Time to Buy! Buy! Buy! (Service Credit)

Many pension plans allow members to purchase service credit. This may be counterintuitive for some folks, but many plans allow you to “buy” years where you didn’t work under the pension system and then treat those years as if you had. This typically both increases your ultimate pension benefit and often can allow you to retire earlier than if you didn’t purchase. The policies around purchasing service can vary dramatically from pension system to pension system, and the details matter. The rest of this post will focus on purchasing years with Colorado PERA (partially because that applies to most of my readers), but many of the considerations (pro and con) are the same across pension plans (even if the details are different).

When and how many years you can purchase with Colorado PERA depends both on your membership date and the details of your outside work experience (you have to have work experience outside of – and not concurrent to – your PERA-covered employment in order to purchase service credit). If your membership date is before January 1, 1999, you must have one year of earned service credit and then you are eligible to purchase up to 10 years of combined qualified or nonqualified employment (defined below). If your membership date is after January 1, 1999, you must have one year of earned service credit to purchase qualified employment and five years of earned service credit to purchase nonqualified employment, and you can purchase up to five years of nonqualified employment and up to ten years total.

See PERA’s website for more information, and particularly download publication 5-52 (pdf).

Qualified employment is any U.S. employment where the employer is set up under federal, state, or local government, as well as public and private K-12 school employment, and employment with public employee organizations, such as CAPE, CEA, etc, including time with a PERA-covered employer where you were considered an exempt employee (for example, working part-time at a state university in Colorado while going to school). This can include teaching in another state (although you cannot be eligible for a benefit from that other state’s pension plan if you are going to buy these years with PERA).

Nonqualified employment is all employment which does not fit into qualified employment and basically includes any non-PERA covered employment in the private sector or in a foreign country. (This is simplified a bit, so check out the brochure or contact PERA to clarify if necessary.) Typically, if employment was covered by Social Security (and was not concurrent with PERA employment), then it is considered nonqualified employment.

Purchasing service credit is often not cheap, as the cost to purchase service credit is the actuarial cost of providing the future benefit resulting from the purchase and is calculated using your current Highest Average Salary (HAS), your current age, and your PERA membership start date. Having said that, this is often a great option for many educators, especially early in their career when their HAS is not very high (assuming, of course, that you have the money to make the purchase).

For many people, the ideal way to purchase these years is with pre-tax money, from your 401k/403b/457/IRA plan. You can, however, use post-tax money (any savings or investments you have). If you use post-tax money, the portion of your benefit that you end up receiving that is from this part of your purchase will be post-tax, so will not be subject to taxes when you receive it.

The decision around purchasing service credit is complicated and varies tremendously, but basically the tradeoff you are making is trading a lump-sum of money now (that you could possibly invest and make a lot of money with over time) for a guaranteed increased monthly income for life. For many people, that is a great tradeoff to make (especially if you choose PERA Retirement Option 2 or 3, so it’s increased income for life for the combined life expectancy of you and your co-beneficiary). Also keep in mind the benefit of possibly retiring earlier and you can increase your PERACare subsidy if you would normally have been retiring with less than 20 years of service.

Despite the title of this post, the decision to purchase service credit is a very individual one, and for some folks it might not be the right decision. But I’d like to share two reasons why I think it might be the right decision for many of you, and particularly why right now is a great time to purchase service credit.

The first reason is the behavioral aspect of this. Yes, if you do the math, it’s very possible that if you invest the money in an all-equity portfolio instead of using it to purchase service credit, there is a decent chance you will come out “ahead” compared to the increased monthly benefit you would get from purchasing service credit. But, psychologically, for many people it is much harder to actually spend the money in their investment portfolio as compared to the monthly benefit check they get from PERA. For many folks, they have spent many years saving and investing and building up their nest egg and then, suddenly, they have to decide how much they are comfortable withdrawing from their investments and spending on something.

You may think that’s not you, that you have no trouble spending money. That may be the case, but it’s different in retirement because you no longer have an earned income in the future to plan on. And even the most free-spending people have “what if” concerns, particularly around future medical and long-term care expenses, that often make them hesitant to spend down that nest egg too quickly. No one wants to outlive their money.

On the other hand, the check you get in retirement from PERA each month (as well as your spouse’s check from their retirement plan or social security), is something that you can count on coming this month, and next month, and the next…for the rest of your life. It is much, much, much easier to feel comfortable spending an extra $300 per month (just as an example) because you know it will be “replenished” the very next month with another additional $300, and again the next month, and that will go on until your death. (And, with PERA, if you take Option 2 or 3, it will go on until the death of the second one of you.)

Whereas if you have $50,000 in a retirement account (again, just as an example amount), you have to decide how much you are comfortable withdrawing and spending from that account, knowing that once you spend it down, it will be gone. This often results in folks not spending from that account because they are worried they might “need it in the future.” Again, personal finance is “personal”, so this varies tremendously based on your individual financial situation, your tolerance for financial risk, and other factors.

The second reason I think purchasing service credit might be the right choice for you is specific to this particular point in time (the end of 2021). If you’ve been teaching for at least a little while, you have hopefully also been saving and investing in your 401k/403b/457/IRA. As you might be aware, the last decade or so of investment returns have been exceptional. Using the Vanguard Total Stock Market Index as our proxy, returns over the last 10 years have been 15.95% annualized (or an astounding 339% cumulative gain, meaning you more than quadrupled your money in the last decade). While no one knows for sure what investment returns will be like in the next ten years, based on historical returns it is very unlikely to see such high returns for an entire decade (and we’re likely to see some “mean reversion”, which could mean not only lower returns, but lower than “average” returns).

So, if you choose to use some of your investments to purchase years, what you are effectively doing is locking in your gains and shifting the risk to the pension plan (in PERA’s case, that’s shifting it to the state of Colorado). By selling now, you’re guaranteed the gains you’ve earned over the last decade and remove the risk that the upcoming decade’s investment returns might be below average (or, like the 2000’s, be somewhat of a “lost decade”).

Once you’ve purchased years with PERA, your defined benefit is guaranteed by the state of Colorado. Built into your cost to purchase service credit are a variety of factors, including demographic factors like life expectancy, economic factors like employment and wage growth, and market factors like investment returns. Because all of those are in the future, they are projected factors and reality won’t necessarily match up to the projection. For example, PERA currently assumes a 7.25% annualized return over the next 30 years. While they have handily beaten that lately, there is certainly no guarantees going forward. In some respects, you are “locking in” 7.25% returns on the money you use to purchase that service credit. And, no matter whether the projections are accurate or not, your benefit is guaranteed for as long as you live – you no longer bear any of the risk.

So, while the title of this post is to “buy, buy, buy” service credit, half the reason to do it now is actually related to “sell, sell, sell” some of your investments to purchase that service credit, thereby locking in the gains of the last decade and shifting the future risk to the state of Colorado.

PERA counselors are very helpful at not only helping you figure out how many years you can purchase and what the cost would be, but at helping you evaluate the pros and cons of purchasing. The great thing about PERA is that they are not trying to sell you anything, they get paid for giving good service, so their advice is not compromised by financial incentives to sell you something. I think everyone should at least explore purchasing service credit and get the details, even if you end up deciding not to purchase.

You can actually apply to purchase service credit online. People typically use their Social Security statement as documentation of work experience; be sure to only indicate months/years on your application that you were not covered by PERA. You are not committing to anything, this will just allow PERA to calculate how many years you are eligible to purchase and what the cost will be to you. Once they send the agreement back to you, you can choose to purchase the number of years you indicated, or purchase more (up to the maximum you’re eligible for) or less (or even none at all). So if you think you are at all interested, go ahead and fill it out. It never hurts to have the information, even if you decide not to go ahead with a purchase.

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