More on Purchasing Service Credit

I’ve written before about purchasing service credit, but I wanted to dive in a bit more here. Note that the following is specific to Colorado PERA and uses Littleton Public Schools’ 2021-22 salary schedule for reference. Having said that, the same logic will generally apply to almost all pension systems, although the details will be very different.

Before you can decide whether it’s a good idea to purchase service credit or not, you first have to determine whether you can purchase service credit. There are two requirements for purchasing service credit from Colorado PERA: one based on your membership date and one based on your employment before you started with a PERA-covered employer (or, conceivably, if you left PERA employment, worked somewhere else, then returned, the service cannot be concurrent with your PERA service).

Download the Purchasing Service Credit brochure for all the details, but:

PERA Membership Date

1. 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 in any combination (defined below).
   
2. 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.

Non-PERA-Covered Employment

1. Qualified employment: 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).
   
   The most common scenario for this is teaching in a public school in another state. It’s important to realize that you can only purchase these years with PERA if you are not eligible to receive a benefit from that other state’s pension plan. So, for example, if you were vested in Iowa’s pension plan (IPERS) and left your money in it, you would be eligible for a benefit and therefore could not use those years to qualify to purchase credit with PERA. If, however, you withdraw your contributions, then you could.
   
2. Nonqualified employment: 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.)
   
   The most common scenario for this is any Social Security covered employment you may have had before becoming a member of PERA.

For any month of employment you wish to purchase, you must have earned 80 times the minimum wage that was in effect at that time (the equivalent of working 80 hours at minimum wage during that month). PERA will combine months where you are short of that to give you as many months as possible. People generally use their Social Security earnings statement as documentation.

Cost to Purchase Service Credit

PERA has calculators on their website where you can estimate the cost to purchase service credit at any given time (you’ll have to login to your account first). They will figure the exact amount when you submit a service purchase application (which you can do at any time with no commitment). Here is a table where you can see the approximate cost based on your age and Highest Average Salary (HAS).

So, for example. If you are in the PERA Benefit Structure (most people) and are age 30 (not most people :-), your cost is 16.81% of HAS if you were hired on or before 12/31/2006 and 15.37% of HAS if you were hired on or after 1/1/2007 (the difference is due to the different cost-of-living adjustments in retirement for folks hired before and after that date).

So, if your HAS is $50,000 (just to use a round number that it’s possible you are making at age 30), it would cost $8,405 to purchase one year of service credit if hired on or before 12/31/2006, or $7,685 if hired on or after 1/1/2007. If you were purchasing three years, multiply that by three to find the total cost. If you were purchasing three years, eight months, multiply by 3.667 to find the total cost. You can see from the table that the percentage of HAS continues to increase until around age 52, then slowly decreases. Also keep in mind that your HAS is (hopefully) increasing over time, so it’s a higher percentage of a higher number.

If you’re wondering why that is, it’s simply math. Or, perhaps not so simply, the calculations that PERA’s actuary does behind the scenes to calculate how much money it would take to pay for your ultimate benefit from PERA. This involves complicated assumptions including (among others): PERA’s rate of return on investments, your future salary increases (which also involves the assumed rate of inflation), how long you will continue to work for your PERA-covered employer, and your life expectancy. If all of these assumptions were exactly correct (which they won’t be), then on the day you die PERA will have paid out an amount based on the additional service years you purchased that is exactly the amount you gave them to purchase the years increased by their investment returns. This is not a “free lunch”, this is a “pay for what you are expected to get.”

Buying Early in Your Career or Later?

There is a common misconception that it is “better” and “cheaper” to purchase years earlier in your PERA career rather than later. This arises because it is indeed cheaper (in nominal dollar amounts) to purchase years earlier in your career rather than later, because it’s a lower percentage of HAS (at least up to about age 52) and because your HAS is (typically) lower earlier in your career. But the key word there is “nominal”. Money doesn’t exist in a vacuum; there is a time value to money. Money you use to purchase years with PERA at age 30 could’ve instead been invested and grown to a lot more by the time you might choose to then use it to purchase years with PERA later. Let’s try a specific (very made up but directionally accurate) example.

Using the example from above, where a 30 year old teacher with an HAS of $50,000 hired before 12/31/2006 wants to purchase one year. The cost of that one year is $8,405.

Now fast forward 20 years. This teacher is now 50 years old, and their HAS is now $133,000 (assuming advancement on the salary schedule and increased by a 2% yearly cost-of-living increase to the salary schedule itself). At age 50 it would cost 32.33% of $133,000 which is $42,999. Which is where the sticker shock comes in, “That’s way more than $8,405!”

But you also have to look at what would’ve happened to the $8,405 if you hadn’t purchased years at age thirty. It would’ve grown to $56,544 (assuming a 10% return on investment each year, the long-term historical average for the U.S. stock market). (In other words, it would’ve grown to more than the cost of that same year of service meaning, in real terms, it would’ve been cheaper to wait.) As you can see, while it might look “cheaper” now, it may not actually turn out that way. And there’s no way to tell, because we don’t know what the markets are going to return, how our salary schedules might increase, or how PERA’s actuarial assumptions might change over time (they frequently do).

Having said all that, my bias is that if you decide that purchasing service credit is a good idea for you, then it’s almost always best to do it as soon as you can, because of that very uncertainty about the future. So, if you’re thirty and can come up with the money, then definitely go ahead and do it. But that’s not the same thing as saying that the cost for that same person twenty years later when they are fifty is somehow “outrageous”. It’s not, and in fact may be the “cheaper” option in real terms. Since we don’t know, and because I think purchasing years is a good idea for most people (go back to this post for more on why), it makes sense to do it as soon as you are able to in order to lock in your increased pension benefit and shift all the risk off of yourself and onto the State of Colorado.