There is a great deal of interest in the high-5. Is it really going to happen? When will it take effect? How will it work? Is there some way I can estimate – right now – how much difference it will make?
Considering the current budget/fiscal crisis, there is little doubt the change to high-5 is going to happen, with the only real question being when it will take effect. That is, when will it first be used in calculating the annuities of retiring employees?
This is pure conjecture, but even though policy makers are anxious to start “saving” the money, I believe the startup will not be in the immediate future and it might even be phased in, somehow. Because there are so many employees who have served so many years, planning on the status quo, it is possible the effective date will be several years in the future. But, it is highly doubtful policy makers will make the change effective only for employees hired after the law is passed. This grandfathering would mean the “savings” would not begin for at least 10 years or so. However, your guess on this is as good as mine.
In full operation, how will it work? Instead of using the highest three years of earnings to arrive at average salary, the highest five years will be used. This means, of course, that for virtually everybody to whom it applies, the average will be lower than the current way, and the resulting annuity will be lower, too.
Example: A simplified case
An employee retires on Jan 1, 2013. Her applicable earnings are:
$56,000 from Jan 1, 2012 to Jan 1, 2013
$55,000 from Jan 1, 2011to Jan 1, 2012
$54,000 from Jan 1, 2010 to Jan 1, 2011
Result: High-3 = $55,000 > annuity = $16,500
$53,000 from Jan 1, 2009 to Jan 1, 2010
$52,000 from Jan 1, 2008 to Jan 1, 2009
Result: High-5 = $54,000 > annuity = $16,200
In the above case, assuming 30 years service, using high-5 instead of high-3 means an annuity “loss” of $300 per year.
Note: This is an idealized, simplified example to illustrate how the process will work. In actual practice, there will usually be more than three salaries in three years, and more than five salaries in five years, plus they will not all have the same convenient starting date. Pro-ration is necessary. This is why a computer program is helpful.
Method of Calculating Your Annuity
What effect would there be, in the above example, if the salary was the same (i.e., frozen) for the last three years? The high-3 would be – surprise! – $54,000, and the high-5 would be $53,400.
As soon as we know the specifics, I will change my high-3 and annuity software accordingly. In the meantime, to get an idea of how it might affect you, here is a manual method.
- Take the known high-3 for a given date and multiply by 3, to get the total salary paid for the 3-year period. (To calculate the high-3, you can use no. 3 on the menu of this software )
- Manually calculate the total salary you were paid during the 24 months prior.
- To get the high-5 average salary, add results of 1. and 2., then divide the total by 5.
Be careful in step 2, to actually figure out the amount you were paid, by adding together the salaries for each period. For example: if you had a $54,000 salary for the first 7 months, and then 55,746 for the next 9 months, and 58,343 the final 8 months, be careful to pro-rate each one. That is, divide each annual figure by 12 and then multiply by how many months you earned it. You could even do it by pay period if you wanted to be highly accurate. Also, salary means basic pay from which retirement contributions are deducted (not overtime, et al).
The high-5 is almost certainly going to happen. We all hope the effective date will be as far in the future as possible. It will mean a loss, but compared to paying 6% of your salary for retirement instead of 0.8%, it will be moderate. In the above example, if the employee making $56,000 in her final year had been subject to the proposed 6%, she would have seen $3,360 withheld from her pay, instead of the current $448!