Let’s talk about contingency financial planning. I don’t mean life insurance or a medical crisis– I mean how you’ll maintain your financial independence when a leg of your retirement stool is kicked out from under you. Notice that sentence is “when”, not “if”.

I generally ignore the news on military legislation until it’s been signed into law. The evolving situation changes too much among the press releases, the hearings, and the final version of the military pay tables. Normally I’m not even going to attempt to provide blow-by-blow commentary on the process. However, the events of the last couple of weeks are a powerful example of how quickly you can be blindsided by the benefits bus– or even thrown under it.

The Military Officers Association of America and veteran reporter Tom Philpott were among the first to note that the House and Senate budget committees have voted to cut military pensions. “Working-age” military retirees (younger than 62) and current servicemembers who reach retirement eligibility would have their pension’s annual cost-of-living adjustments reduced by one percentage point below the Consumer Price Index.

Before I get into the legislation’s financial details, let me briefly mention how it happened. Congress and DoD are perpetually attempting to reform the military pension. Several committees, commissions, and think tanks have proposed new systems for years. One of the latest Congressional groups (and DoD, and even the White House) stated earlier in 2013 that changes would only apply to new recruits. Servicemembers and retirees would be grandfathered under the current system.

Grandfathering didn’t happen this time. The Congressional budget committees (not the armed services committees!) reached a comprehensive agreement that reportedly resolves a number of sequestration issues and avoids a government shutdown. Any member of Congress who votes against the amendment’s military retirement cuts could be accused of threatening to waste billions of dollars on another government shutdown. There was not even a debate on the pension change, let alone a hearing or any other discussion. The House of Representatives has already passed the amendment. Despite vocal discord in the Senate, the amendment is also expected to pass there as well with no debate or further changes. In other words, the budget compromise is more important than the cuts to military pensions.

The Legislation

Alert reader “Powerplay” at Early-Retirement.org provided a summary of the Bipartisan Budget Act of 2013. Page 3 of that PDF link notes:

This provision modifies the annual cost-of-living adjustment for working-age military retirees by making the adjustments equal to inflation minus one percent. This provision would go into effect in December 2015. At age 62, the retired pay would be adjusted as if the COLA had been the full CPI adjustment in all previous years, and the service members would receive the full COLA from then on. Service members would never see a reduction in benefits from one year to the next and it will save approximately $6 billion over ten years.”

Thanks to my good friend “SamClem” at E-R.org, here’s the text of the amendment to House Resolution 59, the Bipartisan Budget Act of 2013. The military pension text starts on page 53, and Section 403 essentially says:

(4) REDUCED PERCENTAGE FOR RETIRED MEMBERS UNDER AGE 62.—

(A) IN GENERAL.—Effective on December 1 of each year, the retired pay of each member and former member under 62 years of age entitled to that pay shall be adjusted in accordance with this paragraph …

(B) CPI MINUS ONE.—If the percent determined under paragraph (2) is greater than 1 percent, the Secretary shall increase the retired pay of each member and former member by the difference between

(i) the percent determined under paragraph (2); and

(ii) 1 percent.

(C) NO NEGATIVE ADJUSTMENT.—If the percent determined under paragraph (2) is equal to or less than 1 percent, the Secretary shall not increase the retired pay of members and former members under this paragraph.

(D) REVISED ADJUSTMENT UPON REACHING AGE 62.—

When a member or former member whose retired pay has been subject to adjustment under this paragraph becomes 62 years of age, the Secretary of Defense shall recompute the retired pay of the member or former member, to be effective on the date of the next adjustment of retired pay under this subsection, so as to be the amount equal to the amount of retired pay to which the member or former member would be entitled on that date if increases in the retired pay of the member or former member had been computed as provided in paragraph (2) or as specified in section 1410 of this title, as applicable, rather than this paragraph.

…

EFFECTIVE DATE.—The amendments made by subsections (a) and (b) shall take effect on December 1, 2015.”

If there’s any good news here, it’s that military retirees receiving a disability pension are covered by a different section of federal law, so this change does not apply to them.

Other good news is that implementation of the latest COLA reduction is delayed by nearly two years. The Senate Armed Services Committee is already planning to review this legislation. MOAA and over two dozen other military advocacy organizations are campaigning against the Senate vote and will continue to pursue corrective legislation. 2014 is also an election year, so our elected representatives might even pay attention.

You’re Being REDUXed!

For you veterans who’ve been around for a while, this proposal bears a suspicious resemblance to the last major overhaul to military pensions. REDUX was enacted in 1986 but by 1999 was declared a miserable failure that was killing retention. The High Three “classic” pension system was restored and REDUX was offered as an alternative that almost no servicemember ever chooses. Even with a $30,000 bonus and a five-year head start on a High-Three pension, DoD’s own math shows that REDUX costs a military retiree nearly $100K by the time they reach age 62.

How badly does Congress’ 1% CPI lag affect a military retiree? MOAA says “The cuts will have a devastating and long-lasting impact. By age 62, retirees who serve a 20-year career would lose nearly 20 percent of their retired pay. An E-7 retiring at age 40 today would experience a loss of $83,000 in purchasing power – an O-5 would lose $124,000.”

Several groups have come up with different numbers. However, Kate Horrell at Paycheck Chronicles (who’s also a military spouse) did her own analysis of the claims made by different organizations and came up with results comparable to MOAA.

Let’s take a real-life look at what would have happened to another retiree: me. When I retired in 2002 my pension (O-4>20 “Final Pay”) was $2655/month. In a couple of weeks, my 2014 pension deposit will be $3507/month. In just under 12 years, both the Consumer Price Index and my pension have risen by 32.1%. When I apply “CPI-1” instead of the full COLA, my 2014 pension amount only rises to $3180 for a 12-year gain of just 19.79%. More importantly, my total pension received over that 12 years dropped by over $25,000. Compounded in an equity fund at just 3% over inflation, I would have lost nearly $30K over less than 12 years.

Extending that lag out over another nine years to my 62nd birthday costs even more. Assuming that the CPI stays at 1.6%/year for a decade (Ha!) would raise my full-COLA pension by over 52% between 2002-2023. If the COLA is “CPI-1” for 21 years then that raise drops to only 26%. The compounded losses have risen to just over $100K. Looks a lot like the REDUX math of the earlier example, doesn’t it?

Sure, at age 62 my pension would be boosted to the amount it would have been with 20 years of full COLA. But in the meantime, I would have permanently lost $100K.

I know how I feel about that change. Imagine how you’d feel if you had 15 years of service and expected to stick around until 20. Imagine what you’d do if you were halfway through your first enlistment contract and the retention team dropped by to discuss your re-enlistment.

What You Can Do

Let’s get back to my point in the first paragraph: how can you plan for financial independence when the rules keep changing in the middle of the plan?!?

My first suggestion would be to take a good hard look at the Consumer Price Index and compare it to your own personal inflation rate. Your expenses will change considerably over the years (especially if you’re raising a family) but the national rate of inflation will probably not apply directly to you.

In fact, when you stop working for a paycheck and start living your own life, you’ll find many ways to avoid inflation. You’ll use home energy more efficiently, you’ll drive less, and you’ll shop for bargains. You’ll buy less clothing and you’ll spend less on maintaining a wardrobe. You’ll travel when airfares are on sale, and you’ll live like a local instead of in a resort. You’ll handle your own home/yard maintenance (or eliminate it with a condo) and you might even do your own repairs.

Even if Congress decides that your military pension COLA will be “CPI-1” and you lose $100K from your planning, I think it’s still reasonable to assume that your own personal inflation rate will resemble “CPI-1” as well. You may not need the $100K. That’s my personal experience, and other retirees have reported similar anecdotes.

Next, take a look at your financial independence calculations with inflation rates of both CPI and “CPI-1”. If you can reach your goals with either number then your planning is robust enough to handle a nasty surprise or two.

That’s the real lesson that we can learn from this latest example of political risk. When you’re striving for financial independence, you can’t predict the future. You have to build enough contingency planning into your spreadsheet to enable you to shake off a nasty surprise. If your retirement can be derailed by a single point of failure like this one, then your retirement plans was already too fragile to survive.

The best action you can take to fend off these unpleasant surprises is to keep tweaking your plans. If your retirement forecast can survive the loss of $100K over two decades, then you should be fine.

Note: this is a military personal-finance blog, not a political polemic. Please stay classy in the comments or they’ll be moderated.

Related articles:

Over a decade later, REDUX still sucks

The military drawdown and benefits cuts

Effect of inflation on a dollar

Military pension inflation protection

Effect of inflation on a REDUX military pension

From the 2011 archives: Changing military pensions

and Military retirement: the latest overhaul