Military retirement system structure and benefits

Military Active Duty Retirement

The military retirement system is controversial. For many retired military members, it seems like a great retirement system, but others, mainly Congressional representatives, believe that the system is unduly expensive. Both positions have their merits. On the one hand, the military retirement system is far superior to the retirement compensation packages in most jobs. On the other hand, the retirement system does cost taxpayers a significant amount of money. Perhaps that is why people have begun discussing overhauling the retirement system. If they did, it would not be the first major overhaul of the retirement system. In fact, when looking at the military retirement system it is critical to recognize that there is not a single military retirement system. Instead, there are three distinct retirement systems, and which one applies to a particular service member is determined by when that person served in the military. As such, the military retirement system can seem unduly cumbersome and difficult to understand to outsiders attempting to understand it. This paper will describe each of the three military retirement systems, the Final Pay retirement system, the High Three retirement system, and the Career Status Bonus ReDux system, explain the eligibility requirements for each system, how they operate, and compare their pros and cons.

The biggest perk of the military retirement system is that it is not dependent on a particular retirement age, which is the case in many civilian retirement systems. "The military retirement system is arguably the best retirement deal around. Unlike most retirement plans, the Armed Forces offer a pension, with benefits, that starts the day you retire, no matter how old you are. That means you could start collecting a regular retirement pension as early as 37 years old. What's more, that pension check will grow with a cost of living adjustment each year" (Military.com, 2012). Therefore, military members can, and oftentimes do, retire from the military while working in a second career, thus augmenting their living wage during that period of time.

However, there are downfalls to military retirement pay, as well. "First and foremost, there is no "vesting" in the military retirement system. There is no special retirement accounts, no matching funds provision, no interest" (Powers, 2012). In other words, a service member either qualifies for retirement pay or does not qualify for retirement pay. In order to qualify, a person must honorably serve in the military for over 20 years, with the exception of a few early retirement programs that have been implemented at various points in time to reduce the size of the armed forces (Powers, 2012). Furthermore, it is critical to look at the difference between enlisted and commissioned service members. A person who is a commissioned officer or an enlisted member with prior commissioned service, that service member must have at least 10 years of commissioned service to retire at his or her commissioned rank (Powers, 2012). Commissioned officers with less than 10 years of commissioned service who voluntary retire do so at their enlisted ranks, and only the highest 36 months of active duty enlisted base pay counts for retirement computation (Powers, 2012). Therefore, while a service member can retire at 20 years and receive retirement benefits, the decision when to retire can be based on multiple factors.

An additional difference between civilian retirees and military retirees is that military retirees can be recalled into service. Under the Department of Defense Directive, 1352.1, these 20 plus year retirees can be called to active duty, without their consent, if it is deemed necessary for national security. "In all honesty, however, the chances that a military retiree would be recalled to active duty after age 60, or who have been retired for more than five years, are slim. DOD categorizes retirees into three categories, with category I as the most likely to be recalled to active duty, and category III as the least likely. Individuals over the age of 60 are in category III, which is the same category as individuals with disabilities. Recall of category III retires is extremely unlikely" (Powers, 2012). However, while most military retirees are unlikely to be called back into active duty, it is a possibility, which is directly attached to the receipt of retirement benefits; those who quit the military before reaching 20 years in service are not subject to the same recall conditions.

It is also important to understand the exact specifications for computing time of service for the purposes of determining pension payments. "For all plans, years of service includes credit for each full month of service as one-twelfth of a year. 'Years of service' for officers includes all active service, periods of inactive reserve service prior to June 1, 1958, ROTC active duty time prior to October 13, 1964, constructive service credit for Medical and Dental Corps, and drills performed while in the inactive reserve after May 31, 1958. "Years of service" for Fleet Reservists and all other enlisted retirements include all active service, active duty for training performed after August 9, 1956, any constructive service earned for a minority or short-term enlistment completed prior to December 31,1977, and includes drills performed while in the Active Reserves" (Powers, 2012).

While the members may choose to retire at any age under all three systems, as long as they have served 20 years, there are important differences between the three systems. The most important distinction may be that each system is applicable to a select group of military retirees. What is important to understand is that individual service members do not have a choice between the three different retirement systems. Instead, eligibility for each system is determined by the date that the person entered the service. If a person entered the service prior to 1980, then that person is eligible for the Final Pay retirement system (Military.com, 2012). If a person entered the service between September 9, 1980 and August 1986, that person is eligible for the High 36 system (Military.com, 2012). If a person entered the service after August 1986, that person is eligible under the REDUX system, which means they have the option to choose either the High 36 retirement system or the Career Status Bonus / REDUX (CSB) retirement system, with the High 36 retirement system being the default for people who fail to elect between the two systems (Miltary.com, 2012).

There are similarities between the three retirement systems. For example, under all three retirement systems, if a person stays in the armed forces for 20 or more years, that person is eligible for a pension based on a percentage of basic pay (Military.com, 2012). Likewise, under all three systems, if a person stays in the military for 40 or more years, that person is eligible for a pension based on 100% of basic pay (Military.com, 2012). Therefore, all military retirees get pensions that are figured as a factor of basic pay.

However, basic pay is calculated differently under each of the three systems. There are four major differences between the three retirement systems, which are particularly crucial for those people who joined the military after August 1986 because they have to make elections under their retirement plan benefits. These four major differences are: (1) the basis for determining the individual's highest earnings; (2) the multiplier; (3) the Cost of Living Adjustment; and (4) the Career Status Bonus (Military.com, 2012).

The first important consideration is the determination of base pay. The individual service member has no choice in how his or her basic pay is calculated. Under the Final Pay system, the pension amount is based on a member's last month of pay (Military.com, 2012). In contrast, under the High 36 and CSB/REDUX systems, a member's pension is based on the average of the highest 36 months base pay (Military.com, 2012). Presuming regular raises and promotions during one's military career, which is the norm, and then the Final Pay system will have a higher base pay for the purposes of calculating the pension. All three systems have a bonus for staying in the service past 20 years, which is known as the multiplier (Military.com, 2012).

The second major factor is the multiplier. The multiplier is the percentage of a member's base pay that is received for every year of service. For the Final Pay and High 36 systems, a member earns 2.5% per year of service, with 50% at 20 years and 100% at 40 years of service (Military.com, 2012). In contrast, the multiplier for the CSB/REDUX system changes. It is 2% for the first 20 years, then goes up to 3.5% for the next 20 years (Military.com, 2012). The result is that a service member retiring at 20 years under the CSB/REDUX system will only have earned a 40% pension at 20 years, in contrast to at 50% pension under the other two systems, though they will also be eligible for 100% at 40 years (Military.com, 2012). Moreover, under all three systems, people who choose not to retire at 40 years can actually increase their pension benefits above 100% (Military.com, 2012).

Third, a service member needs to understand the Cost of Living Adjustment (COLA). All three of the retirement systems feature COLAs, which can significantly increase the amount of a service member's pension benefits. "The COLA for the Final Pay and High 36 systems is determined each year by the national Consumer Price Index. But the COLA for the CSB/REDUX retirement system is the Consumer Price Index minus 1%" (Military.com, 2012). However, the COLA is not completely fixed under the CSB/REDUX retiree. "At age 62 the COLAs and multiplier are readjusted so that the High 36 and CSB retirees get the same monthly pay" (Military.com, 2012).

The fourth factor only really applies to the CSB/REDUX retirees. For those retirees, when they reach their 15th years of service, they must choose between taking the CSB/REDUX with a $50,000 cash bonus and a 40% pension check or the High 36 retirement system with no bonus and a 50% PENSION CHECK (Military.com, 2012). The decision is really based on each retiree's projected individual needs and cannot be determined with looking at the individual's personal scenario.

Another interesting scenario is that the different branches of the military have different definitions of retired. For the Navy and the Marine Corps, a member is considered a retired member for classification purposes if the person is an enlisted member with over 30 years service, or a warrant or commissioned officer (Powers, 2012). "Enlisted Navy and Marine Corps members with less than 30 years service are transferred to the Fleet Reserve / Fleet Marine Corps Reserve and their pay is referred to as 'retainer pay'" (Powers, 2012). Then, "when a Navy or Marine Corps member completes 20 years, including time on the retired rolls in receipt of retainer pay, the Fleet reserve status is changed to retired status, and they begin receiving retired pay" (Powers, 2012). "Air Force and Army members with over 20 years service are all classified as retired, and receive retired pay" (Powers, 2012). Therefore, the service branch membership can help determine how someone's retirement is classified. However, it does not actually impact their pay because retired pay and retainer pay are treated the same way under the law (Powers, 2012).

Finally, there are some special circumstances that can impact retirement eligibility or the computation of base pay under any of the three systems. First, some service members may be eligible for disability retirement, which differs from being discharged because of a disability. Disability retirement is something separate and apart from Veteran's Administration (VA) disability benefits. While disability retirement is outside of the scope of this current research, it is important for people to be aware that the presence of a disability might impact a service member's decision to retire, because it can impact the calculation of retirement benefits. Next, a service member's pay will be computed according to the provisions of the Tower Amendment if the Tower Amendment is applicable to that service member's situation (Powers, 2012). "The Tower Amendment was enacted to ensure that [one] will not receive a lesser amount of retired pay than [one] would have received if [one] had retired on a prior date, because of a recent retired pay cost-of-living (COL) adjustment. In the past, there have been times where the retiree COL exceeded the annual military pay raise, which would have resulted in more pay, had the member retired prior to the COL date. The Tower eligibility date is usually the day prior to the effective date of an active duty pay increase (Powers, 2012). Like disability retirement, pension calculations using that fall under the Tower Amendment are outside of the scope of this research, but service members should be aware that the Tower Amendment exists and may be applicable to them.

Final Pay System

The Final Pay system applies to those service members who entered into active duty prior to September 8, 1980 (Powers, 2012). Under the Final Pay system, retired pay amounts are determined by multiplying the service factor or multiplier by the service member's active duty base pay at the time of retirement (Powers, 2012). "To calculate retired pay, multiply years of service by 2.5% (cannot exceed 75%). Multiply the result by your final base pay. Allowances for housing, subsistence or other special pays are not included in any retired pay calculation" (USAA Education Foundation, 2005). "Under this system, members retiring at 20 years receive 50% of their base pay. The amount increases with years of service up to a maximum of 75% of base pay for those retiring at 30 or more years" (USAA Education Foundation, 2005).

The pros of the final pay system are numerous. First, the final pay system is easy to calculate. It simply looks at the service member's final pay. It does not require looking at historic higher pay or penalize those service members who received significant pay increases within three years of their retirement. It allows people to retire at 20 years at 50% of their highest base pay. It makes cost of living adjustments based on the actual consumer price index, which should mean that it keeps the pension payments in line with inflation and other changes in cost of living.

The cons of the final pay system are also numerous. First, while it may be unusual, it is not impossible for a service member of have a lower pay rate at retirement than historically during service, particularly if someone is a former commissioned officer. The final pay system does not allow the person to receive more than 75 of their base pay, so that there is no real incentive to stay in the service for a period greater than 20 years. Moreover, the final pay system does not have the option of a bonus, so that all pension benefits are payable over time. This limits the service member's ability to exercise discretion in personal investments, but also ensures that they cannot squander the money that they get from the bonus.

An example of a final pay scenario is a service member who first entered service prior to September 8, 1980. The service member retired in 2010, with 40 years of service, at a grade of 0-1E at retirement, with a 3.5% inflation rate, a 3.5% annual active duty pay raise, and a 28% tax rate. Initial pension payments would begin at $2,950 per month and by 2049 would be as high as $18,936 per month if the service member were to live for 40 years after retirement. The following charts, reflecting the service member's pay under these conditions, were generated by the Office of the Secretary of Defense, utilizing the Final Pay calculator, though it is labeled as a High-3 Calculator Output.

Before Taxes

After Taxes

Years Out

Year

Monthly Pay

Annual Pay

Cumulative

Annual Pay

Cumulative

1

2010

$4,950

$59,403

$59,403

$42,770

$42,770

10

2019

$6,747

$80,960

$696,876

$58,291

$501,751

20

2029

$9,517

$114,202

$1,679,888

$82,225

$1,209,519

30

2039

$13,424

$161,093

$3,066,524

$115,987

$2,207,897

40

2049

$18,936

$227,237

$5,022,510

$163,611

$3,616,207

(Office of the Secretary of Defense, "Final Pay," 2012)

High-Three System

For service members who entered active duty after September 8, 1980 and prior to August 1, 1986, base pay is not calculated by looking at the final base pay, but by calculating the average of the highest 36 months of active duty base pay received (Powers, 2012). Furthermore, under the high-three system, the initial COLA will be reduced by 1% (Powers, 2012). To calculate base pay, one needs to "Multiply years of service by 2.5%, which equals 50% at 20 years and 75% at 30 years, the same as in the Final Pay System" (USAA Education Foundation, 2005). Once that result is found, one multiplies the "result by the average base pay for the highest 36 months of the member's career, which typically but not always will be the final three years of service" (USAA Education Foundation, 2005).

The pros of the high-three system are similar to the pros of the final pay system. It looks at the highest pay that the service member made, which means that if there has been any decline in pay (which may come with a decline in rank) then the service member would not be punished for having a lower ending pay than beginning pay. The high-three system is easy to calculate. Like the Final Pay system, the High Three system allows people to retire at 20 years at 50% of their highest base pay. It makes cost of living adjustments based on the actual consumer price index.

The cons of the High Three system are also numerous; it does not provide significant incentive to stay in the service more than 20 years. It also does not have the option of a bonus. Moreover, the final pay system does not have the option of a bonus, so that all pension benefits are payable over time. Perhaps the biggest drawback is that it averages pay rather than paying the same base rate as the final paycheck, so that a service member who gets a significant pay increase within three years of retirement will not get the full benefit of that bonus. An additional con is that service members must be officers for 10 years or more in order for officer pay to be considered in that three-year calculation; otherwise, the three years are calculated from the highest 36 months of enlisted pay.

The author will use a similar example for the final pay scenario: a service member who entered service after September 8, 1980. The service member will retire in 2021, with 40 years of service, at a grade of 0-1E at retirement, with a 3.5% inflation rate, a 3.5% annual active duty pay raise, and a 28% tax rate. Initial pension payments would begin at $7,227 per month and by 2061 would be as high as $27,647 per month if the service member were to live for 40 years after retirement. The following charts, reflecting the service member's pay under these conditions, were generated by the Office of the Secretary of Defense, utilizing the High-3 Calculator Output.

Before Taxes

After Taxes

Years Out

Year

Monthly Pay

Annual Pay

Cumulative

Annual Pay

Cumulative

1

2021

$7,227

$86,726

$86,726

$62,443

$62,443

10

2030

$9,850

$118,199

$1,017,418

$85,103

$732,541

20

2040

$13,894

$166,731

$2,452,586

$120,046

$1,765,862

30

2050

$19,599

$235,191

$4,477,032

$169,337

$3,223,463

40

2060

$27,647

$331,759

$7,332,713

$238,867

$5,279,553

(Office of the Secretary of Defense, "High Three," 2012)

Career Status Bonus / ReDux System

Service members who joined the military on or after August 1, 1986 retire under the Career Status Bonus/ReDux system. "These individuals are required to make a decision at the 15-year point of their career. They can elect to participate in the same retirement program above [the High Three system], or they can choose to receive an immediate monetary bonus ($30,000), and elect the "REDUX" system" (Powers, 2012). This system if far more complicated than either of the other two retirement systems, and it is complicated for a reason; the goal of the CSB/ReDux option is to encourage service members to stay in the service for longer periods of time.

The CSB/ReDux option is a "three-phased retirement program designed to encourage members to remain on active duty past 20 years of service. Although it results in reduced retirement pay, it includes a $30,000 Career Status Bonus at the 15th year of active duty" (USAA Education Foundation, 2005). It is important to realize that this system is optional. "At the 15th year of service, these members have two options: take the pre-1986 High-3 Retirement System, [or] receive a one-time lump sum Career Status Bonus and have their retired pay calculated under the new System" (USAA Education Foundation, 2005). Furthermore, "if the member chooses the CSB/REDUX option, two levels of multipliers are used to calculate retired pay: each of the first 20 years of service is worth 2.0% [and] each year from 20 to 30 years of service is worth 3.5%" (USAA Education Foundation, 2005). What is important to keep in mind is that, under the CSB/REDUX option, "the longer the member remains on active duty, the higher the multiple, until retired pay at 30 years equals 75% of base pay, the same as under High-3" (USAA Education Foundation, 2005).

If a service member elects the ReDux system that changes their multiplier. Instead of being determined as it would under the High-Three system, the multiplier is "determined by taking 2 1/2% times your years of service then reduce that factor by 1% point for each year less than 30 years... The "REDUX" ends at age 62 and the individual then begins to receive his/her 'normal' retirement pay (Powers, 2012). There is also an additional downside to taking the ReDux option; "folks who elect "REDUX" will have their annual cost of living allowance reduced by 1%. At age 62, those percentage points are added back to the retired pay, however" (Powers, 2012).

The pros of the CSB/ReDux system are numerous. First, it provides substantial incentives for people to stay in the service past 20 years. It also provides more flexibility for service members, because of the possibility of a bonus, which can be used prior to retirement. This bonus is a significant amount, more than $20,000 in post-tax money, which could be used for all types of life issues that occur prior to old age. Furthermore, though the COLA is lower before 62, at 62 service members are back to the same pay levels as under the other retirement systems.

The biggest con of the CSB/ReDux retirement systems is that it requires service members to elect their retirement program after 15 years of service. If the average service member enters the military at or near the age of 18, then they are being asked to make significant decisions about retirement at the age of 33; they may simply not have enough information about their futures, including their future financial needs, to determine whether they want to choose the High Three or CSB/ReDux retirement system. Another con is that the COLA is lower for people up until the age of 62.

The author will use a different example than the prior two examples. The service member will retire in 2022, with 36 years of service, at a grade of 0-1E at retirement, with a 3.5% inflation rate, a 3.5% annual active duty pay raise, and a 28% tax rate. The person spent all of the money in the bonus for a down-payment on a home at the time of the bonus. Initial pension payments would be a cumulative $59,438 per year and by 2062 would be as high as $168,013 per year if the service member were to live for 40 years after retirement. The following charts, reflecting the service member's pay under these conditions, were generated by the Office of the Secretary of Defense, utilizing the CSB/ReDux Retirement Calculator.