How Are Government Retirement Annuities Calculated?
Retirement is a common topic of conversation among government employees. Old-timers talk about what they will do in a few years once they are no longer working. Newer workers fantasize about that far off day when they will be the ones boasting about their impending exits.
While all public servants should keep the three-legged stool of government retirement in mind, the primary source of retirement funding for most public servants is the annuity provided by their retirement systems. The calculation of the annuity payment greatly impacts both when an employee can afford to retire and what sort of lifestyle that employee will live in retirement.
Few people can afford to retire on their retirement eligibility dates. It means employees typically work beyond their retirement eligibility dates and base their actual retirement dates on the amount of their monthly annuity payments.
Two Variables and One Constant
In most government retirement systems, two variables determine how much an employee's annuity will be: the employee's salary and the employee's years of service. While age is a factor in determining retirement eligibility, it is rarely used when determining annuity payment amounts.
Retirement systems need one salary number to plug into their formulas for determining employees retirement annuity. They use the salary an employee earns in their few highest earning years. Most systems use between three and five years in this calculation. They average the salaries to get the single salary number.
For instance, a retirement system calculates an employee's salary on that employee's three highest earning years. An employee earns $61,000, $62,000, and $66,000 in his three highest earning years. These three numbers are averaged to determine the employee's salary as it relates to a retirement annuity. For the purpose of calculating this employee's retirement annuity, the employee's salary is $63,000:
($61,000 + $62,000 + $66,000) / 3 = $63,000
Years of service are easier to determine than the single salary number. This number is simply the amount of time an employee contributes to the retirement system. Each pay period an employee contributes to the retirement system earns the employee service credit equal to the amount of time in the pay period.
There is one other factor in the annuity payment calculation. It is a percentage applied that in essence tells how much of the calculated salary amount shows up in the annuity for each year of service. That is a long and perhaps confusing explanation, but it makes sense in an example.
Using the $63,000 salary in our example above, let's say the employee has 30 years of service in the retirement system. Let's also say that for each year of service and employee receives 2.0% of the salary number. Here is the calculation expressed as a mathematical formula:
Salary X Years X Percentage = Annuity
Here is our example applied to the formula:
$63,000 X 30 X 2.0% = $37,800
This employee was accustomed to earning around $63,000 per year, but now, this employee receives a government income significantly less. The $37,800 is paid in monthly installments of $3,150. Hopefully, the employee has enough retirement savings and Social Security income to compensate for the reduction.
Now, let's say the same employee works 40 years instead of retiring after 30. Here is the new calculation:
$63,000 X 40 X 2.0% = $50,400
By delaying retirement for 10 years, the employee in this example increases his retirement income by $12,600 per year. It translates to an extra $1,050 per month; however, the employee contributes money to the retirement system for 10 more years while forgoing any annuity payment for those 10 years.
Retirement annuities are fixed income streams. Barring unusual circumstances, the annuity amount an employee is entitled to at retirement is the annuity the employee keeps for life. Annuities can increase with cost-of-living adjustments.
Retirement systems grant COLAs in one of two ways. The first way is for the system to grant automatic COLAs based on objective data such as the Consumer Price Index for a predetermined date. The other way is for the retirement system’s governing board or overseeing legislative body to grant a COLA by vote. When COLAs are subject to politics, proposals are usually based on objective data but can be amended through the legislative process.