By Mike Miles
March 4th, 2013 | Uncategorized
A sudden reduction in your earnings from something like a furlough can be frightening. Some of this fear is justified. Earning less can mean immediate changes in lifestyle for many who are making just enough to meet spending needs.
But some of the fear might be unnecessary — based on a lack of understanding. A 20 percent reduction in income, as has been discussed in response to the threat of sequestration, might wipe out the ability to contribute to the Thrift Savings Plan for more than a few employees. Even those who could maintain their standard of living, or at least adjust to accommodate the reduction without creating a hardship, might be afraid of the downstream implications of failing to make their TSP contributions.
To shed light on this risk and help relieve some anxiety — or, at least, to make sure any anxiety is justified — I conducted some testing on hypothetical Federal Employees Retirement System employees with various ages and financial circumstances. The point of this testing was to assess the impact of reduced retirement savings on retirement standard of living, or RSOL.
For employees at early-, mid- and late-career ages, I created and tested a baseline case in which there was no reduction in income or TSP savings contributions related to sequestration. The employees in these baseline cases saved, as planned, like clockwork until retirement. I calculated the maximum RSOL I would be comfortable producing in the real world according to my practice standards. While the details are important to the analysis, it is not essential to go into them here. The important thing for the purpose of this discussion is that the assumptions and standards used in the analyses were reasonable and consistently applied to all of the test cases.
In each case, the baseline RSOL was calculated and recorded. I then retested each case with a reduction to the TSP savings rate over six months during the coming year. The reduction included 10 percent in payroll deferral, 4 percent in agency matching contributions and 1 percent in agency automatic contributions. The test cases dropped that contribution rate to the 1 percent automatic agency contribution only.
Each of the test employees contributed to the TSP until age 67. Once retired, they were assumed to rely solely on Social Security, FERS annuity and TSP savings for retirement income.
What I found was that a 30-year-old employee who lost the ability to contribute to the TSP for six months could expect a reduction in pretax retirement income, including TSP withdrawals, of about 3 percent. If we assume a 30 percent loss of income to taxes, then the reduction in the RSOL, which should be measured in spendable, after-tax income, is closer to 2 percent.
For example, a 30-year-old employee who, in the base case, could plan to live on $100,000 in total retirement income each year for life, before taxes and adjusted for inflation, should adjust that expectation down to $97,000 to account for the impact of six months without TSP contributions. If a 30 percent total tax rate is assumed on income, then the after-tax RSOL becomes $70,000 in the base case and $68,600 with the reduction in TSP contributions.
The RSOL reduction for a 45-year-old employee falls to about 0.7 percent, and for a 60-year-old, the reduction is about 0.35 percent.
While these results show a measurable reduction in the RSOL, as a planner responsible for delivering results, I find them reassuring. Your first line of defense against furlough should be to absorb as much of the financial impact as possible with changes to your current lifestyle — by spending less now. Once that avenue has been exhausted, you can begin reducing your retirement savings contributions without a high likelihood of producing devastating effects. After that, borrowing is the last resort.
Borrowing to maintain your ability to contribute to the TSP doesn’t make sense, since, in the long run, it will probably harm your RSOL more than suspended contributions. It might be necessary, and even beneficial, to borrow to support your current standard of living, but this borrowing is, in effect, equivalent to extending the time you aren’t contributing to the TSP. If the time it takes to resume TSP contributions after a furlough is doubled while loans are repaid, then the eventual reduction in your RSOL also will be doubled — for life.