When the retirement program for U.S. military service members changed at the start of 2018, about 1 million active duty members were offered a choice between two retirement plans.1 Their decisions can have a dramatic impact on their financial futures. The program is shifting away from an exclusively defined-benefit design (the “High-3” plan) to a blended arrangement that includes a defined-contribution component with a defined-benefit worth 80 percent of the current program (the Blended Retirement System [BRS]).
For most service members, the most important difference is that the new plan offers meaningful financial benefits to military personnel who serve less than 20 years. It also may encourage the habit of personal savings by members, which will enhance their retirement prospects and help them develop habits that will benefit their retirement planning in any post-military careers. These outcomes fulfill the goals in Recommendation 1 of the Congressional Military Compensation and Retirement Committee.2
For service members who want to know, “What plan should I choose?” the answer, as always, depends on personal circumstances. This article attempts to provide a framework for making that decision. One important element is to consider how likely it is that you will retire from the military with 20 or more years of service versus separating earlier.
For service members who separate before reaching High-3 retirement eligibility, the new BRS may be the best choice, as the existing High-3 plan offers them no benefits. Those with only a few years of service are likely to leave the military before retirement eligibility.
For those likely to remain on active duty for at least 20 years, evidence indicates that staying with the High-3 plan is likely the best option. The more years of completed service a person has, the more likely he or she is to stay until retirement compared with a new entrant. (Department of Defense estimates indicate that more than half of service members with six years of service will stay until retirement.) Those who join the blended plan mid-career in 2018 will not get any makeup funding added to the defined-contribution structure for prior service. They only will receive contributions going forward.
But as the analysis that follows shows, the answer is not black and white, and a service member who entered recently and is unsure about his or her future plans should think carefully about the choice. Choosing the BRS and remaining in the military until at least year 20 will very likely offer a smaller retirement benefit than in the High-3. Still, a BRS plan will never be worth less than 80 percent of the High-3 and—depending on investment returns—potentially could approach the same value.
Defined Benefit Vs. Defined Contribution
A defined-benefit plan promises a specific outcome: an employer (the government in this case) commits to the actual retirement benefit, a lifetime annuity with specified payouts. Defined-benefit plans are what most people mean when they speak of “pensions.” The existing program is known as High-3 because the benefit is derived from the average monthly pay of the highest-paid three years in an individual’s career.
A defined-contribution plan promises specified deposits (usually a percentage of salary) to a retirement account. Once the contribution is made, the benefit commitment on the part of the employer is satisfied, and the account itself can grow or shrink with no further responsibility by the employer. (Most for-profit private employers offer these plans today, often referred to as 401(k)s because of the section of the tax code that governs them.) The new plan has both defined-benefit and defined-contribution elements and is referred to as the blended retirement system.
Though the High-3 and BRS each have defined-benefit elements, the two plans have one important difference: The “service multiplier” percentages that determine how the initial benefit is calculated are different.
Under the High-3 plan, an O-5 with exactly 20 years of service and the calculated monthly base pay of $8,500 would receive $4,250 a month for life—$8,500 x 20 x 2.5%. That same individual would receive $3,400 per month under the BRS—$8,500 x 20 x 2.0%. Both payments would be adjusted for inflation after retirement. The 20 percent reduction in multiplier—from 2.5 percent down to 2.0 percent—means the BRS plan offers only 80 percent of the High-3 plan’s defined benefit.3
The Blended Retirement System Explained
If the change in service multipliers were the only difference, the choice would be easy for nearly everyone. However, the BRS also includes a defined contribution that increases the net value of the BRS.
The defined-benefit portion of the BRS is paired with a “thrift savings plan” (TSP) to which participants will contribute a portion of pay and into which they will receive government matching payments. Part of those government payments are mandatory minimums, while another portion is contingent on voluntary additional contributions (Table 2). (Participants in the High-3 plan also are eligible to establish TSPs, but they will not receive government matching funds.)
BRS participants who reach 12 years of service also will receive a one-time payment equal to 2.5 months of base pay if they opt to remain in the military for four more years—“continuation pay.”
This should make it clear that the BRS offers substantial value for those who choose the BRS but then stay in for 20 years. For an enlisted service member with seven years of prior service, he or she would receive $2,599 a month for life with future cost of living adjustments, as well as a 401(k)-like TSP account worth $64,939 (from service member and government contributions and continuation pay invested over the 13 years until he or she reaches retirement eligibility). An officer with the same years of service could receive a $4,930 monthly pension and $128,135 in savings. (See sidebar for comparison of the BRS benefits with the High-3 for a mid-grade officer and enlisted member for each.)
The Bottom Line
Choosing the BRS is a lower-risk proposition for many service members because it will provide benefits without reaching 20 years of service. And the rewards, while lower than the High-3 plan, will still be substantial for those who choose BRS and then re-up until 20 or more years. For those who have several years of service, the probability that they will reach 20 years of service is much greater. They may well find that the High-3 makes more sense, not only because of the 2.5 percent multiplier, but also because the contributions to the TSP will be made for fewer years and have less time to earn through compounding. It is not possible in a short analysis to consider the many variables in each specific person’s situation, so in all cases, service members should consult financial planning professionals to make the best decision for their own circumstances.
Assumptions and Method of Comparison
Because both options include a defined benefit plan with a multiplier of at least 2.0 percent, the analysis that follows excludes that portion from consideration. Instead, the discussion compares the expected value of the remaining 0.5 percent multiplier in the High-3 with the expected value of the defined-contribution and continuation-pay benefits.
For a valid comparison, the two benefits must be compared on the same basis at the same point—the date at which the individual would have reached 20 years of service. To establish the basis, the annuity value has been converted to an economically equivalent account balance for the purposes of this analysis. Estimating a participant’s longevity was necessary to convert the annuity to an economically equivalent account.4
Other assumptions needed for the annuity benefit reflect those used in Department of Defense cost estimates. These include an inflation rate of 2.75 percent, discount rate of 5.25 percent, and pay growth assumption of 3.25 percent. The pay growth assumption is in addition to pay changes due to promotions and length of service adjustments reflected in the 2017 pay tables.5
Figure A shows the probability that a service member from each group stays in the military for 20 years once they have completed a given number of years of service.6
In this comparison, the value of the BRS is the total amount of employer contributions, with investment returns, by year 20. Service members are assumed to contribute 5.0 percent of their base pay each year to achieve the maximum government contribution. The continuation pay received, if any, also is assumed to be invested until year 20. All money also is assumed to earn 5.25 percent interest annually, the same rate used to discount pension payments.
Finally, sample career paths for officers and enlisted personnel also were used to compare plans. (See Table 3) Retirement at 20 years of service is assumed across the board if the service member stays in the military.
Results
Using these assumptions, a value for each option can be calculated for service members at given points in their careers.
Table 4 uses “expected value theory’ to compare outcomes across the whole population of enlisted service members and officers, so the calculations shown should not be considered projections for any individual. It adds up all the possible outcomes and weights them by how likely they are. For the High-3 plan, the expected value at the 20-year point represents the probability a service member reaches retirement eligibility multiplied by the value of the projected benefit at retirement. The BRS plan value reflects the probability a service member will retire or leave before retirement eligibility at each future year. It also reflects the defined contribution and pay continuation received to that point plus investment earnings to the 20-year comparison point. The values presented for the BRS are a weighted average of the projected account balances at each possible year of leaving the military. That is then weighted by the probability of leaving in each future year.
The expected plan values also are shown for members with 1 to 11 completed years of service in 2018, the year in which they are allowed to make the decision.
Table 4 indicates that the High-3 plan likely will be the more valuable option for many service members. Yet, for each career path and year mark, the High-3 plan has a bigger expected value. However, because these values are largely driven by the probability a service member remains 20 years in the military, not every individual should automatically select the High-3 plan.
What is driving the difference in the values of the two plans? First, service members who have completed at least 6 years of service are very likely to remain in the military for 20 or more years. Also, earlier in their careers, officers are more likely than enlisted individuals to stay in the military until retirement. The High-3 plan becomes more valuable the likelier the individual is to stay 20 years.
Younger, enlisted members will experience the smallest difference in plans. While the high-3 plan promises higher value, the lower risk of the BRS may be a more reasonable choice for them. Service members who remain in the military for at least two years will benefit from the BRS. And, if they wind up staying 20 years, they will get those benefits plus 80 percent of the current plan.
The return on assets will impact the value received from the BRS, as the contributions will grow with those returns. Above some average annual return, the BRS will be a more valuable option. That hurdle is high for those with several years of service. For service members (enlisted or officer) with seven years of service at the time they make the decision, an average annual return of 10% for the rest of his or her life would make the two options of equivalent expected value.
Service members are more likely to leave the military early in their career than later, which impacts Thrift Savings Plan (TSP) account balances and means that they will have only a few years of matching contributions added to their accounts. Although those contributions may grow with earnings from investments, an early departure from the military limits BRS value.
With these choices, the government is providing a valuable benefit to service members. Each service member can gauge their own career path and probability of retirement before 20 years—a key factor when it comes to which plan to choose. What is clear from this analysis, however, is that the BRS plan should be considered only if service members save in the TSP and matching contributions are made. Without those matches, the value of the fund is significantly reduced, making the high-3 plan a better choice.
Other Considerations
A set of mortality rates related only to men was used in calculating the value of the high-3 option. Women, on average, live longer than men so the projected value of their annuity may be slightly higher. Female service members might want to take that into consideration as they make their plan choice.
This analysis considered the outcome of decisions based on retiring or otherwise leaving military service. Reserve service options were not taken into account, and the impact of deferring retirement benefits for retiring reservists would require additional analysis.
1. Office of the Actuary, Department of Defense, Valuation of the Military Retirement System—September 30, 2015, April 2017 Appendix C, 65–66. The one million number was attained by adding the number of enlisted and officer personnel counts with 0–11 years of service on those pages.
2. Military Compensation and Retirement Modernization Committee, Final Report, January 2015, 19.
3. Kristy N. Kamarck, Military Retirement: Background and Recent Developments, Congressional Research Service 27 February 2017 RL34751.
4. Office of the Actuary, Valuation, 168–171. In this case, mortality rates for male pension participants in private industry is used because the data was developed for defined benefit plan use. Also, these rates track between mortality rates for enlisted personnel and officers that are used in cost estimates for the military plan. Although, the DoD’s actuaries do not provide the mortality rates in the same manner as the other rates are presented. They do, however, provide how they calculated those rates. See also, Internal Revenue Service, Notice 2016-50, Updated Static Mortality Tables for Defined Benefit Pension Plans for 2017. Appendix rates used are combined annuitant and annuitant rates.
5. Defense Finance and Accounting Service, 1 January 2017 Pay Chart, www.dfas.mil/militarymembers/payentitlements/military-pay-charts.html.
6. Office of the Actuary, Valuation. A key element needed to determine which plan is optimal for most members is an estimate of how many service members will choose to leave before eligibility for retirement each year. Termination Table Rates used are termination rates net of reentrants except when reentrants were larger than terminations. In those cases, only the termination rates were used. These modifications to the first two years reflect the fact that the rates serve a slightly different purpose in this analysis than for the DoD.
Mr. Jacobson is an actuary with experience in the life insurance and annuity industry as well as defined-benefit pension plans. He is the executive director of Life Actuarial Valuation for the United Services Automobile Association (USAA) in San Antonio, Texas. He is a Fellow of the Society of Actuaries, a Member of the American Academy of Actuaries, and a graduate of The University of Texas at Austin.