In this post we’re going to take a look at Option 1 & 2 of SB1040 (known as Senate Bill 1040), a piece of legislation passed here in Michigan which forces all state school employees to change their retirement pension plans by selecting from one of three options. If you’re just now joining us, you may want to read my SB1040 Introduction post first.
SB1040 Option 1 – Recap:
To summarize SB1040 Option 1, we keep the same pension plan, but pay a higher contribution level each paycheck. Right now, the pension is based on a multiplier of 1.5% given by this equation:
[Final Average Compensation from Last 3 Years] x 1.5% x [Years of Service] = Annual Pension Payment
Selecting this option would keep this the same. But it would mean paying a flat 7% of your gross salary into the pension plan (called the Member Investment Plan or MIP) as opposed to what you pay now.
• Our current MIP payment percentage: 3.6%
• 15 years of credit earned, 2 more years of purchased credit to earn, and 13 more physical years to go until 30 years of total credit are earned. My wife’s current age is 35.
• Estimated Final Average Compensation (from MEA website): $72,936.43.
1. MIP Deduction:
First things first, if you choose this option, the main thing that changes is the fact that your MIP contribution per paycheck will go up from what you’re paying now (3.6% for my wife) to 7%. Given our gross pay and current MIP deduction:
• Old: $2,466.58 x 3.6% x26 pays = $2,308.80
• New: $2,466.58 x 7.0% x 26 pays = $4,489.18
• That’s a difference of $2,180.38 in extra payments per year!
Suppose from now until retirement (13 years), we could either stash that $2,180.38 difference in money in a savings account or invest it in stock market index fund returning an annualized rate of 8% per year. The results of each would be:
• Savings Account: $2,180.38 in 13 years at 0% = $28,344.88
• Investment Account: $2,180.38 in 13 years at 8% = $46,867.82
2) 3% Healthcare Deduction:
Since we want health care at retirement, we will continue paying the same 3% we always have. Therefore, the net change will be $0.
3) 401k Balance:
With this option, you will not have the option to start a 401k plan. Therefore, your 401k balance will be $0.
4) Pension to be Earned:
Using the equation above, we can easily calculate what our pension income will be. Estimating a Final Average Compensation of $72,936.43 and 30 years of retirement service, we have:
$72,936.43 x 1.5% x 30 = $32,821.39 of income per year
Note that the plan offers a 3% increase per year for inflation.
5) Health Care Responsibility:
With this option, you’ll be covered for health care benefits at retirement. With a 20% responsibility and an estimated cost of $500 per month, our out of pocket contribution would be:
• $500 x 20% x 12 months = $1,200
SB1040 Option 1 – Summary:
To summarize the results of SB1040 Option 1 (and ignoring the effects of inflation for simplicity), we’d be starting off retirement as follows:
• Lost either $28,344.88 in savings or $46,867.82 in investing due to the difference in increase in MIP contributions.
• Gained $0 on the 3% retiree health care fund since we made no changes.
• Gained $0 in 401k benefit since this Option doesn’t give us a 401k.
• Commit to receiving $32,821.39 each year in pension benefits (with inflation adjustments) for the rest of our lives.
• Commit to paying an estimated $1,200 each year for health care benefits for the rest of our lives (or until Medicare).
This plan clearly keeps most of the things about your retirement pension plan the same. But it also involves paying just over $2,000 more each year. Could you live without that extra $2,000 each year? Unfortunately, we also have no guarantees that future legislation changes won’t seek to change our pension amounts again!
SB1040 Option 2:
This option is basically the same thing as Option 1 except that once you hit 30 years of credit, your contribution amounts drop back down to what you’re paying now (from 7% to 3.6% for us) and the credits you earn beyond 30 get multiplied by 1.25% using the same formula above:
[$72,936.43 x 1.5% x 30 years] +
[$72,936.43 x 1.25% x number of years beyond 30]
= New pension income amount per year
Since your MIP contribution would just go back to what you used to pay, then the difference in payment would be $0. Therefore, you wouldn’t be adding anything to the amount of money you would have lost.
I will not spend much time going through the math for this one since we do not plan to work beyond 30 years. But I will run a hypothetical calculation at the very end of this series just to illustrate the small difference.
In the next few chapters, we’ll look at how these factors affect the other options.
Image Credit: Microsoft Clip Art