Charting a Course Away from the Pension

By Lieutenant Matthew Klopfer, U.S. Navy

Periods of budgetary constraint have caused sudden changes to military benefits in the past. The Military Retirement Reform Act of 1986, which created the less-expensive and controversial retirement program known as Redux, was precipitated by fiscal shortfalls and a divided Congress. Similarly unpopular changes may become viable in the near future, as the cost of the pension becomes more conspicuous. It is expected to increase over the next ten years by more than $11 billion, or nearly 25 percent. 3

To fund its pension liabilities, the government must maintain investments in treasury securities. Treasury-bond returns are perennially misaligned with the expectations of retirement savers and the desires of the DOD workforce. The current historically low interest rates make this arrangement unattractive for our government, as well.

Several proposals have been advanced to counter the expected difficulty in funding the pension program, including a 30-year vesting requirement. Other ideas postpone payments until the retiree reaches a specified older age. Disagreeable though such modifications may be, their adoption is conceivable, especially if we assume a mindset that holds a pension as a necessary retirement benefit.

But if the DOD takes the initiative and presents policymakers with workable options, budgetary pressures on retirement reforms may be mitigated. By taking this opportunity to shape the future of the system, the DOD will also be reshaping its strategy for human resources.

The Federal Employees Model

A contribution retirement plan would address the ills of the current pension setup. Fortunately, the federal government already has the framework of such a system in place: the Thrift Savings Plan (TSP).

In 1984, the first participants in the Federal Employees Retirement System (FERS) were hired, marking the replacement of the Civil Service Retirement System. In the context of federal compensation, it was a momentous reform. Whereas new employees were presented with a multifaceted program featuring enrollment in the TSP, those hired before 1984 had been promised a pension while generally being ineligible to participate in the Social Security program. In 2001, TSP eligibility was extended to military servicemembers.

The TSP is effectively the federal government’s 401(k), a contribution retirement program. FERS participants make an automatic contribution of at least 3 percent of gross pay. These funds are matched dollar-for-dollar by the employer, such as the U.S. Postal Service or Justice Department. Subsequent voluntary contributions up to 5 percent of gross pay are matched at a rate of 50 percent; above that not at all. However, as servicemembers know well, the DOD does not currently contribute any matching funds to TSP deposits.

Benefits That Encourage Retention

If the pension system were replaced with a contribution system similar to that of FERS, the DOD could address myriad shortcomings in its current human-resources framework. Foremost, the department would improve its standing with those it wished to recruit. The pension can be considered a retention tool, rather than one for recruiting, since it may have little significant effect on entry decisions. 4 For some promising young people, such a unique, outdated, non-transferable retirement scheme could actually be a deterrent to joining.

Without the 20-year vesting requirement, the military could create a more effective workforce, one able to respond to the services’ changing needs and plans on a shorter time scale, especially in conjunction with targeted retention bonuses. Additionally, a contribution system would create a path toward integrating the compensation plans of the military forces’ active and reserve components. The concept of an operational reserve would become more of an achievable reality. 5

Currently, upon a member’s separation, the DOD loses the value of untold expertise that is unlikely ever to be regained. A contribution plan could diminish the distinction between active and reserve, making a transition back to active duty a palatable decision and keeping good performers in the reserve ranks. Also promising is the prospect of readmitting separated civilians, without the complication and disincentive of 20-year vesting. No other federal organization has the ability to unlock similar advantages under a contribution system.

A system based on TSP stands in contrast to proposals for creating an earlier vesting period, but feasible reforms could also incorporate some of the ideas advanced by study groups and observers. Indeed, FERS retains a pension-like annuity that is paid out during retirement, in addition to the TSP component.

Significantly, the FERS annuity is calculated differently for those older than 62, providing an incentive to continue in government service past 20 years. This design is not, however, appropriate for many military specialties. An annuity that vests before 20 years could be a good solution, both for servicemembers and for the DOD, even if payment were delayed to an older age.

The FERS’ flexibility, efficiency, and scale make it an excellent model for reforming the military retirement system. After adjusting the annuity as suggested, this system is nearly an off-the-shelf solution, making the enrollment of new recruits and officers all the more executable.

Some will question the wisdom of emulating civil-service retirement schemes. However, we must question our adherence to a system that has been mostly unchanged for more than nine decades and has nearly no civilian analogue in form, function, or scale.

Barriers and Challenges

Several arguments against a contribution plan, or in favor of the existing pension, are familiar to readers who have considered the retirement issue. Resistance to a new system could be significant and unpredictable. The DOD and Congress would have to overcome the political inertia that may inhibit such a change, as well as navigate any associated controversy.

The topic evokes differing interpretations of the social contract between the military and society, which some observers call the military covenant. This could be a significant barrier to building consensus.

Some claim that a contribution plan is excessively complicated or requires too much attention from busy servicemembers deployed abroad. In many regards, the current vesting system is a hands-off process, requiring only reaching the benchmark for an assured pension. But any decisions involved with a contribution plan are hardly more complex than the current “High Three” and Redux options. Indeed, guidance on that mandatory choice is lacking.

Further complicating matters is uncertainty about who would be affected by future reforms. It is preferable to enact alternations only for new entrants, as was the case for the Redux system. To do otherwise would likely damage servicemembers’ trust. A military version of FERS would be an excellent candidate for an optional phase-in. This would accelerate the positive effects of reform for those interested and willing, while benefiting the government’s budget today. In making such a choice entirely voluntary, the DOD would avoid the counseling and disaffection issues associated with Redux.

Opponents of a new retirement system express concern about subjecting servicemembers’ financial security to the risks and fluctuation of financial markets. But the DOD’s lack of support for a contribution plan leaves personnel without the same tools and options that most civilian professionals have.

Retirement Planning in the Open Market

Average account levels at Fidelity, the largest 401(k) administrator in the United States, reached record levels during the final quarter of 2010. 6 Despite an uncertain economy, these retirement systems remain popular and well-utilized. The civilian participants in those programs would scarcely be interested in the rate of return offered by low-interest bonds, which the government is forced to accept in funding the military pension.

The disparity between civilian and military funding requirements is massive. At various times, the DOD must save a dollar amount of perhaps 27 percent to 33 percent of aggregate base pay of all current servicemembers. 7 Civilian workers do not show a propensity to save that is even close to this figure. By comparison, the record high 401(k) balances of February 2011 are associated with a contribution rate of perhaps 8.2 percent of gross salaries. 8 If military personnel had more direct access to their compensation, especially in the form of bonuses and pay raises, the marginal impact on recruiting and retention could be quite significant.

Financial professionals use discount rates heuristically to compare a person’s preference for a dollar today rather than in the future. The discount rate of the general population may be difficult to determine, but some suggestions place it at about 10 percent. That means you would probably prefer 90 cents today rather than a dollar next year. Likewise, an interest rate of about 10 percent would encourage you to save.

Some research suggests that the aggregate military population could have a discount rate of 15 percent. 9 Officers, who make up the majority of the retiree population, have been estimated to discount at 10.5 percent. 10 By contrast, Treasury securities have been yielding below 5 percent in the past two years. So the DOD has to save several times as much money as servicemembers want to receive.

The stock market is not the only risky institution. It is interesting to consider the possibility that servicemembers might attach a risk premium to promises from the U.S. government. Military personnel could wonder how likely it is that their pensions will be honored at the end of their service, or throughout a lifetime of expected adjustments. If this is the case, the pension system is even less useful. Any reforms affecting those in uniform today will only confirm suspicions. Despite the risk of financial assets within the TSP, they do not carry the political uncertainty of a pension.

Regardless, a specific designation in the TSP could mimic investments that the DOD is required to make to fund the current pension system. In other words, TSP funds can be invested exclusively in government securities. By default, the TSP does this anyway unless the member specifies alternative instructions.

Retain Human Capital

The most powerful argument against a contribution retirement system is concern about the greater ease with which servicemembers would be able to leave the military before serving 20 years. This should cause us to question the relevance of that time scale. Personnel with less-necessary specialties and skills should not remain in service for an arbitrary period. But for specialties in high demand, we need tools that encourage retention.

Military personnel are, naturally, very responsive to incentives and bonuses when recommitting to service or accepting separation. By contrast, it is unclear how important the pension is in this decision-making process. As the GAO’s Gebicke observed in 1999: “When given a choice, military members have tended to prefer up-front compensation to deferred compensation.” 11

The pension system may be an expensive and unnecessary outlay for members who desire to stay in the service. If U.S. military personnel do, in fact, prefer higher pay and bonuses, this should be reflected in attempts to modernize compensation.

It is highly likely that DOD retirement programs will change, possibly in the near future. We have the opportunity to craft a system that better promotes the interests of both the military and Americans in uniform. This debate need not concern only costs. A new compensation scheme for future retirees can improve the DOD’s human resources today.

1. Mark E. Gebicke, director of Military Operations and Capabilities Issues, National Security and International Affairs Division, “Testimony on Military Retirement Before the Subcommittee on Military Personnel, Committee on Armed Services, House of Representatives,” Washington, DC: General Accounting Office, 25 February 1999, GAO/T-NSIAD-99-94.

2. Tim Kane, “Why Our Best Officers Are Leaving,” The Atlantic , January-February 2011.

3. Lisa Novak, “Military Retirement System Broken, Board Says,” Stars and Stripes , 7 August 2010.

4. Ibid. See also Nate Fick, “It Is Time to Discard the Military’s 20-Year Retirement System,” Foreign Policy , 6 May 2010.

5. John D. Winkler, “Developing an Operational Reserve: A Policy and Historical Context and the Way Forward,” Joint Forces Quarterly , October 2010.

6. Reuters, “Fidelity: Market Gains Push 401(k)s to Record High,” 23 February 2011.

7. James Grefer, “Comparing Military and Civilian Compensation Packages,” Alexandria, VA, CNA Corporation, 2008, p. 74. William Hix and William Taylor, A Policymaker’s Guide to Accrual Funding of Military Retirement (Santa Monica, CA: Rand Corporation, 1997), p. xii.

8. Jessica Dickler, “401(k) Savings Hit Record High,” CNN, 24 February 2011.

9. Beth Asch et al., Assessing Compensation Reform: Research in Support of the 10th Quadrennial Review of Military Compensation (Santa Monica, CA: Rand Corporation, 2008), p. 68.

10. Grefer, “Comparing Military and Civilian Compensation Packages,” p. 64.

11. Gebicke, “Testimony on Military Retirement,” p. 2.

Lieutenant Klopfer, a naval aviator assigned to VFA-192, graduated from the McIntire School of Commerce at the University of Virginia.

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