One of the perceived benefits of working in the railroad industry is the access afforded to employees to a Railroad Retirement Annuity. However like most benefits in life it comes with a cost to not only the employee but also the employer. Tier 2 of the Railroad Retirement Annuity is unlike any other pension scheme in that it mandates contributions from the employee and the employer to fund this program. Let’s look further into Tier 2 and understand if the employee is receiving value for these contributions.
Where Does the Money Go?
The railroad employee pays 4.9% of their paycheck into Tier 2 each year. There is maximum contribution limit of $98,700 for 2019, which means every dollar above the limit isn’t subject to Tier 2 tax. The railroad contributes a much larger percentage into Tier 2 for each employee. Railroads contribute 13.1% for each employee and have the same income limit of $98,700. When these funds are collected they are theoretically sent to National Railroad Retirement Investment Trust (NRRIT) for investment. The NRRIT is an independent organization, separate from the federal government. It is run by a board of trustees composed of three members selected by rail labor, three members selected by rail management, and an independent member selected by the other trustees. Unlike Tier 1 and/or Social Security, it invests in multiple asset classes besides and including U.S. Treasuries. For example in 2018, the NRRIT has 58% in Global Equity (US, Non-US, Private Equity), 20% Global Fixed Income(US and non-US), 8% Real Estate, 4% Commodities, 8% Other. The purpose of the NRRIT is to manage and grow the funds they receive from the Tier 2 payments.
How Much Do I Get?
We now know how much is being taken out and where it is being invested. Let’s look at what benefits are received in retirement. At retirement, the retiree will receive a Tier 2 annuity payment. The Tier 2 monthly amount is determined by taking 7/10 of 1% of the employee’s average monthly earnings using the Tier 2 tax base in the 60 months of highest earning years while in the railroad industry. Let’s look at a quick example to demonstrate the math for this monthly payment:
|Employee's Highest 60 Monthly Earnings||$7,750|
|Multiply by 7/10 of 1%||$54.25|
|Years in Railroad Service||30|
|Monthly Tier 2 Benefits||$1,627.50|
Is It a Good Deal?
Now that we know how Tier 2 is calculated, let’s get to the crux of the issue. Is it a good deal after contributing 4.9% of every paycheck for your career? The answer is very simply yes. However, the benefit grows substantially every year that you continue to work. Using the example above the payout to a 30 railroad employee versus a 20 year employee is that the former will receive a Tier 2 benefit that is roughly 55% larger than the 20 year railroad employee. How about if I just invested that money on my own and was given a lump sum at retirement? Let’s assume someone joined the railroad 30 years ago at $40,000 a year and has gotten a 3% raise every year, their final 60 months of employment would average $7,411. Their Tier 2 monthly benefit would be $1,556. Now let’s assume they invested that invested 4.9% of their paycheck instead of it going to Tier 2. Let’s also assume their money had earned a 7% return for 30 years. They would have a nest egg of roughly $230,000 at retirement. If they took that nest egg a purchased an immediate annuity to replicate their Tier 2 benefits, they could expect a monthly income of $1,080 per month. As you can see the Tier 2 benefit is almost a 50% better outcome then investing the 4.9% on your own. It’s not even close.
Some of the other advantages of your Tier 2 annuity are that it compels you to save for retirement by garnishing 4.9% of your paycheck. Additionally it could free the individual up to make additional investment assets into higher return asset classes if your risk profile fits that. One more thing to consider is when you are contemplating leaving the industry for another opportunity; it isn’t an apple to apples comparison regarding salary. You need to look at the intrinsic value of the Tier 2 benefit versus your new compensation structure. You could be leaving significant money on the table by no longer participating in the Tier 2 program.
I hope you found this article helpful. I will in future blog posts discuss the reductions in your Tier 2 for early retirement. If you would like to discuss your retirement planning and how Tier 2 fits into your overall plan please schedule a free 30 minute consultation.
Photo by Luke A. Renish
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. Highball Advisors encourages you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Highball Advisors, and all rights are reserved.