Reforming the Structure of the Military Compensation System

by Beth J. Asch, Richard Johnson, John T. Warner

Research Brief

Dramatic technological changes are anticipated in the military in the next century. These changes are likely to lead to increased skill-level requirements among military personnel and an increased need for flexibility in managing the career paths of a better trained, more technically skilled military workforce.

RAND was asked by the Department of Defense (DoD) to analyze whether a compensation system that has changed little since the end of World War II can enable the military to efficiently meet its current and future force size, composition, and wartime capability objectives. To attain these objectives, the compensation system must enable the military to attract, retain, and motivate high-quality personnel at a reasonable cost and enable its leaders to flexibly manage service members' careers to meet the military's diversity of skill requirements.

The results of this research effort are presented in several RAND reports performed under the auspices of RAND's National Defense Research InstituteReforming the Military Retirement System, by Beth J. Asch, Richard Johnson, and John T. Warner; A Policy Analysis of Alternative Military Retirement Systems, by Beth J. Asch and John T. Warner; and A Theory of Military Compensation and Personnel Policy, by Beth J. Asch and John T. Warner.

RAND analyzed modifications to the military retirement system, including replacing it with a civilian-like retirement system, such as the Federal Employees Retirement System (FERS), which covers many federal civil service employees. Our analysis shows that if such a civilian-like retirement system were coupled both with separation pay targeted to specific individuals and occupations and with pay raises that increase with rank (a "skewed pay raise"), the DoD would be able to enhance the overall efficiency and quality of the military workforce and better manage and organize the careers of military personnel.

Furthermore, if the new retirement system was specifically patterned after FERS, the changes would be based on a retirement system whose elements are known and proven and would be easier to implement than other proposed compensation reforms. Such a retirement system would be akin to private-sector retirement plans in which participants set aside part of their salaries, choose from alternative investment options, retain benefits when they change careers, and are able to receive full benefits only after they reach a prescribed retirement age, typically 62.

Finally, our analysis shows that under certain circumstances, DoD could save as much as $2 billion a year in 1996 dollars by switching to a FERS-like compensation system.

The Current System is Unique

Military compensation—largely active pay and retirement pay—makes up more than a quarter of annual DoD outlays. In fiscal 1996, DoD compensation outlays totaled about $60 billion, 70 percent of which was basic pay and retirement/separation pay. Since 1984, the DoD has funded retirement pay on an accrual basis, wherein it sets aside money each year to fund payments to its current forces after they retire.

The military retirement system differs from most civilian plans: It allows individuals to immediately collect benefits after 20 years of service, regardless of age. Individuals who begin military service in their late teens or early 20s can retire with immediate lifetime benefits in their late 30s or early 40s. Civilian plans, on the other hand, typically restrict benefits to individuals who have reached a particular age, regardless of their length of service. The military system pays no benefits to members who have served less than 20 years.

Some observers have advocated replacing the military retirement system with a civilian plan that vests participants at age 55 or older. However, switching to a pure civilian-like system without making any other changes to the compensation or personnel systems would significantly reduce the value of the military compensation system to service members. Not only would they have to accept lower take-home pay resulting from contributing to their retirement funds, they also would have to accept a much later full-benefit retirement age. Our analysis shows that such reductions in military compensation would hurt retention and erode the quality and motivation of U.S. military forces. Consequently, we concluded that if DoD moved to such a civilian-like retirement system, it would also need to raise pay to maintain the size and quality of the active personnel force.

Different Types of Pay Raises Lead to Different Results

Using theoretical and empirical models developed at RAND, we evaluated three options for offering a pay raise to active-duty personnel.

The first option, a FERS-like system with an across-the-board percentage pay raise, is not very attractive: It would result in significant drops in the productivity and quality of military personnel. This is because an across-the-board pay raise would flatten the skewness of the military's current compensation structure, which awards individuals higher raises in compensation as they climb in rank.

The second option we studied, a FERS-like system with a skewed pay raise, would enhance the skewness of the current system. It would produce a more-productive and higher-quality military force. But in so doing it would create an active-duty compensation structure that is more lucrative than today's for those in mid and late career. As a result, this option would strengthen the "golden handcuffs" that are created by the current system for mid-career personnel, create new golden handcuffs for senior personnel, and, overall, make it even more difficult for the DoD to manage forces flexibly.

The third option—a FERS-like system coupled with skewed pay raise and separation payments—is the best of the three options that we reviewed. It would not only produce a more-productive and higher-quality military force because of the skewed pay raise but also provide DoD with force management tools it does not possess today. Our theoretical analysis suggests that a key purpose of separation pay is to induce personnel to separate voluntarily at a point before they would otherwise want to leave. Separation payments are needed to solve the golden-handcuff problem, because they have the effect of inducing personnel to separate when it is in DoD's best interest for them to do so. Because the separation payments can be provided earlier in military occupations requiring "youth and vigor" and delayed in skills where there is a bigger payoff to experience, this third option would improve management flexibility.

The third option would also produce measurable cost savings under some circumstances. Assuming a real government discount rate of 2 percent, we estimate that the DoD would save about $2 billion annually in steady-state personnel costs, about 3 percent of current personnel costs. Direct outlays for personnel rise because of the pay raises, but those extra costs are more than offset by reductions in the accrual charge required to fund future retirement liabilities. At higher assumed government discount rates, however, the cost savings diminish.

Change Will Foster Multiple Benefits

A properly designed civilian-like system could have multiple benefits. Compared with the current system, it would be more equitable, because it would allow individuals with less than 20 years of service to receive retirement benefits. It would allow military members to have some choice in how their retirement funds are invested, a trend among private-sector and civil-service retirement plans. It would improve the quality and productivity of the armed forces. And by breaking the golden-handcuff hold that the current system has over individuals and the services, it would allow the DoD to more effectively manage its forces. Even though cost savings based on current force management practices are small in percentage terms, long-run savings might be greater as DoD gains experience with use of such a system.

This report is part of the RAND Corporation Research brief series. RAND research briefs present policy-oriented summaries of individual published, peer-reviewed documents or of a body of published work.

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