Base Cost-of-Living Adjustments for Federal Civilian and Military Pensions and Veterans' Benefits on an Alternative Measure of Inflation

In 2010, the federal government paid $69 billion in pension benefits to 2.5 million civilian retirees and their survivors, as well as $51 billion to 2.2 million military retirees and their survivors. The government also paid $43 billion in compensation to 3.5 million disabled veterans and their survivors and $4 billion in pension benefits to about 500,000 veterans and their survivors. All of those benefits are linked to the CPI-W (the consumer price index for urban wage earners and clerical workers), but the extent of inflation protection varies from one program to the next, as does the age at which benefits are payable.

Pensions paid under the Civil Service Retirement System (CSRS) are subject to annual cost-of-living adjustments (COLAs) that provide complete protection against increases in the CPI-W. Pensions paid under the newer Federal Employees Retirement System (FERS) are fully protected only when that increase is less than 2 percent per year. If the percentage increase in the CPI-W is between 2 percent and 3 percent, FERS annuitants receive a COLA of 2 percent; if the increase exceeds 3 percent, the COLA is the percentage increase in the CPI-W minus 1 percentage point. Unless they retire on disability, FERS annuitants receive COLAs only at ages 62 and above, whereas all CSRS annuitants receive COLAs. CSRS and FERS participants generally can begin to receive pension benefits at age 60 with 20 years of service or at age 62 with 5 years of service. Participants with 30 years of service are eligible to receive benefits even if they retire before the age of 60.

Pensions for military personnel hired before August 1, 1986, garner COLAs that provide complete protection against increases in the CPI-W. People who entered service after that date have a choice: They may elect to stay under the old system and receive a full COLA, or they can accept a $30,000 bonus after 15 years of service and receive reduced annual COLAs that equal the percentage increase in the CPI-W less 1 percentage point. Those who choose the latter arrangement receive an increase in their pension at age 62, restoring the annuity to what it would have been had the full COLA been paid. After age 62, retirees again receive the reduced COLA (but from a higher base because of the increase at age 62). Most military personnel have declined the 15-year bonus and retained eligibility for the full COLA. Active-duty military personnel are eligible to receive pension benefits after completing 20 years of service, regardless of age; reservists are not eligible for retirement annuities until they reach age 60; and personnel with fewer than 20 years of service generally are not eligible for any benefits unless they retire on disability.

Full COLAs are attached to veterans' disability compensation and pensions. Disability compensation is paid to veterans with certified disabilities, in amounts that depend on the severity of the disability. Veterans also are eligible for means-tested pensions.

This option would replace the CPI-W with the chained CPI-U (the chained consumer price index for all urban consumers) as the index by which federal civilian, military, and veterans' benefits are adjusted for inflation. The Congressional Budget Office estimates that, on average, the chained CPI-U will grow 0.25 percentage points per year more slowly than the CPI-W over the next 10 years. Under this option, annual COLAs would equal the increase in the chained CPI-U for CSRS annuitants, military retirees, and veterans. Comparable adjustments would be made for FERS annuitants when the increase in the chained CPI-U was less than 2 percent a year. FERS annuitants would receive a COLA of 2 percent when the increase in the chained CPI-U was between 2 percent and 3 percent and a COLA 1 percentage point below the increase in the chained CPI-U when that increase exceeded 3 percent. Military retirees who chose the $30,000 bonus under the new system would receive a reduced COLA equal to the percentage growth in the chained CPI-U minus 1 percentage point.

The chained CPI-U is initially published as a preliminary value and then revised over the following two years. As a result, implementing this option would require the use of preliminary data. CBO discussed the details of the approach in a Web-only technical appendix released with its February 2010 issue brief, Using a Different Measure of Inflation for Indexing Federal Programs and the Tax Code.

CBO estimates that those changes would decrease mandatory outlays by about $6 billion between 2012 and 2016 and by $24 billion from 2012 through 2021. On average, a CSRS annuitant would receive about $3,900 less over 10 years than under current law; a FERS annuitant would receive about $1,000 less. The average military retiree would receive roughly $3,000 less over 10 years relative to current law, veterans' disability compensation would be about $1,500 less, and veterans' pensions would be about $1,200 less. (Using the chained CPI-U for all federal benefit programs that are indexed for inflation, including Social Security, would reduce outlays by about $36 billion through 2016 and by about $145 billion through 2021.)

A rationale for this option is that the CPI-W overstates increases in the cost of living, so using the chained CPI-U would reduce federal outlays while still ensuring that benefits do not fall relative to the cost of living after a recipient becomes eligible for those benefits. The CPI-W measures inflation on the basis of price changes for a fixed basket of goods that is periodically updated. The chained CPI-U provides a more accurate measure of changes in the cost of living by more quickly capturing the extent to which households adjust their consumption when relative prices change. Another argument in favor of this option is that federal pension plans would still offer more protection against inflation than most private pension plans do.

According to a 2001 survey, fewer than 15 percent of private-sector plans gave annuitants formal annual COLAs, and another 25 percent made ad hoc cost-ofliving adjustments.

An argument against reducing the COLA is that the prices faced by annuitants could rise faster than the prices faced by the population at large. In particular, annuitants are likely to spend more than younger people do for medical care, the price of which generally grows faster than the prices of many other goods and services. An experimental price index for goods and services purchased by the elderly (the CPI-E) grew an average of 0.27 percentage points per year faster than the CPI-W from 1982 to 2010. Thus, the benefits received by retirees may decline over time in real terms under current law, and using the chained CPI-U would accentuate that decline. CSRS annuitants would be particularly affected because they are most dependent on their pensions: CSRS annuitants typically receive larger pensions than FERS annuitants do, but CSRS annuitants did not receive the matching contributions to their Thrift Savings Plan accounts for which FERS annuitants were eligible. Moreover, CSRS annuitants may have declined to switch to FERS because they believed that they would always have the protection against inflation offered by the current COLA rules. Also, because military personnel can retire earlier and receive immediate pensions after just 20 years of service, their lower COLAs would have larger effects over longer periods. Finally, because current and prospective employees would be expected to analyze retirement benefits when comparing alternative wage and benefit packages, reducing federal retirement benefits could hamper the government's ability to recruit and retain a highly qualified workforce.