Federal employees covered by the Federal Employees Retirement System rely on three subsystems to provide continuing income in retirement: a life annuity, Social Security and the Thrift Savings Plan. Participation in the annuity and Social Security subsystems is automatic, and benefits you will receive are calculated according to predetermined formulas — and you can estimate what your benefits will be. TSP participation is voluntary, yet it has the largest potential benefit of the three if used to its fullest capacity.

The TSP is a defined contribution, or savings, plan made up of contributions from both the employee and the employer. Effective in 2006, employee contributions will be limited only to a flat dollar amount and no longer will be limited to a set percentage of basic pay. In 2006, employees will be allowed to defer up to $15,000 of their basic pay, pretax, to the plan. Employees age 50 and older will be allowed to make an additional so-called catch-up contribution of up to $5,000 for the year. In addition, employees will automatically receive an employer contribution equal to 1 percent of basic pay. The government will also
match employee contributions, dollar for dollar, against the first 3 percent of basic pay, and will match 50 cents on the dollar for the next 2 percent. That’s a total of 5 percent of basic pay in employer contributions for employees who contribute at least 5 percent themselves.

This brings us to the first rule of TSP participation for FERS participants: Whenever possible, contribute at least 5 percent of your basic pay to the TSP through payroll deduction. Your contributions and the 1 percent automatic employer contribution are yours to keep from the time they are deposited, and the employer matching contributions are yours after three years of employment.

It is important to recognize how important the TSP is to your retirement income stream. First, the TSP is portable in the event that you change, suspend or terminate employment later. Your vested account balance can be withdrawn or transferred to another retirement account and retained until needed. The TSP is the federal counterpart to the 401(k) plan, the cornerstone of many private-sector retirement plans. Moving into the private sector without a substantial defined contribution plan balance might force you to take a big step backward along the road to retirement.

Second, the TSP has the potential to generate the lion’s share of your income in retirement. Take, for example, a FERS-covered employee who begins employment in 2006 at age 32 earning $50,000 per year. If she works to age 62 and retires, her Social Security retirement income benefit might be about $18,000, in today’s dollars, and her FERS annuity might be about $17,000 per year. But, if she contributes 15 percent of her pay to the TSP each year and earns 5 percent per year on her investments, after inflation, she could have nearly $700,000 in her account after 30 years, which could translate into another $28,000 per year in retirement income, if managed properly. In this case, the TSP will be responsible for providing more than 44 percent of retirement income, without taking advantage of the maximum deferral limits or catch-up contributions. While this is a simplified example, it demonstrates the significance of TSP participation in providing for retirement.

While participation in the TSP is a critical part of retirement income planning for every FERS-covered employee, its benefit increases as salary rises. This is because the percentage of preretirement income replaced by Social Security benefits in retirement falls as preretirement income rises. At lower income levels, say below $30,000 per year, Social Security can replace more than 40 percent of preretirement income, but for retirees who earned more than Social Security’s maximum wage base — currently $90,000 — the replacement rate can be below 20 percent. Since the federal annuity — and its income replacement rate — increases an essentially fixed amount as income goes up, the burden of maintaining a given overall income replacement rate in retirement falls on the TSP.

It is also important to remember that much of the guidance that is published in the popular media is based on a target income replacement rate in retirement of 60 percent — that is, it assumes that you are happy to cut your income by 40 percent in retirement. In my experience, many people realize, as they approach retirement, that they’d prefer to live on 80 percent to 100 percent of their preretirement income. For those retiring under FERS, the TSP, particularly with its new, more liberal contribution limits, will make this possible.

Written by Mike Miles
For the Federal Times
Publication December 10, 2005