The FERS annuity is the foundation of the federal employee retirement plan. While some federal employees may know how to calculate their FERS annuity, I have found that there are four elements of FERS that people fail to grasp.
Understand how your FERS annuity is calculated at different ages
The first thing to know is the difference in the calculation at age 62. The FERS retirement formula is:
your high 3 x number of years of service x 1%
HOWEVER, if you work until age 62 and retire with 20 or more years of service, the formula changes. Instead of getting 1% per year worked you will receive 1.1% per year worked. An extra 0.1% on 20 years of service will add an additional 2% to your high 3.
The extra 0.1% can make a big difference for the employee that is considering retirement around the age of 62, or the employee that is considering retirement after age 62 and near the 20 years of employment threshold.
Here is an example of the potential difference in retirement income.
|Age||Years of service||High-3||% of High-3||FERS Annuity|
As you can see, working one more year could help this employee get an extra $3,280 a year in retirement.
Know How Your Survivor Annuity Works
Married employees need to keep in mind that they probably won’t receive their full FERS annuity because of the survivor annuity (SA) reduction. If you are married at retirement, you will have the option of electing a 10% reduction for a spousal benefit of 50%, or a 5% reduction for a spousal benefit of 25%.
Most feds need to elect a survivor benefit so their spouse can have the extra income if they predecease their spouse. Another reason to elect a SA is so the nonfederal spouse can continue Federal Employee Health Benefits (FEHB) if the federal spouse dies first. Without a SA, the surviving nonfederal spouse cannot continue FEHB. This is something to be aware of if you are considering using life insurance to replace the SA.
Your COLAs won’t keep up with inflation
Most retirees that receive a pension don’t receive any type of annual increase on their pension, however, FERS retirees do receive an annual COLA. The downside to that COLA is that it won’t keep up with inflation.
Here is the formula for the FERS COLA.
|CPI-W||FERS Retirees receive|
|Less than 2%||Actual|
|More than 2% but less than 3%||2%|
|More than 3%||Actual minus 1%|
As you can see in the table, retirees’ COLAs can lag the CPI significantly in times of high inflation.
What does this mean in real life? Your expenses are increasing at a higher rate, conceivably, than your income.
This is something that FERS employees should be aware of and plan for.
This is something that very few feds think about but should be factored in to a retirement plan. When a preretiree is contemplating their investment strategy, what is the value that should be put on the FERS annuity? What about the value given to Social Security?
So often I see people compartmentalizing the annuity and looking at it in isolation from the rest of their investment strategy. The best plan is one that integrates all the different components so that it captures the way these things relate and impact each other.
There are many opinions on whether or not a dollar value should be given to pensions when a retiree allocates their investments, but at the very least, it shouldn’t be ignored. The reality is that a federal employee that has 2/3 of their income guaranteed can afford to take more risk in their investment portfolio.
Here is an example of a newly retired federal employee with the following:
- 62 year old retiree
- FERS annuity = $24,000 a year
- Social Security = $20,000 a year
- Thrift Savings Plan balance = $400,000 (this could be IRA dollars as well)
A lot of retirees want to invest conservatively in their TSP when they retire, but they also only look at their TSP balance when they determine their allocation. The typical 50/50 (50% stocks and 50% bonds) retiree portfolio changes significantly if we add in the value of the FERS annuity. If we are using the 4% rule for investment withdrawals, then the value of the above FERS annuity would be $600,000. Since the annuity is guaranteed, it would be considered very conservative; therefore all $600,000 would be considered fixed dollars.
Additionally, if we were to include the value of Social Security in the investment allocation, it would be worth $500,000. With these two income streams accounted for, the investor’s allocation looks very conservative, even if the entire TSP balance of $400,000 were invested in stocks.
- Total value = $1,500,000
- Fixed portion = $1,100,000
- Aggressive portion = $400,000
Does this mean all federal employees should invest their entire TSP in the stock funds? If we look at investing from strictly a logical perspective, then most federal employees probably could, but investing is a lot more than just numbers and math.
Emotion plays a huge role in investment decisions and is often times responsible for people making the worst decisions at the worst times!
To be clear: don’t go change your TSP allocation to 100% stocks without considering everything involved. At the same time, it is important to understand that having 2/3 of your income guaranteed in retirement could allow you to take more risk with your investment portfolio.
Summary on 4 Things to Know About Your FERS Annuity
- Understand how your FERS annuity is calculated at different ages
- Know How Your Survivor Annuity Works
- Your COLAs won’t keep up with inflation
- Know how your FERS annuity relates to your investment strategy
These are four important aspects of your FERS annuity that should be considered when you are doing your retirement planning. If you don’t have a retirement plan currently in place and would like to talk about how to get one, you can email us here.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.