Federal Pensions: Thrift Savings Plan Has Key Role in Retirement Benefits
Released: 1995-11-20T00:00:00

Letter

Background

In 1986, the Congress replaced CSRS with FERS for federal employees hired beginning January 1, 1984, in part to (1) recognize the inclusion of federal employees under Social Security and (2) reduce federal pension costs. Among the concerns of congressional deliberators in crafting FERS were that its retirement benefits be comparable with those under CSRS and enable employees to maintain their standard of living in retirement. To accomplish these and other goals, FERS provides a retirement benefit that comprises three components: a basic FERS annuity, Social Security payments, and TSP payments. The total income from these sources is meant to help individuals to receive retirement benefits comparable with CSRS benefits and commensurate with their retirement income goals.

The basic FERS annuity is similar to CSRS in that it guarantees a specific monthly retirement benefit based on age, length of creditable service, and the average of the highest 3 consecutive years’ salaries. However, the FERS annuity is lower because its benefit formula credits each year of service generally at 1 percent while CSRS service credits range from 1.5 to 2 percent per year of service. In addition, cost-of-living adjustments authorized by FERS are lower and generally are not provided before age 62.

Unlike the FERS basic annuity, the benefit provided under Social Security’s benefit formula declines as a proportion of individuals’ preretirement earnings as their earnings increase. For example, a person aged 62, with a certain lifetime earnings pattern and earnings of $20,000 in his or her final year of employment, would receive Social Security benefits that represent about 35 percent of those earnings. In contrast, a person aged 62, with a certain lifetime earnings pattern and earnings of $75,000 in his or her final year of employment, would receive a benefit that represents just about 17 percent of those earnings.

Pension professionals believe that to maintain roughly the same living standard in retirement, individuals’ income needs generally range from 60 to 80 percent of their preretirement annual pretax earnings. Among other things, retirees typically pay less taxes, do not have work-related expenses such as daily commuting costs and clothing needs, may no longer have dependent children, and may have their mortgages paid.

TSP is administered by the Federal Retirement Thrift Investment Board, which is an independent agency. The Board consists of five part-time members who are appointed by the President. TSP’s daily activities are carried out by a staff headed by an executive director selected by the Board. Retirement benefits from TSP are the flexible component of FERS because they depend on the amount that is in each employee’s account at retirement. Thus, TSP can help FERS-covered employees to save toward a total retirement benefit that is commensurate with their retirement income goals.

Employees under FERS are automatically enrolled in TSP because federal agencies are required to contribute an amount equal to 1 percent of their employees’ salaries to the plan. In addition, employees can make voluntary contributions up to 10 percent of their salaries: agencies match the first 3 percent on a dollar-for-dollar basis and the next 2 percent at 50 cents to a dollar, for a 5 percent total agency contribution; additional employee contributions are not matched, but all contributions and earnings thereon are tax deferred. CSRS employees may also participate in TSP by contributing up to 5 percent of their salaries; while there is no agency match, the contributions and earnings are tax deferred. However, all employee contributions are limited to a statutory inflation-adjusted cap, which was $8,994 in 1993.

TSP contributions can be invested in a federal government securities fund (G fund), a commercial bond fund (F fund), and a commercial large capitalization stock fund (C fund). The C and F funds are passively managed index funds that track changes in a certain body of securities in the stock and bond markets. These investment options were specified in TSP’s statute, which also provided for adding investment options, via amendments, at the request of TSP’s Board. In addition, TSP’s law restricted the amounts that could be invested in the C and F funds through 1990.With the lifting of the restriction in 1991, employees have increased their contributions to the C and F funds. For example, in January 1991 about 5 percent and 2 percent of contributions were going into the C and F funds, respectively, while in August 1994 the comparable rates were 35 percent and 10 percent. In January 1995, TSP contributions and earnings were invested as shown in table 1.

TSP’s three funds have had different average annual rates of return since 1987. The C fund has averaged 12.5 percent, a higher return than the F and G funds’ average earnings of about 8.0 percent each over the 7 years of plan experience. The C and F funds also have been more volatile than the G fund as shown in figure 1.

Figure 1 shows that a $1,000 investment in the C fund on January 1, 1987, would grow to $2,452 over the following 7 years based on actual annual rates of return. Similarly, $1,000 investments in the F and G funds would grow to $1,836 and $1,868, respectively, over the same period. The higher returns available from the C fund also connote the somewhat higher risks inherent in a stock portfolio. Thus, the retirement income TSP ultimately provides a participant will depend on how much the individual has contributed and on the rates of return earned on those contributions. Since returns and risks are related, the ability to diversify investments among stocks and bonds is an important factor for participants in a program such as TSP because it allows them to tailor their investment portfolios to reflect the level of risk they are willing to assume.

Extent to Which FERS-Covered Employees Contribute to TSP

The proportion of FERS-covered employees contributing to TSP has steadily increased. For example, in September 1987 some 219,000 FERS-covered employees (about 38 percent) were making voluntary contributions to TSP; whereas, in September 1994 about 942,000 (76 percent) were doing so. However, the degree of voluntary participation in TSP has varied considerably among salary ranges as shown in table 2.

Most of the 300,000 (24 percent) FERS-covered employees who did not make any voluntary contributions were lower-paid workers. Historically, such employees have been less likely to make voluntary contributions than have employees in the middle and higher salary ranges. However, as the table shows, the lower salary ranges have shown the greater increase over time in the percentage of individuals who make contributions.

Salary Deferral Rates Have Increased, but Lower-Wage Employees’ Rates Remain Lower Than Others

Overall, in 1993 FERS-covered employees making voluntary contributions were deferring an average of 5.7 percent of their salaries compared with 3.7 percent in 1987. The deferral rates varied from 4.4 percent of their salaries for low-wage employees to 7.2 percent for the highest-wage employees as table 3 shows.

Also, as with the percentage of employees making contributions, deferral rates vary among salary groups. The deferral rate among employees in the lower salary range has also increased the least compared with the rates of the other employees since 1987—about 27 percent compared with over 50 percent for all but the highest salary range. The 41-percent increase in the highest salary range may be partly due to the statutory inflation-adjusted cap on annual contributions, which was $8,994 for 1993.

TSP Contributions Needed to Reach Target Retirement Replacement Rates

Our analysis showed a disparity in the extent to which higher- and lower-paid employees under FERS may need to contribute to TSP to achieve total FERS retirement benefits that would be commensurate with their preretirement standard of living. In general, lower-paid workers may achieve retirement income goals, or total benefits that are in the range of 60 to 80 percent of final annual earnings, with minimal TSP deferral rates, while higher-paid workers need to defer at correspondingly higher rates.

A July 1986 Congressional Research Service report included illustrative comparisons of the replacement rates under FERS and CSRS for various retirement assumptions and TSP benefits from (1) just the mandatory agency 1-percent contribution and (2) employee voluntary contributions of 5 percent. In our analysis, we updated the Congressional Research Service’s illustration for employees retiring after 30 years of service at age 62. Our analysis showed that such employees with earnings in the lower salary ranges might achieve a level of FERS benefits that would be within 60 to 80 percent of final annual earnings with just their agencies’ mandatory 1-percent contribution but that employees in the higher salary ranges would not. However, using conservative assumptions of TSP returns of 6.1 percent, contributions of 5 percent throughout their careers would also provide higher-paid employees with an overall FERS replacement rate within this range as shown in table 4.

Again, the disparity in the total replacement rates largely results from the varying level of benefits that Social Security provides to individuals in different earnings brackets. As table 4 shows, the Social Security replacement rate is just 14 percent for an employee aged 62 with final pretax wages of $100,000 but over twice as high (35 percent) for someone with final wages of $20,000.

Furthermore, table 4 shows that a 5-percent deferral provides a total FERS replacement rate for higher-paid workers that is in the lower end of the range that pension professionals believe is needed (that is, the 64 and 68 percent shown in table 4). These lower replacement rates may not reflect such individuals’ retirement income goals and, consequently, these employees would need to contribute more than 5 percent to TSP to achieve a higher level of total FERS benefits.

In general, the lower TSP’s investment earnings are the more an individual would need to contribute in order to reach a certain total FERS replacement rate goal; conversely, higher TSP returns would provide individuals with a higher retirement income than they projected as their goal at a given deferral rate. For example, using TSP’s actual average rate of return of 8.95 percent for the period 1988 to 1994 produces TSP replacement rates that are about 50 percent higher than those shown in table 4.

Effect of Preretirement Contributions Not Explained in TSP Educational Materials

The TSP Board produces and provides to federal agencies a variety of educational materials for their employees. Among other things, these leaflets, pamphlets, and brochures emphasize the monetary benefits of TSP, such as the advantages of tax deferral, the effects of compounding, and the higher returns possible from beginning to make contributions early in one’s career. In addition, these materials inform employees about the pros and cons, including potential risks, of investing in each of TSP’s three funds and the earnings history of each fund.

However, TSP’s educational materials are not explicit in discussing the importance of employee TSP contributions in achieving total FERS retirement benefits that would be commensurate with preretirement living standards, that is, benefits in the range of 60 to 80 percent of earnings. For example, the materials do not include illustrative examples of FERS replacement rates at varying TSP deferral rates and their effect on total FERS benefits. Private sector plans have such examples in their educational materials. Were TSP’s Board to revise its materials to include that type of example, it would need to do so in collaboration with the federal Office of Personnel Management (OPM), which has some responsibility for overall FERS education, including establishing training programs for agency retirement counselors.

TSP Board to Seek Two Additional Investment Options

In May 1995, TSP’s Board decided to seek legislation that would add two investment options: an indexed domestic small capitalization equity fund and an indexed international equity fund. The Board selected these funds because they add diversity and provide the opportunity for greater returns than the current options though at somewhat increased risk. Adding the two funds would make TSP’s number of investment options and mix more like those provided under private sector section 401(k) plans.

TSP’s Board began looking into the possibility of increasing the number of investment options in 1992 after the statutory restrictions on C and F fund investments expired. Among other things, the Board reviewed the investment options generally available under section 401(k) plans and the returns and risks associated with them. On average, most private sector section 401(k) plans offer four or more investment options that include a number of bond and stock funds of varying risk.

The Board’s actions to broaden TSP’s investment options are consistent with pension professionals’ beliefs that employees should have a variety of investment options encompassing a range of risks and returns to provide the opportunity for higher earnings that would increase their retirement nest eggs. The new options would allow TSP participants to diversify their investments. The new funds would complement the C fund, which has historically outperformed the G and F funds by an average of about 4.5 percentage points since 1987. Proposed legislation to add the options was introduced in the Senate on July 27, 1995, and in the House of Representatives on September 12, 1995.

Conclusions

TSP was designed to provide one source of retirement income for FERS-covered employees. However, unlike the two other FERS components whose benefits are determined by formula and are constant for individuals with the same work histories, TSP’s benefits will vary according to the amounts that employees have contributed and the investment returns on those contributions. Because of the effects of Social Security’s benefit formula, higher-paid workers will be more dependent on TSP income than lower-paid workers in maintaining their standard of living in retirement. TSP’s educational materials, however, are not explicit in making this distinction. These materials should explain and provide examples of contribution rates and their relationship to preretirement earnings and potential retirement income.

TSP was also designed to be a retirement savings vehicle for federal employees that is similar to section 401(k) plans for workers in the private sector. The addition of the indexed domestic small capitalization equity and indexed international equity funds will provide federal employees the same opportunity that those in the private sector have for tailoring their investment portfolios to reflect the returns they seek and the risks they are willing to undertake.

Recommendation to the Congress

We recommend that to help ensure that TSP participants have investment opportunities similar to those available under comparable private sector plans, the Congress enact legislation adding the two investment options sought by TSP’s Board.

Recommendation to the Board

We recommend that the Board, in collaboration with OPM, include in TSP’s educational materials (1) an explanation of TSP’s pivotal role in enabling employees under FERS to achieve their retirement income goals and (2) explicit illustrations of the effects of TSP deferral rates on total FERS benefits.

Agency Comments and Our Evaluation

The Federal Retirement Thrift Investment Board provided written comments on a draft of this report (see app. II). The Board disagreed with our recommendation that TSP’s educational materials include an explanation of TSP’s role in FERS and explicit examples of the effect of TSP deferral rates on total FERS benefits. The Board stated that such actions by TSP would constitute employee education about FERS, which is an OPM responsibility under the FERS statute. The Board noted that its educational materials are replete with illustrations that show the dramatic effect of contributions and investment earnings on the size of an employee’s TSP account. However, the Board added that the materials do not analyze or explain the impact that employee TSP accounts will have on total FERS retirement income because FERS legislation gave that responsibility to OPM. Also, the Board provided some technical comments that we incorporated in the report as appropriate.

While OPM has some responsibility for FERS education, such as establishing training programs for agency retirement counselors, we do not agree that authority to educate employees on the effects of TSP investments on their total FERS benefits is vested exclusively in OPM. We continue to believe that the Board is in a better position to develop educational materials that include explicit examples of TSP’s potential effects on FERS retirement income. Such examples would demonstrate TSP’s pivotal role in the context of FERS, particularly given the effect of Social Security’s benefit formula. For example, an OPM booklet on FERS includes examples of replacement rates for four individuals retiring at various ages, with differing work histories of federal and nonfederal service, and with TSP deferral rates of 3 and 5 percent. However, while the examples are helpful in showing the increased benefits derived from contributions at 5 percent compared with 3 percent, they are not explicit in demonstrating TSP’s significance in overall FERS benefits at retirement.

Without its FERS context, we believe the value of TSP’s educational materials to the individual employee is greatly diminished. Furthermore, TSP is the appropriate source for such information because it periodically contacts all employees who participate in the plan—including those not making any voluntary contributions. Accordingly, we believe that TSP should prepare such educational materials. OPM officials stated that the Board could do so in collaboration with OPM.

As arranged with your office, unless you publicly announce the contents of this report earlier, we plan no further distribution until 5 days after its issue date. At that time, we will send copies of this report to other congressional committees and members with an interest in this matter and to others upon request.

Our review was performed under the direction of Donald C. Snyder, Assistant Director. Other contributors were Endel P. Kaseoru, Evaluator-in-Charge, and evaluators Carolina M. Morgan and Gregory Curtis. If you or your staff have any questions about this report, please call me on (202) 512-7215 or Mr. Snyder on (202) 512-7204.

Methodology Used to Calculate FERS Replacement Rates

We calculated illustrative FERS replacement rates for each of the program’s three components—the basic FERS annuity, Social Security benefits, and TSP—for employees retiring with 30 years of service at age 62, the average federal retirement age in 1994 for regular retirements. To make our calculations, we simulated the salary histories of five hypothetical federal employees and estimated the annuities they would receive under certain assumptions. The time frame for our analysis was 1986 through 2015.

To produce the salary histories for our model, we used wage growth rates that are consistent with federal General Schedule salaries. The workers in our model began their federal careers in 1986 at entry-level salaries for GS-2, –3, –5, –7, and –9 and retired in January 2016 at age 62 with final annual salaries, as measured in 1995 dollars, of $20,000, $30,000, $45,000, $75,000, and $100,000. We first created an inflation-adjusted earnings history for these workers and then converted it to current year earnings using the actual inflation rates from 1986 to 1995 and 3.4 percent thereafter.

To determine employees’ FERS annuities, we used the basic FERS annuity formula in the law. However, while the formula computes the benefit at 33 percent of the average of the highest 3 consecutive years’ salaries, the replacement rate is less than 33 percent because the estimated wages grow in each of the 3 years prior to retirement; thus, the 3-year average used to calculate the annuity is lower than the final year’s wages. To calculate Social Security benefits, we used the “ANYPIA” software program provided by the Social Security Administration’s Office of the Actuary. In applying this program, we used the alternative I assumptions of future economic activity from the 1994 report of the Board of Trustees of the Federal Old Age and Survivors Insurance and Disability Insurance Trust Funds. The alternative I assumptions are conservative, and thus they produced replacement rates that were lower by 1 to 5 percentage points than the rates produced by alternatives II and III.

To calculate the TSP replacement rates, we estimated the balance in the individuals’ accounts at retirement based on employee and agency contributions of 5 percent each and the agency-only 1-percent contribution. For our baseline analysis, we assumed that the accounts earned a conservative return of 6.1 percent, the same rate the Congressional Research Service used in its analysis. We also calculated replacement rates using a weighted average of actual TSP returns from 1988 to 1994 of 8.95 percent. This higher annual rate of return produced TSP replacement rates that were about 50 percent higher for each salary level. We then calculated an annuity for each account balance using a worksheet in TSP’s annuities booklet. We assumed an increasing single life annuity at 6-percent interest, the rate used in TSP’s worksheet. The replacement rates we computed, shown in table 4, vary by final year wage because each had a different growth rate over the 30 years we modeled. We also tested different rates of wage growth, returns on TSP, and the FERS annuity and found the results were consistent across the five final salaries we modeled.

Comments From the Federal Retirement Thrift Investment Board

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