Practical Retirement Readiness

The Cash Flow Transition into Retirement

Stephen Zelcer | Financial Advisor for Federal Employees

When you go from the work into retirement, there’s obviously a financial transition that takes place, but there’s also a mental transition. There’s a mathematical formula that people mentally subscribe to. It goes like this: work equals money. Simple.

And if you subscribe to that formula, then you likely subscribe to the negative version of that formula, which is: no work equals… no money! That version of the formula creates an anxiety as people transition into retirement. And, as we will see below, because of the financial hiccups in getting back into a normal cash flow, the anxieties may feel confirmed! The resulting nervousness may result in a perpetual fear of running out of money which may prevent you from touching, spending and enjoying your investments.

However, if you know what to expect, and brace yourself, you’ll be able to ride out the hiccups without stress, and transition into retirement with confidence.

Here are 7 financial hiccups you will likely encounter right after you retire:

#1 — Your Pension Does Not Start Right Away

Wouldn’t it be nice if your income just seamlessly transitioned — DFAS stops depositing every two weeks, and OPM picks right up? Well, I have news for you. First of all, your pension doesn’t come every two weeks. It comes once a month.

And, second, your pension doesn’t start the month after you retire. It starts the calendar month after you are “deemed” retired. And you’re not deemed retired if you worked a single day in that calendar month. You’ll have to wait a month after that.

For example. Say your last day is August 1. Because you were working on August 1, you’re not deemed retired in August. When are you deemed retired? September. And when does the first pension check start? October. And here’s the kicker — when that October check finally arrives, the amount of that check will only reflect your retirement income for September. What about August? You were separated for almost the entire month of August, but you weren’t “deemed” retired, so no pension. And in August you weren’t working either, so no paycheck. You just lost an entire month of compensation. Don’t do that to yourself.

Planning tip: If you haven’t chosen your retirement date yet, target a date close to the end of the month. It doesn’t literally need to be the last day of the month — but as close as you can get. That’s the ideal.

#2 — The First Retirement Checks Are Wrong (Interim Checks)

Even once your pension check starts, they’re going to be inaccurate. And it’s amazing how this works — they’re always inaccurate in OPM’s favor. Here’s why. Before they can pay you correctly, they have to verify your entire federal career. That verification process is called adjudication.

Until they adjudicate, they shortchange you. They send you interim checks — somewhere between 50% – 80% of your pension. And on top of that, they don’t include the FERS Supplement. So not only are they shortchanging you on the pension, they’re also leaving out the supplement — for as long as it takes them to adjudicate.

Adjudication usually takes about two months… assuming there’s no backlog. But guess what? There’s always a backlog, especially these days. So I tell my clients to expect a minimum of six months where the are being shortchanged.

(And that’s assuming your federal career is easy for OPM to adjudicate. But, if you have any complexity in your career – for examples: you switched from agency to agency, or you switched retirement systems, or you owe a deposit or redposit, or you bought back your military time, or didn’t buy back your military time, or you got divorced – these complexities extend the adjucation process, and that’s where you hear the horror stories of people who need to wait 12 months, 18 months, 24 months until they finally got adjudicated.)

Here’s the good news. When they finally, finally adjudicate, they back-pay you everything they shortchanged (without interest¸ of course).

#3 — FEHB Premiums During Interim Checks

During those interim checks, OPM is not withholding your FEHB premiums. Does that mean you lose your health insurance for the first several months of retirement? Thankfully, no — you keep your coverage even though nobody’s paying for it. But when they finally adjudicate and back-pay you all that shortchanged money, they have to withhold every FEHB premium that should have been coming out along the way. So that back-pay is going to be smaller than the raw math suggests.

#4 — What You Tap to Bridge the Gap

So, when you retire you’ve got a gap (possibly a month) where no pension is coming in, and then months of interim checks that shortchange you. The obvious question is: what are you going to tap into, to make up the shortfall?

Lump-Sum Annual Leave — Smaller Than You Think

You may be relying on your lump-sum annual leave payout. And it’s very realistic to retire with hundreds of hours of annual leave — you might be looking at a lump sum of $20,000, $30,000, $40,000 or more. Sounds great. But there’s a problem: when they pay it out, they withhold an obscene amount of taxes. Obscene. Instead of getting $40,000, you might only see about $24,000. So if you were counting on the annual leave to tide you over while OPM shortchanges you, you might want to check the math.

Your TSP — Accessible, But Not Instantly

So maybe you say, “Fine, Stephen, I’ll just access my TSP.” Good — but there’s a catch. The TSP has you in one of two statuses: employed or separated. And, depending on your status, that’ll determine which forms the TSP allows you to access. To take a withdrawal as a “separated” person, someone has to manually flip your status from employed to separated — and until they do, you won’t even see the separated forms. That status change takes about three, sometimes four weeks. Then you submit the withdrawal form, and processing takes another three weeks. Do the math: that’s six weeks, sometimes seven or eight, before the money reaches you. A little bit ridiculous, actually — but that’s how it works.

So, bottom line: The annual leave might not be enough after that obscene withholding. The TSP takes weeks to access. Which means you may need to have some of your own reserves available to carry you through that interim period.

#5 — Taxes and Withholding in Year One

Did you know your federal pension isn’t fully taxable? There’s a portion that’s not taxable — it’s the money you contributed into the FERS system every pay period. You already paid taxes on those contributions, so you don’t pay them again when that money comes back to you.

You can see how much you’ve contributed to the FERS system on your LES, in box 19 (assuming DFAS runs your payroll) titled “cumulative FERS retirement.”

One caveat on Box 19: It’s only accurate if you’ve been with the same agency your entire career. If you’ve been hopping from agency to agency, Box 19 will only reflect your time at your current agency, so you may need to dig up the rest.

Whatever that amount in Box 19, that’s your FERS contributions which you’ve already paid tax on, so it’s no longer taxable. OPM stretches that non-taxable amount over your life expectancy (OPM has mortality tables for this stuff). If you elect a survivor annuity, OPM will use a joint life expectancy,

Now here’s the cash flow wrinkle, and it’s a good-news-bad-news situation. The bad news: in your first year of retirement, OPM will not tell you how much of your pension is taxable versus non-taxable. On that first-year 1099-R, the taxable box just says “unknown.” Like it’s some great mystery they can’t solve. That’s the bad news. The good news – from year two onward they figure it out for you — but year one is an educated guess. Two things to keep in mind about tax witholding:

• Don’t over-withhold out of fear. Remember that annual leave they taxed so obscenely? You likely overpaid on it. So you actually may not need to withhold as much on your pension in that first year — that overpayment is already sitting there working in your favor.
• TSP’s withholding — and lack-of-withholding. The TSP withholds a mandatory 20% for federal tax. But who says 20% is enough? With your pension and Social Security, you might already be in the 22% bracket, especially if your spouse is still working. And, amazingly, the TSP does not withhold state tax at all. So if you live in a state with income tax, consider telling OPM to over-withhold on the state side of your pension to make up for any TSP withdrawals you may take.

#6 — Sequencing Social Security

The FERS Supplement — the fake Social Security — bridges you until 62. It has an earnings test. Earn too much and they’ll reduce it, and you’ll have to file an earnings report each year declaring what your earnings were. Also, at 62, it disappears, even if you’re not collecting the real Social Security. I actually encourage my clients to take Social Security at age 62, but if you don’t want to do that, you will want to think through your income while delaying Social Security.

For all its shortcomings, Social Security actually got the application process right. They have an automated system; they’re not working out of a cave like some other agencies we know (ehem, OPM). And you can apply up to six months in advance, and they’ll have your correct checks to you within three to four weeks — no adjudication limbo.

#7 — Build Your Conservative Bucket

If you’re going to be relying on your investments in retirement, you really need to set up what I call the conservative bucket. The function of this conservative bucket is to buy you time in case the market crashes.

Here’s what I do with my clients. I forecast how much investment income my clients will need in their first 10 years of investment reliance. For example: say you’ll need $20,000 a year of investment income. 10 years of $20,000 is $200,000. I place this $200,000 very conservatively (think G fund). This way, if the market crashes, they will have enough money in their conservative bucket to allow 10 years for the market to recover.

Let’s illustrate how this looks in real life: I have clients who retired in January of 2020. Two months later – COVID. The market dropped about 33% in a six-week stretch — and these people had just retired. Now imagine being forced to sell stocks into that decline to support yourself. That would be a disaster. But my clients didn’t have to. Their stock side went down, sure, but their conservative bucket stayed stable. So they simply drew from the conservative bucket and gave their stocks time to recover. And that time is critical: historically, the market usually recovers. Sometimes in a few months, sometimes in a few years. In almost all cases, the market recovered within three years. I set aside 10 years.

When should you have this 10-year conservative bucket in place? Well, if you’re already relying on your investments, you want that conservative bucket secured now. I don’t like waiting for the last minute. I use a gradual 5-year transition. This 5-year transition starts five years before you start relying on your investments, which is not the same thing as 5 years from retirement: For example – you may retire while your spouse is still working, and in that case you may not need to touch your investments at all yet. The 5-year transition starts five years before you start relying on your investments.

Having these buckets in place will help provide you with stable income whether the market goes up or down.

TSP’s Pro-Rata Problem: Having the conservative bucket isn’t enough — you also need to be able to draw from it selectively. Bad news: the TSP won’t let you choose. Request a withdrawal and it pulls pro-rata across all your funds, selling your stocks even when the market is down. The workaround is to move money into an IRA, holding your stock fund and bond fund separately — just keep enough in the TSP to bridge you before 59½.

Bringing It All Together

So, if you really want to be ready for retirement, remember there are two transitions. The mental one is letting go of the “work equals pay” mentality and letting OPM, Social Security, and your own investments to now do the work for you. The financial one is planning your cash flow around the bumps: the pension that starts a month later than you expected, the interim checks that shortchange you for months, the FEHB premiums that come due out of your back-pay, the first-year tax guesswork, and the reserves and conservative bucket you need to have in place before you ever draw a dollar.

None of these bumps is alarming once you know to expect it. The people who stress are the ones caught off guard. If you’d like help mapping this out for your own situation, that’s exactly what my team and I do.

This material is educational and general in nature and is not individualized financial, tax, or legal advice. Your circumstances are unique — please consult before acting.

Stephen Zelcer — Financial Advisor for Federal Employees