I was talking recently about retirement with one of my clients who is approaching 40 years of federal service. He’ll be 62 when he hits 40 years in 2024 and the back of the napkin FERS annuity math looks like this:
40 years x 1.1% multiplier = 44% of High-3
He’s ready to go out, and it’s much deserved.
In this article I’m going to cover the following:
- How the FERS basic annuity is calculated
- How much your pension could be worth in portfolio dollars
- What other sources of income you may consider
- How much income you may need in retirement
- How to make it all work together
How the FERS Annuity Works
We know the FERS annuity (pension) offers guaranteed income with cost-of-living adjustments. This type of defined benefit plan, or pension, is not very common for most employees in the U.S. today.
The FERS annuity will be a key piece of retirement income for him and for most federal employees. While 40 years is a very long career, according to the Office of Personnel Management (OPM), the average retirement age is around 61 years old and the average length of service at retirement is 25 to 26 years.
Some simple back-of-the-napkin math can also get us close to what the average FERS pension income from these average retirement numbers would be.
For most Federal Employees the FERS annuity formula equals:
- Hi-3 Salary x 1% x Years of Service
OR - Hi-3 Salary x 1.1% x Years of Service (if retiring on immediate annuity at or over age 62 with 20 or more years of service)
Essentially, you get 1% or 1.1% of your highest salary as a federal employee for every year of work, guaranteed for the rest of your life.
A FERS career that lasts 25 years could have 25% to 27.5% of the pre-retirement highest average salary replaced with the pension, depending on the applicable multiplier, before considering any additional sources of retirement income.
The FERS pension is unique for a few reasons:
- It’s guaranteed by the federal government, including an optional survivor benefit
- The contribution rate required for employees is low
- Cost-of-living adjustments start at age 62
- A special retirement supplement may apply from the minimum retirement age to age 62
How Much is a FERS Annuity Worth?
Sometimes we get folks asking the question: How much would we need to have saved if we left federal service to make up for losing the pension benefit?
In other words, if you didn’t have a FERS pension, what value of investments would you need to generate the same income?
I don’t particularly love this question, however, I find it interesting, and there is more than one way to think about it. For instance, you could surrender an investment portfolio to an insurance and annuity company to create a similar income stream that would be guaranteed by the insurance company.
With a private annuity, the portfolio value needed would usually be substantially less than what’s needed to create a sustainable distribution strategy from an investment portfolio over a potential 30+ year time frame, but it comes with the significant costs and implications of giving up your principal balance to the insurer.
If we want to keep our investment principal and design a distribution strategy, one way to think about this is to use the 4% rule, a common method for determining a “safe” withdrawal rate from an investment portfolio. The strategy is centered on limiting the portfolio’s income distribution to 4% per year or less. If you do this, you have a high probability of not outliving your portfolio money according to the strategy.
The reality is that the 4% rule isn’t exactly a rule; it’s a strategy that offers a way to assess a ballpark value for retirement income planning. It shouldn’t necessarily be taken as fact, but it’s useful nonetheless.
Using the inverse of the 4% rule’s formula can show us the portfolio value needed to create a specific income stream.
Retirement income x 25 = portfolio value
Example
- Your projected FERS annuity x 25 = portfolio value equivalent
- $50,000 annuity x 25 = $1,250,000 portfolio
It’s easy to see how a FERS pension could be worth substantial portfolio dollars. This framework can also be useful to help figure out the rest of the retirement income puzzle.
What Other Sources of Retirement Income Will You Have?
Within FERS, retirement is about the big 3 – the FERS basic annuity, Social Security income, and the Thrift Savings Plan (TSP) – although Social Security is a benefit available to most U.S. workers not just those in federal service.
Depending on your savings and investing habits, other assets may exist on the balance sheet that can generate income as well – IRAs, taxable investment accounts, real estate properties, etc.
Social Security
Social Security works well as a complementary source of retirement income, but it was never intended to be a primary source of income for retirees.
However, Social Security is going to be important for almost everyone. How much retirement income this benefit may provide depends on various factors.
The program is funded by a dedicated payroll tax on employers and employees. Both pay 6.2% of wages up to the taxable maximum of $160,200 (FY 2023) into the system, while self-employed folks pay the full 12.4%.
According to SSA.gov, the current maximum benefit is estimated to be $2,572 at age 62 and $3,627 at full retirement age (FRA) for 2023.
Without getting too far in the weeds let’s brainstorm a bit.
Let’s assume you were making $160,200 before you retired and now qualify for the maximum benefit of $2,572 per month at an age 62 retirement date. Taking the benefit at 62 would replace $30,864 per year or 19.2% of pre-retirement income ($160,200).
If waiting to claim at full retirement age (age 67), you would replace $43,524 ($3,627 per month) or 27% of the same pre-retirement income of $160,200.
There are a lot of variables to consider with Social Security. This article is based on the FERS annuity and is only intended to include a high-level and simple discussion on Social Security benefits to help provide perspective around structuring a retirement income plan.
Generally, individuals with lower wages may replace a higher percentage of their pre-retirement income with Social Security benefits than those with higher wages. Waiting until full retirement age or further until age 70 increases the dollar amount of benefits based on delayed retirement credits.
Check your estimates for a better idea of what you can expect. We can ballpark benefits replacing 20% to 25% of pre-retirement income, but you should pull down your personal estimates from ssa.gov as work records and benefits vary widely.
Thrift Savings Plan
Making significant contributions, receiving an employer match, and investing well are the upfront work that can help grow a healthy TSP account balance. However, the hard work doesn’t stop there.
Making your portfolio money last over a lengthy retirement is as hard or even more difficult than growing it in the first place.
Revisiting our earlier discussion on how much your FERS annuity is worth can provide the framework for determining potential income available from a TSP account referencing the 4% rule strategy.
Creating a sustainable income strategy from your TSP account can be tricky. Plan to take a maximum amount of 4%-5% of your portfolio value as income on an annual basis. This yearly amount may include modest adjustments for inflation. The investment mix within your portfolio should be thoughtfully constructed pre and post-retirement.
You can apply this formula as a reference point:
Income needed x 25 = Portfolio Balance Required
Or
Portfolio value / 25 = Income available
There are also planning strategies with the TSP that can help create an opportunity to potentially maximize your funds from an investment and tax standpoint.
Other Assets
Do you have taxable investment accounts, IRA or Roth IRA accounts, real estate investments, or other assets that may be able to produce income?
The same rules apply to how much income you can take from other retirement or investment account portfolios. Real estate and other assets will have unique characteristics.
Tax diversification strategies can play well here. That means leveraging account types that carry different tax treatments that may maximize a future retirement income strategy.
Buckets to consider: Pre-tax, after-tax, and taxable.
Last step: Add it all up. How much income does your retirement income worksheet show you might have in the future?
How Much Will You Need?
People get frustrated with financial planners focusing on this question, and it makes sense – it’s abstract and nearly impossible to know what we’ll need in the future with so many unknowns, but we need to take a stab at it for the sake of planning.
This part may feel like a bit of guesswork and that’s fine. Think about how long you plan to work. Think about how long you could possibly be living in retirement. Think about how your expenses may change. Think about how much retirement income you’ll need to keep the lifestyle goals you’re after.
Are you planning to pay off your mortgage before retirement? Do you want to travel? Do you have charitable intentions? Do you plan on helping kids and grandkids?
One of the first steps is to evaluate how much you are currently spending and break it down into detailed categories.
If you spend 80% of your income and save or invest the other 20%, this is probably pretty close to what you’ll need in retirement. Most financial experts use an estimated retirement income need of between 80%-100% of what you are currently spending.
For example, someone with a salary of $150,000 and current spending equal to 80% of his or her income would have an annual spending amount of $120,000. This means you would need to replace somewhere between $96,000 – $120,000 of annual income in retirement.
Is this realistic? Everyone’s situation is different. Some people will spend less and other folks desire to spend more based on lifestyle goals.
In most cases, some expenses will change or drop off while new things will pop up that require spending.
Some expenses that may drop are taxes, housing, childcare, and commuting. Some expenses that may increase are travel and entertainment, health care, fitness and wellness, gifting, and professional help.
Spend some time with it. Expenses vary quite a lot by person.
What is your current spending and what is most likely to change over time?
Putting It All Together
Okay, let’s take a moment to regroup. I’ve thrown a lot of information out there in an article intended to discuss the FERS pension and its role within a retirement income plan.
This stuff is incredibly subjective, but here are some rough numbers to consider:
Many retired families we work with may replace 50% or more of their pre-retirement income between a FERS basic annuity and Social Security Income. It’s up to other assets like the TSP, IRAs, investment accounts, and real estate investments to make up the difference, usually somewhere around 30% of pre-retirement income, to get where we want to be with retirement income and lifestyle goals.
The FERS pension may replace somewhere north of 25% of a career federal employee’s pre-retirement salary. Review your personal estimates and think about how long you want to or can possibly see yourself staying in your federal career.
I believe the role of the FERS pension is to work alongside Social Security benefits as the core of your retirement income plan. This can lessen the stress on portfolio assets, limit volatility risks like the sequence of returns, and reduce longevity risk due to the guaranteed nature and originating source of the income – the Federal Government.
However, a good plan does require doing the math on how much you are spending. This is something that’s going to be unique to each person and family. Every situation is different, but you can apply the retirement planning framework discussed here to work out an idea of what you might expect down the road.
Oh my gosh! This turned into something much bigger about retirement income vs. a quick take on the FERS pension. I hope you find it useful!
I also publish a biweekly newsletter with insights into topics like this and more. Don’t be afraid to ask questions. I’m here to help.
The content is developed from sources believed to be providing accurate information. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
