As a Federal Employee, you are part of a system that offers comprehensive benefits that include retirement and healthcare, and as part of your retirement benefits the Federal Employee Retirement System (FERS) offers a pension component. The FERS pension is a promised retirement income stream that is funded primarily by government agency contributions.
How does FERS work?
Most federal employees contribute .8% of their annual salary to FERS while the agency contributes 10.7% or more. Your employee contribution is withheld from after-tax income, making it subject to income and payroll taxes.
As part of the Middle Class Tax Relief and Job Creation Act of 2012, mandatory employee contribution rates were increased substantially. Feds hired after December 31, 2012 contribute a mandatory 3.1% of their annual salary. The Bipartisan Budget Act of 2013 increased the contribution rate further to 4.4% for those hired after December 31, 2013. Agency contributions have also been increased.
Based on these contributions, the federal government promises to pay you a monthly annuity through your retirement. With a defined benefit plan like the FERS pension you don’t need to worry about how the money is invested; your obligation is simply to make mandatory contributions and stay employed for the required amount of time to be eligible for benefits.
How much does this equal in guaranteed pension income?
The general formula is as follows:
* Under Age 62 at Separation for Retirement, or Age 62 or older with less than 20 years of service
FERS Pension = 1% x high-3 salary x years worked.
*Age 62 or Older at Separation with 20 or More Years of Service
FERS Pension = 1.1% x high-3 salary x years worked.
This equals 1% – 1.1% of your highest annual salary for every year of federal service. You can max out your benefit with more than 30% of your pre-retirement income covered.
What would it take to match this income stream through investing?
Outside of calculating the income you can expect, it is interesting to compare how much you would need to save independently to match this income stream and looking at how much you will have contributed to your FERS pension over time as a federal employee.
For example, if you worked 30 years and retired with a high-3 of $100,000, your gross annuity would be worth $30,000 a year for the rest of your life.
We can talk about the costs you can expect to incur to bring you to net income, but for illustration, let’s put what it takes to earn $30,000 a year from an investment portfolio in context. This is a hypothetical example for illustrative purposes only. Actual amounts will be based on your particular situation.
The 4% rule is widely accepted as a sustainable distribution strategy from an investment portfolio for retirement income. To keep it simple, it says you can take 4% of the principal of your investments as income on an annual basis (we won’t get into COLA and other issues for the sake of simplicity) without outliving your money.
Applying this rule you would need $750,000 in investment assets to generate $30,000 annually.
How does this compare to the amount of contributions you are making to the FERS pension, and just how much would you need to invest to accumulate $750,000 in 30 years?
First, for illustrative purposes let’s look at the hypothetical cost to you based on employee contributions to the system in our scenario.
Let’s assume you reached $100,000 as your high-3 after 30 years of service for the federal government. Your salary likely started somewhere much lower 30 years ago, so let’s adjust backwards. Using a present value calculation with an average of 3% annual pay increases over that 30 year time period, this starts us at a salary of $41,199.
Based on the historical annual employee contribution rate of .8%, over the next 30 years you would have contributed $16,480.08, or just $45.78 per month toward your FERS pension, the same one we just equated to an investment portfolio worth $750,000.
Looking at it based on a new hire’s contribution rate of 3.1%, we have a total contribution amount of $63,860.32, or $177.39 per month, and at the 4.4% contribution rate, we come out with a total contribution of $90,640.45, or $251.78 per month.
How much would you need to save in your TSP or IRA account to equal $750,000?
If we assume an 8% rate of return for 30 years, you would need to save an average of $503.23 per month and a total contribution of $181,162.80 (using the same contribution for simplicity) over the same 30 years. Obviously, this is just an example for illustrative purposes, so results and amounts can vary. The hypothetical rates of return used do not reflect the deduction of fees or expenses inherent to investing.
Clearly the legacy employees have a great deal, but then again so do new hires.
Replacing 30% of income is a nice benefit, but how do we replace the rest of your pre-retirement income, and what are the hidden costs and considerations you may not be thinking about?
The good news is that as a FERS employee you are eligible for up to a 5% agency contribution to your TSP account. Funding the TSP and additional long-term investment accounts can help put you on the right track to building the nest egg you need. What are your goals for retirement income and how do you plan to meet them? If you’d like to discuss your plan, I welcome you to schedule an introductory call.
District Financial Advisors, Justin Holtz and LPL Financial are not affiliated with or endorsed by the Federal Government.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are investment advice specific to your needs, such services must be obtained on your own separate from this educational material.
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