DoD Reforms Don’t Go Far Enough

Ordered to reduce spending by $487 billion over the next decade, the Defense Department responded with a 2013 budget proposal that would lower end strength, kill acquisition programs and adjust force postures. Yet the most telling sign of the budget strictures is the department’s willingness to undertake reforms on one of the most controversial and costly programs: military compensation.

Pay and benefits account for roughly one-third of the defense budget, and its share is growing, crowding out other elements such as shipbuilding, training and maintenance. If DoD could reform compensation, it could better meter the impact of austere budgets, reduce strategic risk and avoid additional hard decisions in future budgets. So the department is seeking congressional approval for a series of self-described “modest” reforms to pay and benefits — an issue that Congress has long treated as an untouchable third rail. While it appears that department leaders weathered recent congressional budget hearings, opponents continue to mobilize support in Congress to avoid these reforms, leaving the outcome far from certain.

What is certain is that DoD did not go far enough. Even if Congress supports all of the requested reforms in the 2013 budget, which is doubtful, Michael O’Hanlon at the Brookings Institution believes they would account for just one-ninth of required savings over the next decade.

This article advocates a more robust, but not radical, series of reforms that could save almost one-fourth of the required amount and better control future costs without compromising the effectiveness of the human capital strategy or violating the nation’s commitment to the all-volunteer force. These reforms target each component of compensation: cash, noncash and deferred benefits. And they would do more than save money: They would begin to transform a military compensation system that has remained doggedly unchanged for decades, and is today replete with structural, equity and flexibility problems.

Cash Compensation

Of the three components of overall compensation costs, cash compensation accounts for the largest portion; within this component, basic pay accounts for 60 percent of costs. Each year, DoD requests changes to basic pay (that is, raises) in the budget process. It regularly implements across-the-board changes to base pay rather than targeted adjustments. By law, annual pay raises are tied to the Bureau of Labor Statistics’ Employment Cost Index (ECI). But in recent years, Congress has often authorized pay raises that exceed the ECI, repeatedly dismissing the department’s lower requested adjustment. Between 2000 and 2011, Congress enacted pay raises beyond the statutory rates in all but two years.

While service members welcome the increased pay raises, Congress does not typically appropriate additional money to fund them. This forces the department to draw the money from other areas of its budget. For example, Congress authorized a pay raise for 2011 that was 0.5 percent higher than the ECI. According to the Congressional Budget Office (CBO), this boosted 2011 compensation costs by $350 million, and by almost $2 billion over four years. This kind of crowding-out inexorably reduces procurement and operations and maintenance accounts. The second- and third-order effects of these increased pay raises, such as the compounding effect on future-year costs and the cost of retirement pay — which grows every time base pay is adjusted — are even less understood.

These pay raises have eliminated the pay gap between military and civilians that was originally touted in the 1990s. Today, quite the opposite is true. Based on analyses conducted over the past decade, military compensation has been found to be largely commensurate with civilian pay regardless of the methodology employed. In fact, as of 2011, DoD found that military cash compensation exceeded the 75th percentile of comparable civilians, well in excess of the self-imposed goal of the 70th percentile. Taken alone this statistic is compelling. However, when placed in the context of the structure of military compensation, it becomes even more so. In 2004, the Government Accountability Office (GAO) found that cash compensation comprised only half of overall military compensation, compared with 82 percent for private industry and 67 percent for federal civilians. Therefore, if noncash and deferred benefits are included, military compensation compares even more favorably. While these kinds of comparisons should not be the ultimate arbiter of military pay because of their inherent limitations, they must at least be considered in the discussion.

To slow the growth of cash compensation costs, future pay raises must be controlled. In the current plan, DoD supports the control of pay raises but will not implement any reform until 2015, effectively postponing any potential savings. The delay fails to capitalize on the prevailing austere budget conditions and by delaying action for two years reduces the likelihood of any reform.

An alternative approach that would save $17 billion over the next decade is to index all raises, beginning in 2013, to the ECI minus 0.5 percent. This would slow the rate of growth of military pay and allow cash compensation to return to the 70th percentile goal over time but still provide an annual pay raise to the force, albeit below the rate of inflation. Service members would continue to receive adequate cash compensation and the department would ease some internal budgetary tensions.

Noncash and Deferred Benefits

Cash compensation is not where the real problem lies. Most compensation is delivered in noncash and deferred benefits via more than 25 programs that include educational benefits, family housing and barracks, health care, retirement pay and more. Several of these programs are growing at unsustainable rates, and three — health care, installation-based services and retirement — warrant detailed discussion.

Military service members, retirees and dependents have access to one of the most generous and accomplished health care systems in the nation. In general, active-duty service members and mobilized reserve-component members continue to receive medical care at no cost. Their dependents receive low-cost care with limited exceptions when covered under the most popular plan: Tricare Prime. Retirees under 65 and their dependents receive care through a choice of plans at costs well below those found in the civilian sector. Retirees over 65 and their dependents can enroll in Tricare for Life (TFL) at no charge to supplement Medicare coverage. Additionally, all Tricare beneficiaries also retain access to space-available services at military treatment facilities. It is reasonable to conclude that military personnel and their dependents receive generous health care benefits.

These benefits come at great cost. DoD will spend almost one-tenth of the defense budget on health care in 2013 and it will only get worse. No other area of the budget is growing faster. If not addressed, CBO estimates these costs could grow from $52 billion in 2012 to $92 billion in 2030. Four factors are driving the growth: medical inflation, expansion of benefits, growth of covered population and pharmaceutical costs. Medical inflation continues to outpace overall inflation; DoD is not immune to this phenomenon because it sends many Tricare beneficiaries to civilian-market health care providers. Although the department cannot control medical inflation, it is attempting to address the other three growth factors in the 2013 defense budget.

For the past two decades, Congress has continued to expand health care benefits and resist any rollback. For instance, enrollment fees for retirees under 65 have remained relatively constant since 1995, although Congress approved a modest increase in 2012. Congress has also eliminated, reduced or held constant co-pays, catastrophic caps, and deductibles for services and prescriptions over the same period. As a result, DoD reports that retired Tricare beneficiaries pay only 11 percent of their health care costs today, compared with 27 percent in 1996. One of the most significant expansions, according to GAO, was the implementation of TFL, which alone drove 48 percent of DoD health care cost growth between 2000 and 2005. As benefits expanded, so did the number of beneficiaries. Today, GAO reports that 9.6 million beneficiaries are eligible for services, only 42 percent of whom are active-duty service members and their dependents.

To address the expansion of benefits and growth in beneficiaries, DoD has asked Congress to approve a series of reforms that transfer a reasonable share of health care costs to service retirees. Specifically, the department is seeking to increase Tricare Prime enrollment fees for retirees under 65, moving from a single fee to a tiered fee structure based on retired pay. These fees, along with enrollment fees implemented for Tricare Standard and Extra, will be phased in, with future rate adjustments indexed to medical inflation beginning in 2016. Catastrophic caps and co-pays will also be adjusted and indexed. For example, annual enrollment fees for the highest tier will move from $520 to $2,048 by 2017, according to DoD. While some may argue that this is a massive increase, it is important to remember that these fees have been essentially constant since the 1990s, reflecting no inflationary growth. According to the Kaiser Family Foundation, civilians have felt the full effect of medical inflation, with a comparable civilian paying on average $4,200 annually in health care premiums today.

Additionally, the department is proposing to implement modest annual fees for Tricare for Life with future adjustments also indexed for inflation. What has essentially been a “free good” for Medicare-eligible retirees will now cost $475 for a retiree in the top tier in 2017, according to DoD. The department characterized this as a modest increase, given that they found comparable civilian coverage in 2009 averaged $2,100. The intent of the fees is to reduce overuse and, potentially, overall demand by making civilian plans more attractive. However, implementing an enrollment fee alone is likely insufficient to achieve either outcome. The department should have also requested the authority to reduce covered costs and increase out-of-pocket costs for TFL beneficiaries. Only then will the department significantly reduce the $8.4 billion it spends annually on Medicare-eligible retirees.

Finally, DoD reports that its pharmaceutical costs are growing dramatically — from $1.6 billion in 2000 to $7.5 billion in 2009, with almost two-thirds of those sales conducted through more costly retail outlets versus military treatment facilities or the Tricare mail-order service. To address this growth, the department plans to adjust the pharmacy co-pays for retirees and active-duty dependents. The revised structure is intended to limit demand, reduce the most costly retail option, and incentivize mail-order and treatment facility services, which are more cost-effective means of providing pharmaceutical services. This change will save the department much money. And unlike the reforms to retiree Tricare services, the department does not need congressional approval to reform pharmaceutical services.

The health care reforms proposed by DoD are reasonable by any measure and long overdue. In sum, the reforms will result in retirees bearing a greater burden of their costs but continuing to receive exceedingly generous health care benefits. While the department could generate additional savings by implementing some of the minor policy adjustments to TFL as outlined above, the current proposal will save $70 billion to $80 billion over the next decade and place DoD health care costs on a more predictable and manageable path. The department must now wait and see if its rationale can persuade Congress to overcome its reluctance to roll back benefits.

Moreover, why stop at health care? The department could save another $8 billion to $9 billion over the next decade if it eliminated some installation-based services that have outlived their original purpose, are inefficient means of providing compensation and quite simply do not represent a core competency of the department. Commissary and post/base exchange services were originally designed for the days when military bases were isolated, such as cavalry forts in the middle of the Great Plains. Similarly, domestic on-base schools were often established to provide the only available means for free education or as an alternative to racially segregated schools. These conditions no longer exist; the context has changed.

Given that the original reasons for the creation of these services are no longer relevant and that not all service members require or have access to these services, they are an inefficient means of compensation. While the savings may be modest, the department has missed an opportunity to garner resources for higher-priority programs and begin to update some of the compensation system’s more outdated elements.

The Retirement System

Military retirement is perhaps the most scrutinized military benefit, but it is also the one that does not require immediate reform to rein in costs or generate efficiencies. In fact, DoD recently affirmed that the current retirement system is affordable, accounting for less than 4 percent of the defense budget and growing at an acceptable rate. Nevertheless, that did not stop the department from requesting yet another independent commission, this time with BRAC-like authorities, to develop alternatives to the current retirement system. While the current system is less than perfect, few critics offer compelling reasons for change.

Recent criticism has focused on the fairness of the system, concluding that it is inequitable because only 17 percent of service members eventually retire. However, this fact is to be expected given the closed nature of the military personnel system, the hierarchical structure of the military, and the sacrifice it takes to serve a full career. These conditions, in addition to the moral imperative the nation has to its service members, warrant a retirement system fundamentally different from civilian systems. If there is concern over service members leaving without benefits, then additional programs may be warranted to address this need but not at the expense of the current system.

Another frequent criticism cites the inflexibility of the system as a force management tool. This is a specious argument. On numerous occasions, Congress has approved additional authorities for the department to use in shaping the force. This was the case in the early 1990s during the last large drawdown of military forces and will continue to be the case during the coming drawdown. The department will continue to have the flexibility needed to manage the force.

Finally, the decision to seek reform of the current retirement system, which is arguably effective and affordable, is made even more peculiar given the department’s choice to abrogate its authority on such an important component of compensation. The department should review and consider compensation reforms holistically and be willing to own the entire review and reform process, not just certain components of it. Congress should not support this effort and instead return the process to the department for resolution. Further, Congress should require the department to address the dearth of decision support tools and data that are prerequisites for assessing compensation alternatives across all components.

Closing Thoughts

Faced with budget reductions over the next decade and the potential for even greater reductions under the terms of the 2011 Budget Control Act, the Defense Department made some difficult decisions in the 2013 budget, including the proposal of modest reforms to military compensation. The purpose of these reforms is to address the fastest-growing costs in the defense budget, which are effectively crowding out other programs, and to generate internal savings to help mitigate austerity measures. Yet even if the need for reform is compelling, congressional support is far from certain. The irony is that the department faces a considerable challenge to implement reforms, even though they do not adequately achieve these purposes.

DoD’s proposed reforms will save money, but their limited scope and modest nature will not adequately control future cost growth. Moreover, they miss an important opportunity to update key elements of compensation. This article advocates a more robust approach, including immediate cash compensation reform, minor adjustments to the proposed health care reforms, and the elimination of many installation-based services. Together, these measures could save an additional $40 billion over the next decade while beginning the process of updating the compensation system. In sum, these reforms would slow cash compensation growth and reduce the value of noncash and deferred benefits by transferring greater costs to service members and retirees. But most importantly, these reforms would continue to compensate service members and retirees at levels commensurate with their sacrifice and commitment to the nation.