Expert's View

Lately there’s been a lot of water cooler chatter about the possibility of federal retiree annuities being based on an employee’s highest five consecutive years of average basic pay rather than three years as it is now. While I have no way of predicting whether legislation will be introduced to do that, or be passed by Congress, or be signed by the President, I thought it would be a good idea to see what difference it would make.

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With a two-year freeze on annual federal pay increases, it would be easy to say that the change wouldn’t make much difference. But that would be to ignore the fact that salary increases still are happening through within-grade increases and promotions. Besides, the day will come when the pay freeze ends and annual raises will be paid again.

With that in mind, let’s consider Mr. Fed, who has 25 years of service, a salary of $60,000 and who receives annual raises averaging 3 percent. Obviously, his raises won’t be exactly 3 percent a year, but let’s use that for illustration. (Historically speaking, that figure is conservative. Before this year, federal employees received a raise every year since 1986, ranging about 2-5 percent. Before that, there were raises each year going back to at least the early ‘60s, sometimes twice a year, some of them much higher. Within-grade raises, which average 3 percent themselves, and raises on promotion are on top of basic raises.)

Say Mr. Fed is five years from retirement. His salary for those five years would be $60,000, $61,800, $63,654, $65,564 and $67,530.

On a high-3 salary calculation, the last three years would be used to produce his salary base, meaning $65,583. A high-5 salary base would be $63,710.

Say Mr. Fed is in FERS, as he would be if first hired in 1986. The civil service annuity portion of the FERS formula is 1 percent of the salary base per year of service. At 30 years of service in 2016 (and assuming he retires before age 62, when the multiplier would go up by a tenth, with that much service), the benefit difference between a high-3 base and a high-5 base would be the difference between $19,675 and $19,113–$562 a year.

For comparison, let’s put Mr. Fed in CSRS. We can do that by saying he was hired five years earlier, in 1981, and that he is retiring this year with the same salary history over his last five years of employment. At 30 years of service, the CSRS formula yields a benefit of 56.25 percent of the salary base. Therefore, on a high-3 basis, his annual benefit would be $36,890. On a high-5 basis, it would be $35,837—a difference of $1,053 a year.

Note that a FERS civil service benefit is smaller than a CSRS benefit because Social Security and employer contributions to TSP accounts are elements of FERS. Also note that the formulas differ for specialty category employees, such as law enforcement officers.

The difference between high-3 and high-5 further would compound over the years, as retirement COLAs are applied onto a smaller initial benefit.

In effect, when you retire, you drag the anchor of your prior years’ basic pay with you. The more years used to determine the calculation base, the smaller your annuity will be. That’s why you should be paying more attention to the high-3 vs. high-5 debate than idle water cooler chat.