here but for me, with 4 years of active duty time as an officer I was only required to deposit $3,700 in order to buy back my military service. This bought me 4 years of seniority and time in service credit towards my pension. This was well worth it to me.
How and when you leave federal service really matters
In order to qualify for an immediate annuity you have to meet the below requirements.
“If you retire at the MRA with at least 10, but less than 30 years of service, your benefit will be reduced by 5 percent a year for each year you are under 62. Unless you have 20 years of service and your benefit starts when you reach age 60 or later.”
Age Years of Service
What I will show you in an example is how leaving at your MRA with 30 years of service is a huge difference compared to leaving two years earlier with 28 years of service.
What is your pension going to be?
In order to answer that question you need to take a guess at what your salary might be over the years. In the below example, I’m showing a 37 year old Washington, DC, area fed. Let’s call him Walter. Walter has a current salary of $112,600 (the average). From age 37 to 59 Walter receives a 1% pay raise. This is probably low. There have been times when feds haven’t gotten any pay raise from the President or Congress. But even in those years feds would often receive raises from within their command or agency. For the purposes of this exercise I’m going to keep it at a 1% growth over the years. The below then also shows the average of the last three years.
The Growth Of Income Over Time
In the year 2039, at age 59 Walter leaves the workforce with a high-3 average of $144,367. By using the 1% of high-3 x years of service formula we get to the below. And because Walter is below the age of 62 he also qualifies for the social security supplement. In the below graphic I came up with the $16,452 supplement number by using a calculator I have access to on a human resources site.
As stated previously, in addition to the money, Walter would also be able to purchase health insurance at the same premium as if he was working as an employee.
Those Two Years Make A Difference
But notice that age 59 is two years over Walter’s MRA. If Walter decides to leave federal service at age 57 and take an immediate pension his payment will be reduced. Not only will he not receive the social security supplement but his annuity payment will be reduced by 15%. That is 5% penalty for each year from age 57 to age 60 because of the below rule.
“If you retire at the MRA with at least 10, but less than 30 years of service, your benefit will be reduced by 5 percent a year for each year you are under 62, unless you have 20 years of service and your benefit starts when you reach age 60 or later.”
The difference in total amount $56,874 – $33,626=$17,248 from age 59 to age 62.
Once the social security supplement goes away the difference goes down to $6,740. Not quite as bad but still less.
How Much Is Two Years Worth To You?
Why would someone not just stay put for two more years to retire at age 59 instead of 57? That’s a whole post by itself probably. How much is two years worth to you? I think it all comes down to the total picture of your financial situation. How much do you have saved and how badly do you need those extra guaranteed funds every month in retirement?
If someone were to retire at age 57, why would someone elect to take the 15% reduction and not just wait for 3 years to start their pension? Besides just needing or wanting the money, the answer is health insurance. Only with an annuity turned on can you purchase your health insurance. If you postpone the start date of your pension you will have to find health insurance on the exchanges.
Your other options for health insurance are likely more expensive. Judging the future of the health insurance landscape is a fool’s game at this point. Taking the reduction might prove less expensive in the short run. In the long run maybe not. Having access to affordable health insurance from age 57 to 65 solves a lot of problems. It solves a lot of the “slightly early” retirement planning concerns. The other option of course is to retire and wait to turn your pension on. This would avoid the 15% per year reduction. Your savings would then be your sole source of income to cover your expenses to include a health premium purchased on the exchanges. Or whatever they are going to call it in the future.
And you made it. If you are still reading, thank you.
In a future post I will show some examples of how having a pension can impact your retirement planning, withdraw rate, and show an example of why a federal family might not need to save for retirement at all.