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So what happened to the FERS surplus?

News stories from Bloomberg and the Hill report that the postal service’s surplus in its FERS retirement fund, estimated last year at $10.9 billion, had shrunk to just $2.6 billion:

John Berry, the director of the Office of Personnel Management, said that the surplus in the Federal Employees Retirement Service had shrunk to $2.6 billion in 2012, down from almost $11 billion last year.

Berry told Postmaster General Patrick Donahoe, in a letter obtained by The Hill, that a drop in long-term interest rates was the main cause for the decline in the surplus.

Read more: OPM: USPS projected pension surplus shrank – The Hill’s On The Money.

That news has, understandably, caused postal workers to ask what’s going on. One commenter asked “Please explain to me how USPS goes from a $12 billion FERS surplus to a $2.6 billion when the interest rate drops .50 percent? Something’s screwy here.” Another wrote “I think this says that someone’s playing games with the money.”

What’s actually happening isn’t really all that mysterious. The Office of Personnel Management, which oversees the federal pension program, has to make estimates of how much money it will need to fulfill future employee retirement payments. There are a number of factors involved- how much employees will earn while they’re working, how long they’ll live after they retire, etc. The OPM letter mentioned in The Hill’s story deals with another of these factors: how much interest will OPM earn on the retirement funds it has already collected?

Based on the assumption that it could get an average interest rate of 5.75% on its funds over the long term, OPM had estimated that the USPS had $10.9 billion more in its FERS fund than would be required to meet future pension obligations. Given that interest rates have stayed far below that level since the start of the recession, OPM revised its estimates slightly, forecasting average long term rate of 5.25%. Based on that small decrease in interest rates, the so-called “surplus” dropped to $2.6 billion. No money changed hands- it was simply a recalculation of the future value of the FERS fund based on a lower interest rate.

It’s the same calculation that many employees inside and outside of government have been making in recent years as the rates of return on TSP or 401K accounts have slowed, or even gone negative. Here’s an oversimplified example: suppose you invest $1,000 in an account that promises you 5.75% interest compounded and paid annually- the same rate OPM used originally. After 25 years, your original $1,000 will have grown to $4,045. Now reduce the interest rate to 5.25%, OPM’s new rate estimate. At that rate, the value of your investment grows to just $3,593 after 25 years. So a half percent drop in interest results in an 11% drop in the future value of your investment.

If you need to have $4,045 at the end of 25 years, the lower rate of interest means you’ll need to start with more than $1,000- $1,125 to be exact. Once again, no money has changed hands- all that has changed is the estimated rate of return- and yet your fund now has a $125 “deficit”. This scenario is analogous what OPM has to plan for- a defined benefit. If your TSP doesn’t performed well, you might put off retiring for a while. If OPM’s funds don’t perform as expected, it can’t delay or reduce your pension- instead it has to find the money somewhere else.

If there’s a bright side to the story, it’s that OPM’s estimates are far more conservative than the numbers being used by some state and local governments. According to the National Association of State Retirement Administrators, the average state retirement plan assumes a 7.8% rate of return. While that is actually less than the actual average return of 8.3% over the last 25 years, few analysts think it’s realistic given current economic conditions. In addition, few if any of those jurisdictions have anything like the $44 billion trust fund the USPS has built up under PAEA to pay for future retiree benefits.

So the bottom line is that there’s nothing particularly mysterious or sinister in the sudden shrinkage of the FERS surplus. It’s just a reminder that when there’s this much money at stake, a small change in your assumptions can make a big change in your outcome.

Update: Some people don’t believe the numbers- feel free to check my math in the followup:

More on the FERS surplus: do the math!