Military's New Hybrid Retirement Plan a Mixed Bag

U.S. armed forces--get ready to salute the 401(k). The military, which currently has a traditional defined benefit plan, will adopt a new hybrid program next year that blends an existing defined benefit for career personnel with a matching contribution to a 401(k)-style account aimed at covering those who don't make a lifelong career of the military. It's the biggest overhaul in retirement benefits in years--and it's a mix of good and bad news for military personnel.

Unlike the private sector, the legacy defined benefit actually is called a retirement pay system. That's because retired military personnel are classified as inactive ready reserve who can be recalled in case of national emergency. And, retirement pay can be suspended under certain circumstances--for example, if a recipient begins to receive a disability benefit or is convicted of certain crimes.

Retirement pay essentially is a generous defined benefit pension with cost-of-living adjustments, but it has been available only to military personnel who serve at least 20 years. That means it has been available to a relatively small percentage of Americans who serve: 30% of commissioned officers and 8.5% of enlisted personnel, according to Lt. Col. Steven G. Hanson, who oversees compensation and benefit matters for the U.S. Army. Bottom line: just 20% of the entire armed forces have been getting any kind of retirement benefit at all.

Under the new blended system, the value of defined benefit retirement pay will be cut by 20% to make way for matching contributions to service members' defined contribution accounts.

"We feel the change will have a very positive net effect,” Hanson says. “The new system preserves a defined benefit system even though so many private sector companies are ditching it--and we're adding a competitive plan combining defined benefit and defined contribution.”

However, the changes do involve some pain--starting with the haircut to defined benefit retirement pay. But some observers worry that the defined contribution system will face challenges similar to those facing private sector plans--and they question the military's readiness to educate personnel about how to use the new system.

Here are the key changes.

Reduced multiplier for pensions. The old system awarded pensions based on multiplier of 2.5% for each year of service; that will be cut to 2.0%--a reduction of 20% in the pension annuity.

Participation in the Thrift Savings Plan. Military personnel already have access to the federal Thrift Savings Plan, a defined contribution plan which is widely admired for its ultralow cost and simplicity. Under the new plan, the Department of Defense will automatically contribute 1% of basic pay, and will match contributions to a participant's first 3% of contributions dollar for dollar, and 50 cents on the dollar for the participant's next 2%. (Five percent of basic pay is the ceiling on the automatic plus matching contributions).

Continuation pay. The new system will encourage troops who complete 12 years of service to stay an additional four years in order to earn a pay bonus that can be paid out as a lump sum or a series of payments.

Lump sum pensions. Service members in the new system will be offered lump sums at retirement in exchange for a portion of their pension. The service member will be able to take either 25% or 50% of their pension as a lump sum, and the pension will be reduced accordingly. The changes will affect personnel who elect to move to the system and those who enter service starting Jan. 1, 2018.

The reforms aim to spread retirement benefits more equitably, but also save money. The Congressional Budget Office has estimated that the new retirement system will reduce costs by $13.5 billion from fiscal years 2017 to 2025--although that funding likely will be repurposed for other defense needs.

And the plan may change a bit before all is said and done: The Pentagon is seeking changes, requesting that Congress revisit the continuation of pay provision and timing of the matching contribution provisions. The armed services are seeking more flexibility on when the lump sum payments would be made, and for some revisions in the matching contribution formulas.

Changes of this magnitude are bound to generate some pushback, and a survey found that 73% of current military families would prefer to be grandfathered into the old system. The survey was conducted by First Command Financial Services, a financial planning firm specializing in serving military households. At the same time, however, 61% said they are at least somewhat favorable toward the plan for government contributions to a new service member's TSP account.

The best strategies--and outcomes--depend on the individual’s situation, says Scott Spiker, CEO of First Command. "If you have less than 12 years of service and you know you plan to make the military your career, stay in the old plan. If you have less than 12 years and know you'll be getting out, take the new deal and max out the TSP as best you can--at least you'll get a benefit that you wouldn't have had otherwise.”

The shortfalls of the new system, Spiker says, aren't very different from the problems in the private sector defined contribution system--getting people to contribute and save, and making good investment choices. Currently, just 42% of armed forces personnel participate in the TSP, according to a First Command analysis of federal data.

"My fear is that we are leading people down a path with long-term deleterious consequences," Spiker says.

Financial education is another concern. An independent commission that crafted the reform proposals recommended creation of a robust retirement saving literacy initiative to bring service members up to speed on how to get the most out of the new blended system. Currently, all service members go through a mandatory eight-hour general financial readiness training that covers everything from how to buy a home to investing and avoiding credit card scams. The commission had recommended separate funding to beef up the retirement saving education component, but Congress has not allocated funding.

Hanson says the military's general financial literacy effort will be expanded starting early next year to cover the new plan.

"We have a somewhat vulnerable population, so we cover many areas of financial knowledge to help give service members better financial acumen," he says.

But Spiker is unimpressed with the efforts to date.

"The financial literacy efforts in place now are a joke," he says. "The retirement component essentially is an unfunded mandate; it needs to be much more robust."

An annual survey testing financial readiness conducted by the firm points to the need for greater financial training. Military respondents were significantly more likely than their general population peers to say they completed a financial education program (39% versus 21%), but the benefits of those programs were not reflected in test scores. In fact, 63% of military personnel who completed financial education programs failed First Command's financial literacy test, compared with 56% of test-takers who had not received financial education training.

On the plus side: the new system uses the TSP--arguably the nation's best defined contribution system. It features very low costs, a short and easy-to-understand set of investment choices, and options to convert savings into an annuity stream at retirement via a third-party insurance company.

Moreover, if predominantly younger, noncareer military personnel can be convinced to save, that will be a win, since compounding over time will be their friend. So will portability: after their military service ends, veterans can either leave their accounts in the TSP or roll them over to new private sector employers.

Says Hanson: "For people who leave after two, four, or eight years, we now have a more portable benefit."

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work, and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.