The DoD can Further Optimize its Retirement System

BLUF: The DoD could probably save money, increase servicemember compensation, and better optimize talent management if it further increased TSP contributions while reducing 20-year retirement pensions.

Introduction to the Military Retirement: For decades, the DoD had a retirement system where after 20 years of active-duty service (and upon leaving the service) a servicemember (SM) was entitled to an immediate annuity based on years of service and basic pay using a 2.5% multiplier. For instance, after 24 years of service, a SM essentially earned 2.5% * 24 = 48% of their base pay for the rest of their life.  In 2016, Congress created a new system called the Blended Retirement System (BRS) that reduces the base pay multiplier to 2.0% but adds two new components: 5% matching Thrift Savings Plan (TSP) contributions and continuation pay (CP) (a few month’s pay for signing and continued service obligation for 8-12 year SMs).

The traditional 20-year retirement model (T20R) served as a powerful retention tool.  It takes a lot of time and resources to develop a senior Non-Commissioned Officer (NCO) or a field grade officer, and the T20R is a strong incentive for retaining talent who often have lucrative civilian career options. The problem with the T20R is that it is expensive to the Department of Defense (DoD), accounting for about $52 billion of its budget annually.[1]

The BRS was developed in the interest of saving money while also strengthening talent management.  Costs are initially higher under the BRS because of expenditures for CP and TSP matching contributions, but costs will eventually lower due to the lowered retirement pensions.[2]

The BRS promotes talent management because it improves incentivizes for short-term and mid-term service as well as long-term, 20+ year service.  Some individuals who would be valuable assets to the DoD are not necessarily careerists, and matching TSP-contributions is an incentive to attract them. Additionally, too many servicemembers tend to leave at 20 years; the BRS would better incentivize additional service.

My Argument: The military/Congress decided on a matching contributions rate of only up to 5% of base pay, but I argue that a higher percent of matching contributions, such as 10%, can further save the DoD money over its T20R system, increase average SM compensation, and increase talent management by offering more optimal incentives for SM retention.

Current Retirement System Example: A typical compensation scenario under the traditional retirement system: If an officer retires at a paygrade of O-5 at 20 years of service, it will cost the DoD an additional $10,278 per year compared to the BRS model which has a pension set at 40% of final base pay.  With future improvements in medical care, 20-year retirees (approximately 42 years old) might very well live up into their 90s, which may be 50 years after their retirement. Under the T20R, this 50-year pension would cost the DoD $2,569,530, and under the BRS, this would cost $2,055,624. Out of this $513,906.00 in savings comes the TSP matching contributions and continuation service pay in the new BRS.

Blended Retirement System Example:  Under the BRS, the military plans to match up to 5% of a SM’s contribution to their TSP. Over a 20-year career where a SM chose to donate at least 5% of their base pay to the TSP, this would cost the DoD $75,573.80 over the 20 years.  Continuation pay, an additional retention incentive, costs the service 2.5*base pay. For an O-4 with 12 years in service, this would cost the DoD $18,075.45. Under the new BRS, the military is not spending approximately $513,906 due to the difference in pensions (at 50 years after retirement), while additional expenditures for a 20-year officer retiree would generally only amount to $93,649.254.  Just as the DoD is saving $420,256.74, SMs who transfer to the BRS lose approximately this much income over their lifetime due to smaller monthly pensions (assuming they would have donated the TSP matching contributions themselves).

Proposal: While the DoD ought to save money and cut costs, I argue that it is even more important to offer competitive incentives for the sake of talent management and retention.  To illustrate a point, if the military were to maximize TSP contributions (limit of $18,500) for a 20-year career officer, this would cost the DoD $370,000. This is still less than the $420,256 in savings the DoD makes under the new BRS. This would allow the SM to open up a private investment account like a Roth IRA, which one would expect to match the returns of the TSP.  While the DoD would still be saving $50,256, the SM still investing $18,500 a year could now reasonably expect to earn an additional $550,894 over 20 years assuming a market growth of 4% over inflation. If the SM did not touch this money and stopped contributing to the Roth IRA after retiring at 20 years TIS, they could expect to have both their TSP and Roth IRA each worth $3,915,032 after 50 years.

This is an extreme argument to exemplify a point: the DoD can save money and increase SM compensation by utilizing market forces and compounding interest.  Only about 17% of SMs end up serving 20 years and retiring [3], so it would be very costly to the DoD if it were paying everyone an additional $18,500 a year for their TSPs. The military, however, is interested in increasing short-term service incentives for talented individuals who know a 20-year career is not for them.  The military also may be interested in reducing the incentive for mid-career (8-15 years) SMs to force themselves to continue service (out of fear of walking away with no retirement benefits; this the military does not want to retain members who really are ready to go). Additionally, the military is interested in reducing the overly strong incentive for talented senior SMs to get out shortly after 20 years of service.[3] See Appendix A for a chart of officer retention.[3]

To balance these incentives and the cost behind them, the DoD can increase matching TSP contributions to, say, 10%, while paying for this through reducing the pension percentage of base pay after 20 years to say, 35%.  For an officer who allots the full $18,500, and would allot the extra 10% of their Base Pay saved by the DoD’s 10% matching contributions, this would yield an extra $55,089.45 after 20 years.

According to my model (detailed below), a SM will always have less total compensation than the T20R until after 24 years after retirement at 20 years (assuming a RR < .5).  After 24 years, BRS retirees will see their total compensation surpass that off T20R retirees. If a BRS retiree is most interested in maximizing their lifetime compensation (perhaps for the sake of setting up a trust for a good cause) and they are willing to bear the lower pension up until their 24th year after retirement (approximately 66 years old), they are actually best off with a lower RR.  The best RR for that frame of mind is actually 0.

Model

Problem: Find an optimal TSP matching contributions rate and pension rate (as a final percentage of final base pay) to maximize lifetime earnings of service-members (SMs) without increasing costs to the DoD.

Variables:
        RR, the new 20 year retirement rate to optimize ;
LSEn, lifetime service earnings at year n ;
        TBPn, total base pay, the summation of base pay earned in all ranks prior to year n ;
        BPn, base pay at year n ;
        TCn=MCR*BPn ;
        RDn, retirement pay difference n years after being retired ;
        TSPn, value of TSP account at year n after starting account ;
        TSPr, value of TSP at exit from government service ;
       Yr, year of military retirement ;
        Yc, year of cessation of benefits ;
        n, years (of service or retirement) ;

Parameters:
         SMBRS, the number of service members (SMs) in the BR ;
         I, inflation rate of the US dollar, assumed to be 2% ;
         MRR, market return rate and rate a balanced TSP portfolio is predicted to grow.  For a particular solution, I assume 6% annual growth (1.06) ;
         MCR, the BRS matching TSP contribution rate ;
         AYURD, Average number of years lived until from retirement to death

Assumptions: For simplicity’s sake, I assume the TSP index fund growth will remain constant.  I also ignore future rises in the cost-of-living with the presumption that the military will continue to make cost-of-living-adjustments to its pay and retirement system.  I am also speculating an increased rate of SM retirement from 17% to 20%.

Model
General model for lifetime service earnings at year n due to TSP account growth:
Β  Β  Β  Β  Β  Β  Β LSEn= TBPn – n * TCn + TCnΒ * ( 1 – MRRnΒ ) / ( 1 – MRR )

 Model for TSP account growth after retirement:
            TSPn = TSP*  MRR * ( Yd – Yr )

Additional cost of the BRS to the DoD compared to T20R for an individual SM:
           MCR * BP* n + 2.5 * BP12

Savings to the DoD compared to T20R:
           ( .5 – RR ) * BPr * 12 * ( Y– Y)

Cost of BRS:
           ( MCR * BP* n + 2.5 * BP12 ) * SMBRS( .5 – RR ) * BPr * 12 * AYURD

The general solution to find the optimal solution is:
RD(RR, n) = 6BPr + 12nRRBPr – 6nBPr -(3nRRBPry(1 – nMRR))/(25*(1 – MRR))

The particular solution:
RD(RR,n)= 13896nn + 129504nRR – 64752.2n – RR 27792nn

Importantly, we should set realistic constraints on RR and n:
           .2 < RR < .5   ;   0 < n < 50

The constraints are chosen because the markets could fail and SMs should still have a safety net of 20% of their final base pay.  A 50-year cap is chosen because of the assumption that retirees will want to eventually utilize their TSP accounts (at this age, perhaps setting up a trust).

Rather than try to save the DoD money in this model, I am routing all the money from the savings from the reduced pension payouts back into the TSP matching contributions for all service members. Because there are now 5 SMs to provide matching TSP contributions for instead of just 1 SM to provide a pension for, the savings from a reduced payout will be divided by 5, and this will be the amount of money the DoD can pay out to each SM over their careers.

Normally, rank determines compensation, but to simplify this model, everyone will receive the same amount of matching contributions over their careers. Thus, this model divides the amount of TSP matching contribution money available to each SM by 20 and provides this as the maximum amount of matching contributions available to each SM every year.

See Appendix B for an Excel sheet that uses Solver to optimize for the pension and matching contributions rate.  What we find is that the function is non-convex in the domain defined by our constraints, so there are no relative maxima.  There is only an optimum RR for any given n (and vice versa).

Further Discussion: If one is willing to wait over 24 years after retiring to touch their TSP accounts, it seems that my current model is better than the T20R. However, what I have failed to account for is how much money extra money a SM retired under the T20R could invest in private investment accounts.  This amount is modeled by the expression:

(.5 – M) * BP* (1 – MRR*n) / (1 – MRR)

For example, an O-5 SM retiring under T20R and investing the difference between the two pensions could expect to have more money regardless of RR (as long as it is the same as the TSP) up until year 36.  The BRS only surpasses 36 years after military retirement due to the 20 years of earlier TSP contributions that would finally catch up and make the difference.

While it takes a long time for lifetime compensation for my modeled BRS SMs to surpass the T20R SMs, the benefit of this really seen elsewhere.  Now, every SM, regardless of how long they stay in the DoD, has a retirement benefit. Not only does this help millions of individuals financially, but it also will considerably promote talent management.

Appendix A

appendix2BRS

Appendix B

appendix3BRS

Link to Google Sheets File

Sources

[1] https://budget.house.gov/hbc-publication/364048/

[2] https://www.rand.org/pubs/research_reports/RR1373.html

[3] https://warontherocks.com/2015/03/military-retirement-too-sweet-a-deal

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