Table of contents

March 31, 2011 by · 5 Comments

Another milestone!

I’ve proofed the second draft of the typeset manuscript, and by the time you read this post the book should be headed for the printing press. The publisher will get it back for a final scrub in 3-4 weeks. If everything looks good then the first print run will start shipping to the distributor for the military exchanges a month or two later.  You can now pre-order the book on Impact Publications’ website.  If you’re ordering from an APO/FPO or Alaska/Hawaii address then use this overseas order page.

The pocket guide, a 4″x5″ format with 64 pages, is a great summary for transition seminars and conferences. Impact’s offering substantial discounts for bulk orders. If you’re visiting military career seminars or job fairs, you may see their display and have the opportunity to peruse a sample.

Here’s the book’s table of contents, along with rock&roll quotes from a draft (sorry, no audio track):

Introduction

  • (“What’s money? A man is a success if he gets up in the morning and goes to bed at night and in between does what he wants to do.”  — Bob Dylan)
  • “Why are you still working?”: the question that started this project
  • “Why plan for the future? I could be killed tomorrow!”
  • How this book can help
  • How to read this book

Chapter 1: Plan Your Post-Military Life

  • (“Life’s been good to me so far.” – Joe Walsh, philosopher and Eagles guitarist)
  • The biggest obstacles confronting all retirees: healthcare and inflation
  • The biggest benefits of a military retirement: TRICARE & an inflation-fighting pension
  • Where are all the retirees? How do we ask for their advice?
  • What they don’t tell you at the military’s “Transition Assistance Programs”
  • Which do you want? An occupation, a bridge career, or an avocation?
  • Bridge careers, career surveys & assessment tests
  • Myths of military retirement and early retirement

Chapter 2: You’ve Decided to Retire! So Calculate Your Income

  • (“You can check out any time you like, but you can never leave!”  — The Eagles, “Hotel California”)
  • Humor: Things you shouldn’t learn to do before you retire
  • The Department of Defense military retirement pay system
  • What the Transition Assistance Program can do for you– and what it can’t
  • Advance planning
  • Financial myths of retirement
  • Retirement budgeting & finances
  • How much will I need?
  • How much can I spend?
  • Sample calculations for a warrant officer deciding when to retire under Final Pay

Chapter 3: Start the Year Before

  • (“We gotta get out of this place…”  -- The Animals
  • (“There must be some kind of way out of here…” — Bob Dylan, interpreted by Jimi Hendrix)
  • Filing your retirement request
  • What to tell your kids, parents, shipmates, & friends
  • What to do with your unused leave
  • Choosing where to live
  • How far away from the commissary, medical, dental?
  • Military-friendly states
  • Are you a perpetual traveler? What does your family think?
  • The expatriate lifestyle– intriguing but not for everyone

Chapter 4: Countdown to Your Final Six Months.

  • (“We’ll be takin’ care of business…” — Bachman Turner Overdrive)
  • Attending the Transition Assistance Programs (TAP) training
  • Self-assessment software & worksheets
  • Discharge paperwork
  • Medical & dental exams
  • Exit interviews and last-minute questions
  • Cleaning up the details
  • The retirement ceremony
  • The command’s farewell
  • Saying “See you later” to everyone else

Chapter 5: Retirement for Reserves and National Guard

  • (“So often times it happens that we live our lives in chains, and we never even know we have the key…” — The Eagles)
  • Another way to get to 20 years for the military pension & TRICARE
  • Extended mobilizations
  • Avoid these other civilian-military pitfalls
  • Health insurance while retired awaiting pay
  • The pension starts at age 60, but you can retire right now on savings

Chapter 6: Bridge Career Options

  • (“Aw, that ain’t workin’– that’s the way you do it!” – Dire Straits)
  • Retiring without a military pension or even the Reserves/National Guard
  • The Safe Withdrawal Rate (SWR)
  • “How to” examples from Ken and Arif

Chapter 7: Move in the Right Direction

  • (“You can’t always get what you want…” — The Rolling Stones)
  • Military compensation and the lifestyle
  • Start saving now
  • Frugal living is not deprivation
  • Payroll deductions
  • The Thrift Savings Plan, IRAs, and taxable investment accounts
  • Real estate: renting versus buying
  • Tailor your portfolio to your military pay and to your pension
  • The “fog of work” (with apologies to von Clausewitz)

Chapter 8: The First Two Years After Retiring

  • (“This is a thing I’ve never known before, it’s called easy living.  This is a place I’ve never seen before, and I’ve been forgiven.” — Uriah Heep)
  • (“I . Wanna rock & roll. All night. And party ev-er-y day.” — KISS)
  • Relax & reconnect
  • Taking a long-term perspective– Terhorst’s “two-year test”
  • Re-engage with family
  • Lifestyles in retirement (the perpetual question: “What do you do all day?”)
  • Don’t recreate your old environment
  • Forget about who you were: discover who you are
  • Dealing with “retiree guilt”
  • Volunteering for charity or neighbors
  • The inevitable job offers
  • Small financial steps
  • Healthy lifestyle
  • Rebel a little
  • Where do you want to go next?

Chapter 9: The Future

  • (“Ya know ya got to… keep on rolling…” — REO Speedwagon)
  • (“That’s why I’m goin’ to Kathmandu!” — Bob Seger)
  • You will change. Your plans may change too.
  • Long-term goals
  • Find your avocation?
  • Paying it forward
  • “Who are you with?”: Blowing the job interview of the decade
  • Conclusion: Enjoy the journey

Appendices

  • Effect of Inflation on a Dollar
  • Saving Base Pay and Promotion Raises
  • Retiring on Multiple Streams of Income
  • Effect of Inflation on a REDUX Military Pension
  • “Present Value” Estimate of a Military Pension
  • Asset Allocation Considerations for the Lump-Sum Value of a Military Pension

Chapter & Appendix Notes
Bibliography & Index
Recommended Reading

If you’ve been reading the blog for the last six months, you’ll notice that just about every subject in the table of contents has also been discussed in a blog post.  (The “Recommended Reading” list is updated here.)  The book, however, covers them in more detail with all the stories from over 50 servicemembers & veterans who have been there & done that. The book’s checklists came from their experience (and mistakes!). A highly successful Reservist wrote the outline and a number of paragraphs for Chapter 5, including ways to leverage your civilian and Reserve/National Guard careers off each other.  Ken & Arif contributed their career stories (military and civilian!) for Chapter 6.  The rest of the chapters are filled with examples and advice from over the other contributors.

The pocket guide squeezes the book into 64 4″x5″ pages. That was a pretty painful limit but it gives you a brainstorming boost for a transition-assistance seminar. Impact Publications has seen a great response to earlier drafts of the pocket guide (thanks!), so we’re offering bulk discounts to the military’s transition-assistance programs as well as state Veteran’s Affairs offices.

Now that you’ve seen the table of contents, what other topics would you like to learn about?  We’ll discuss them here!  The most popular ones will be added to the e-book and future editions.

If you’d like to contribute your own story for a guest post or the book’s next edition, then either comment here or use the “Contact Me” link on the right-hand side of the menu bar just below the waves at the top of the page.  Thanks!


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Military-related tax links

March 30, 2011 by · 2 Comments

I’ve been doing our tax returns this week, so naturally when I take a break I’ve been… reading about doing taxes.

This Military.com tax article summarizes 2010 changes for servicemembers and veterans. Federal tax returns not due until 18 April?!? I can live with that.

For those military who’ve spent the last few years overseas, the federal first-time Homebuyer Credit is extended up through 30 April 2011 (as long as the purchase closes by 30 June). If you returned from overseas duty and became a first-time homebuyer in 2010 (or if you’re working on it in 2011) then you probably made the deadline. Specific details are in this IRS summary.

For those who are still starting out on their own tax returns, here’s a good Military.com summary of the various ways that servicemembers can save on their taxes.  For those of you with a little more experience (or who like reading the source documents), the nitty-gritty details for military tax-related issues are in IRS Publication 3, the Armed Forces’ Tax Guide.

When my spouse joined the Reserves, she also joined the Navy Reserve Association (established 1954). It’s since changed its name to the Association of the U.S. Navy and widened its focus to include all active duty and Reserve Navy. One of my perennial favorites of their monthly magazine has been the annual tax tips for the military.

The AUSN 2010 Federal Tax Return Tips article applies to all members of all the services, including retirees.  It’s five pages long with detailed line-by-line discussions of how to treat military income & deductions, as well as other considerations that you may not have encountered before. I use tax software but I still end up reading every line of this article to make sure that I haven’t overlooked a good deal. Add it to your bookmarks and put a reminder in your tax file to look up the next edition in 2012.

In another unpleasant tax-related event, Hawaii’s governor has proposed balancing the state budget by taxing military pensions.  (As a long-time Congressional Representative in Washington DC, Neil Abercrombie served on the House Armed Services Committee.)  Hawaii has a very strong military culture, especially in the National Guard and Reserve, and many local military retirees are not pleased with this initiative.  The draft bill is aimed at “rich” retirees (couples with adjusted gross income over $75,000), but the threshold is not indexed to inflation.  Hawaii has long enjoyed a reputation as on of the nation’s most tax-friendly states for retirees, but this “tax creep” could surprise many future retirees who receive COLA pensions and Social Security.

So are you reading this post because you’re finished with your tax return, or because you’re “taking a break”?


Related articles:
Will Congress change military retirement?
The biggest benefits of a military retirement
Serving Uncle Sam: Tax Breaks for the Military

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Lifestyles in military retirement: learning to surf in Hawaii

March 28, 2011 by · 7 Comments


Here’s an amazing statistic: I’ve blogged for over six months on just about every aspect of military financial independence and early retirement. In nearly 80 posts, what’s been the most popular topic for over a week?:  Surfing. Are you people miserable on deployment or what? Just how cold a winter has it been up there? Or are all of those hits coming from my daughter, who tremendously enjoys her Mainland college but terribly misses surfing?

Well, I’ve never had a “real” job, but I know enough about business to recognize when to give the customers what they want. So here’s everything you need to know to start surfing in Hawaii. To all you other surfers reading this (including my daughter): please post a comment if I’ve overlooked something. And if you’re already a surfer then you can skip down to the last paragraph for the next challenge.

If you want to surf then you should start by ignoring all the cool vocabulary and fancy equipment. Everyone had to start with a first lesson, and we were all clumsy. Don’t be intimidated by the challenge, but do be respectful of experienced surfers by giving them plenty of room out there. Stay well to one side of their cluster and don’t compete with them for the same wave. You’ll learn the right-of-way rules and etiquette later.

If you can swim, then you can surf. It’s that easy. (The shameful fact is that a 1990s survey revealed over 30% of Oahu’s surfers still don’t know how to swim well enough to make it back to the beach if they’re separated from their board.) I used to surf while wearing an orthopedic knee brace and I could still get up fast enough to enjoy a good ride.

Surfing with torn ACLs

If you really want to read up on the sport (not necessary but comforting) then I’d recommend a library copy of the Start-Up guide to surfing or the Start-Up guide to longboarding.  Or try a “how to” video like this one.

If you want to surf a lot when you’re in Hawaii, then work on your shoulder muscles before you get here. You don’t need much acceleration but you will need a smooth consistent stroke to get back out to the break after riding one all the way to the beach. To choose your exercises, stand up and rotate your arms in vertical circles. Feel those shoulder muscles rippling away? Work on them. Do the freestyle crawl in the pool (half a mile would be great) and maybe try 100 yards of the butterfly. Do 25-50 pushups at least 3x week, and add some pullups if you’re feeling the endorphins kick in. Just don’t overdo it, and take a break for the last few days before you travel.

If you’re visiting Hawaii for the first time then you’re probably in Waikiki. To avoid the crowds of local surfers, weekday mornings around 9 AM are best. Look for the statue of Duke Kahanamoku by Kuhio Beach Park (on Kalakaua between Kaiulani and Liliuokalani) and then wander onto the sand looking for any beach concession with a stack of rental surfboards. If you’re over 100 pounds then you want to rent a board that’s at least nine feet long. (That’s written 9’0″ and pronounced “nine-oh”.) If you’re over 150 pounds then you want to rent at least a 10’0″. If you’re over 200 pounds then consider a 10’6″, but they’re hard to carry around unless your arms are at least 35″ long. Cheerfully admit to the concessionaire that this is your first surfing experience (they can already tell) and ask for a lesson. Depending on your attitude (humility helps) and their business, expect to spend $40-$75.

If you’re staying at a Kapolei beach condo (or the new Disney resort), and if you’re still carrying a military ID card, then skip Waikiki (you can do the rest of it later) and head straight to White Plains Beach in Kalealoa.  (Some of you old salts may remember when it was the Navy’s Barbers Point Naval Air Station.) The parking lot is at the end of Tripoli Drive near the Coast Guard Station. (If you get to the USCG station then turn around and go back to the first right.) The lifeguards will be setting up after 10 AM and will be happy to rent you a board (in exchange for your military ID) and give you a lesson for $30.

A rental 10'0" for a first-time surfer. Note the fin is at the back and behind his back so it doesn't bang into anything.

White Plains Beach rental board

Be ready for a lot of sun and for sliding around on slick surfaces. Rent or buy a nylon/polyester rash guard– any style or color or sleeve length will do if it fits a bit loose under the arms and comfortably on your torso. If you don’t get a rash guard then try a t-shirt. Slather on the sunscreen and apply more after the first surfing lesson. Otherwise you’ll be too sunburned & sore to do another session in two days.

You’ll have a board that’s either slick fiberglass (with sticky wax on the deck), or plastic with a deck of foam rubber. It’ll weigh up to 15 pounds and it’ll feel awkward to carry. Take it slow & easy and try not to bang the fin into anything. Yes, everybody is watching you, but they all had to start somewhere too!

You’ll begin with the board on the sand and lay on it as if you were paddling. You’ll learn how to push up, get up on your knees, bring one foot forward and then… just stand up. Which foot you bring forward depends on which feels comfortable to you. Most surfers put their left foot forward, but a few (mostly left-handed) bring their right foot forward. You can learn either way.

When you stand up, you’ll have your feet on either side of the board’s centerline for balance. Most of your weight will be on your back foot (especially if you want to turn) and a bit of a crouch always helps. Don’t feel that you have to POP up in a hurry– your first waves won’t be very big and you’ll have plenty of time. Just push up with your hands on either side of the centerline, bring your front knee forward when you feel that you’re in control, and stand up when you’re ready. Or just stay down on your hands and enjoy the ride. Your choice.

Enjoying the ride

After practicing on the beach, you’ll strap a leash on your back ankle. That helps you keep the board from turning into an unguided missile when you fall off it. It also means you don’t have to swim all the way back to the sand to retrieve it afterward.

The instructor will help you get the board into the water. You’ll push into the shallows, lay on top, and use that crawl stroke. Keep the board’s nose an inch or two above the water and try to get a smooth glide going, but there’s no hurry. Paddle straight into the white foam on top of the wave so that the board’s momentum carries you over it.  If a wave washes over you, keep a grip on the edge of the board and start paddling again as soon as the wave passes.

Entering the water

When you’re out to the break, probably with waves 2-3 feet high and well clear of other surfers, the instructor will turn you around and help you figure out when to paddle into one. You’ll usually get a helping push into your first few waves. You’ll start paddling when the wave is about 20 feet behind you (look over your shoulder to judge that) and you’ll keep paddling until you feel the back of the board rise up and go faster. When the board accelerates then you can stop paddling, put your hands on the deck in pushup position, and think about standing up. Keep the nose up out of the water as you do so (an occasional splash or two is OK) and take it slowly. Try to get the feel of the wave and enjoy the ride. Keep an eye on where your feet end up so that you can adjust their position on the next ride. Some of you will stand up right away, others will need six or eight tries. You’ll have it within the hour.

When the wave runs out, or you’ve had enough, then just sit down. Don’t jump off or dive off because the water might be shallow. Get down on the board and hold on to it so that it doesn’t shoot away from you and bang into anyone anything.

Then turn the board around, paddle back out, and try it again!

Your first surf session will probably be an hour. If you don’t feel your shoulder muscles grumbling by then, stop anyway. You can do more in 30 minutes (for maybe 30 minutes tops) or wait for the day after tomorrow.

If you’re not happy with laying down and standing up then ask the instructor about a stand-up paddleboard. It’s a little more complicated than paddling a canoe but you’ll figure it out within 30 minutes and get a great torso workout. Stroking your paddle into the waves on your feet is more challenging and you might not get the hang of it for a session or two. Just take it easy and focus on your balance & control.

Paddling out with another great surfer

If you’re already an experienced surfer, then visit Hawaii between November and February when the North Shore is practically guaranteed to be at least 10-15 feet along seven miles of beaches. Rent a board in Haleiwa or sign up for a school like Progressive Surfing. Champion pro Myles Padaca will elevate your skills and have you looking forward to those 15-footers. My daughter and I got trashed & thrashed more than once, but it was one of the best Christmas presents ever.

Related sites:
Beach webcam of Duke Kahanamoku’s statue

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Asset allocation considerations for a military pension (part 3 of 3)

March 24, 2011 by · 4 Comments

(Thanks to Tomcat98 of the Early-Retirement.org discussion board for introducing me to one of the authors of the studies quoted here and in the book.)

Here’s the conclusion to the nitty-gritty details of the following question:

If you’re receiving a military pension, then how should you invest the rest of your portfolio?

Investors are always admonished to have a diversified portfolio of stocks, bonds, cash, and perhaps real estate or commodities. Investment companies offer “balanced” funds, and the TSP offers “lifestyle retirement” funds that adjust their stock/bond asset allocation to a target retirement date. However these methods ignore an investor’s human capital of their pensions and Social Security. An earlier post showed that the lump-sum value of a $3000/month military pension is at least $1 million. This inflation-adjusted pension is paid by the federal government using Treasury securities that have zero risk, so it’s the equivalent of an extremely high-quality bond portfolio. An investor with a $250,000 investment portfolio split between stocks and bonds may think that their stock/bond asset allocation is 50/50. But adding in the $1 million lump-sum value of a military pension shifts the actual stock/bond allocation to 10/90! *  Even if the investment portfolio loses half its value, the loss of overall net worth is not 50% but rather 10%.

Other researchers have found similar imbalances for retirees whose Social Security benefits have skewed their asset allocation almost as heavily toward bonds.

How should military members use this information? How does it affect their decision to stay in the military? How can the lump-sum value of their pension and Social Security benefits affect their asset allocations?

First, servicemembers have to consider their human capital in their decision whether to leave the service or stay until retirement. During a 20-year career it’s possible for enlisted to earn over $1 million in pay and benefits, and officers to earn twice as much.  Money should not be the most important factor in a retention decision– but it’s significant. “It’s only money” is a tough choice to follow through on!

Second, military veterans can assume more risk (returns and volatility) in their investment portfolios. Their likelihood of continued employment is higher than most civilian occupations and their human capital is distributed more evenly during their careers. Their asset allocation could be more conservative if they leave active duty for the Reserves/NG or quit the military entirely, but during active duty they can invest more aggressively.

Third, a military pension is probably a veteran’s most valuable asset. As a high-quality bond, it allows investors to move the rest of their investment portfolio heavily into stocks or other assets. If loss aversion causes emotional distress during a bear market, the paper losses in a stock portfolio can be considered a small percentage of the retiree’s net worth. Their pension and Social Security are inflation-adjusted assets that are far more significant, even if a stock portfolio loses half its value. Veterans (and financial advisers) have to consider the lump-sum value of these benefits in designing investment plans and asset allocations.

*[ End note: A $250,000 portfolio split 50/50 between stocks and bonds has $125,000 in each asset class. A $1 million pension value adds $1 million of bonds for a total of $1,250,000 split between $125,000 in stocks (10%) and $1,125,000 ($1 million + $125,000) in bonds (90%).]


Congratulations! If you’ve read this blog for the last six months then you’ve just reached the end of the book’s table of contents! The book includes much more than this blog, of course, but you’ve just finished hitting the high points. From now on I’ll post about ideas for the next edition, or subjects that didn’t fit into the text, or material that ended up on the editor’s floor.

But before we start back in on those topics, we’ll take a break to talk about more surfing.

Related articles:
Asset allocation considerations for a military pension (part 1 of 3)
Asset allocation considerations for a military pension (part 2 of 3)
“Present value” estimate of a military pension
Saving base pay and promotion raises
Military pension inflation protection
Tailor your investments to your military pay and your pension
Where to put your savings while you’re in the military

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Asset allocation considerations for a military pension (part 2 of 3)

March 23, 2011 by · Leave a Comment

Here’s the second part of a three-part post to answer the nitty-gritty details of the following question:

If you’re receiving a military pension, then how should you invest the rest of your portfolio?

One noted economist compares an investor’s portfolio against their lifetime income.   Moshe Milevsky’s book “Are You A Stock or A Bond?” describes the “human capital” of lifetime earnings and pensions. Although savings are important to retirement, the size of an investment portfolio may be a minority of a retiree’s net worth when compared to their lifetime earnings power and their pension income.

Servicemembers and retired veterans, with their stable incomes and high-quality inflation-fighting pensions, have a particularly high human capital.

“Human capital” is also a good perspective on a military career. Veterans tend to be paid less than their civilian counterparts (while getting shot at more often), but their likelihood of continued employment is much higher. Milevsky’s book uses the examples of university professors and Wall Street stockbrokers. Professors make far less each year but (with tenure) can look forward to a lifetime of paychecks. Stockbrokers may earn millions in one year but could be unemployed the very next morning. Their high-dollar earnings power has no guarantee of continued employment. The challenge for both occupations is to manage their assets to be supported by their lifetime earnings, no matter how low or uneven their income may be.

Human capital is a relatively new concept and not yet widely accepted. Most financial analysts and website calculators ignore human capital by treating salaries and pensions as “just” a stream of income. Human capital’s impact is not considered on a portfolio’s overall asset allocation.

Military retention is another impact of human capital. At some point every one of 1.4 million veterans (and their 1.9 million family members) has to decide whether to stay on active duty or to continue drilling in the Reserves/National Guard. Only 15% of the military’s members reach 20 years. A pension is not the only reason to stay on active duty, but it would certainly help people endure long, dangerous deployments or stressful midwatches. The military may be a familiar lifestyle with a guaranteed paycheck, but is it worth the pain? If “human capital” could compare the earnings of active duty to the Reserves/NG, or assess the impact of completely quitting the military, then the analysis could bring financial logic to an intimidating lifestyle decision.

“Net worth” doesn’t account for cash flows like pensions or Social Security, so their income has to be included as their lump-sum equivalent. A convenient assumption about inflation-adjusted pensions is that their payout is constant in today’s dollars– they maintain their buying power for the rest of the retiree’s life.

Reserve/National Guard pensions and Social Security are more complicated because their payouts start later. However Congress and the Department of Defense attempt to improve retention by raising military pay at least as fast as inflation, while promotions and longevity pay keep servicemembers ahead of inflation. It’s conservative to assume that future pay dollars will have the same buying power as today’s dollars. The Social Security website’s benefits calculator also produces its results in today’s dollars, and benefits are adjusted for inflation. That means Reserve/NG pensions and Social Security are paid in inflation-adjusted “today” dollars through the rest of a life expectancy.

The lump-sum discounting math is more complicated for military pensions with survivor benefits and for civilian defined-benefit pensions without inflation adjustments. Military retirement calculators can give an estimate of the lump-sum value of survivor benefits. Civilian corporations estimate their pension calculations on an actuarial analysis of lump-sum value, and labor unions offer their own analyses.

Once projected pensions and Social Security benefits have been converted from income streams to lump sums, they should be included in a veteran’s net worth. Investment portfolios would be added at their current value, as well as homes or rental real estate. Personal property (such as vehicles, furniture, recreational equipment, and clothing) can also be included. Mortgages, vehicle loans, and other debts are subtracted to get the total net worth.

The results can be startling.

Tomorrow: adjusting a retirement portfolio’s asset allocation for a military pension

Related articles:
Asset allocation considerations for a military pension (part 1 of 3)
“Present value” estimate of a military pension
Saving base pay and promotion raises
Military pension inflation protection
Tailor your investments to your military pay and your pension
Where to put your savings while you’re in the military

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Asset allocation considerations for a military pension

March 21, 2011 by · 11 Comments


Here’s the first part of a three-part post to answer the nitty-gritty details of the following question:

If you’re receiving a military pension, then how should you invest the rest of your portfolio?

Frankly, to the majority of you readers, this will be a boring technical essay. The big picture of this week’s posts is that emotions will influence our investing no matter how logical we attempt to be, and a military pension lets us feel a lot better about stock-market volatility.

But if you plan to invest your savings in more than just Vanguard’s total stock market & total bond market index funds, then here we go:

There are two aspects to every financial decision– the logical and the emotional. Both aspects are equally important, and investors who make their decisions from just one aspect will find it very difficult to stick with their commitments. Investor psychology research into “loss aversion“ has shown that losing money causes far more pain than gaining it. Even if an asset-allocation plan is chosen with the most rigorous criteria and extensive analysis, the inevitable high volatility or unexpected losses will cause far more pain than the benefit of any gains. That emotion can overcome rational thinking. Investors eventually decide that the most logical and well-researched asset-allocation plan is useless if they’re not also emotionally comfortable with the results. When the markets do badly, even for a short period, distress can cause investors to sell out (and lock in their losses) at the worst possible time. This path to retirement is long and painful.

One distress-free option would be to invest in assets that have no volatility and never lose money. Treasuries, TIPS, and I bonds all attempt to offer this solution. One drawback is that these “risk-free” investments pay a very low rate of return (sometimes no return at all) and Treasuries can actually lose value to inflation.  Their low yield means that it also takes longer to save enough to support even a frugal lifestyle. When this type of a portfolio is big enough to for its returns to support retirement, it will only keep up with the Consumer Price Index (CPI).  If a retiree’s rise in personal spending exceeds the CPI then they risk outliving their assets as their personal inflation erodes their value.

A high-stress option would be to embrace volatility. Many investors spend months researching the mathematics and histories of asset allocations. They become experts on the correlated performance among different classes of stocks, bonds, real estate, commodities, and cash. The idea is that when one asset class is performing poorly, another asset class will be rising at least as quickly to offset the overall portfolio. Nobel-winning researchers have been able to “prove” that a diversified portfolio built from uncorrelated asset classes is actually less volatile than the individual assets in that portfolio.

Regrettably, the diversification “proof” only works most of the time– not all the time. As the recession of 2008-09 showed, the markets are still not efficient. Low-correlated asset classes can still drop together for days or even weeks before investors stop their panicked selling and are tempted to buy. “Portfolio insurance” methods can reduce the impact of these rare episodes, but their expense reduces the portfolio’s overall return. Spending hundreds or even thousands of dollars a year on hedging (for stock options that expire worthless) seems like wasted money during a hot bull market.

Another option, dividend investing, is a variation on a diversified portfolio of volatile assets. Investors own shares of diversified yet high-yielding stocks. They plan to receive enough dividends to live off the portfolio’s yield without ever selling any shares. This plan works well in a bull market because companies generally strive to please their shareholders by raising dividends even when their shares are growing in value. In bear markets, a company will avoid cutting its dividend when possible to keep shareholder faith (and its share price). Long-term investors can look forward to years of dividends that hopefully meet or exceed inflation while never having to worry about volatility or selling shares in a bear market.

A minor drawback to dividend stocks is that their share price tends to grow more slowly than the rest of the market because their yield is a larger part of their total return. Another issue is that it takes a larger portfolio of dividend stocks to support retirement expenses. Instead of spending principal, a dividend portfolio can only support a withdrawal rate of its total dividends– usually 2-3.5%. The portfolio never runs out of money since principal is never consumed, but it takes longer to save enough to support retirement.

Unfortunately the last recession also showed that companies will cut their dividends to avoid bankruptcy. The stocks of banks and investment firms were hit particularly hard, with some even cutting their dividends to a token penny a share. Dividend-paying stocks are an important part of a diversified portfolio, but dividend stocks should not be the only asset of a portfolio.

A final option would be to sidestep volatility and render it irrelevant. It requires having enough in cash (money markets and CDs) to support living expenses during a bear market. Retirees live off their pension and their cash while they wait for the bear market to end and their assets to recover. A two-year cash buffer (as much as 10% of a portfolio) works well for all but the longest bear markets. Although investors can ignore downward volatility for months or even years while they’re spending the cash, the emotional impact can still be severe enough to make them question the wisdom of this asset allocation.

Most investors choose a middle ground among the various investing options. They invest in assets paying dividends as well as those whose returns are expected to beat inflation. Diversified portfolios assume risk with volatile assets, but the assets are split among several classes to (hopefully) reduce overall volatility.  Part of the portfolio is also kept in cash to support living expenses during bear markets. The asset allocation allows investors (and their spouses!) to enjoy a good night’s sleep.

Even with this accumulated wisdom, investors are still trying to put stock-market meltdowns in perspective. It’s painful to watch equity portfolios go into free fall and temporarily lose 50% of their value, even if diversification minimizes the paper losses. It’s a great opportunity to rebalance by buying more shares at a discount. The portfolio’s cash allocation provides the spending money to ride out a bear market while waiting for the rest of the assets to recover. But the emotional depths of a bear market can still make even the most dedicated investors question their logic and their discipline.

Next post: “human capital” and the asset-allocation value of a military pension.

Related articles:
“Present value” estimate of a military pension
Saving base pay and promotion raises
Military pension inflation protection
Tailor your investments to your military pay and your pension
Where to put your savings while you’re in the military

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“Present value” estimate of a military pension

March 17, 2011 by · 9 Comments


(For those of you who follow the stock market’s performance, the inspiration for this post came two years ago: March 2009, the bottom of the Great Recession’s markets. Back then I had no clue that someday I’d be blogging about it.)

How much is a military pension worth?

The answer is more than just cash flow. Another way to ask the question is: How much is that pension worth as a lump sum?

Humans aren’t very good at estimating income or inflation adjustments, and emotions always influence our otherwise logical financial decisions. Unfortunately an investment that looks like a great deal in a glossy magazine ad can turn out to be “great” only for the seller. A very effective way to analyze a pension’s value is to put the numbers in terms of both the pension’s monthly cash flow and its lump-sum equivalent.

The answer’s format can change a veteran’s decision. The Department of Defense still offers a REDUX Career Status Bonus because many military members (and their families) are tempted by a “big” number like $30,000. But an earlier post showed that the CSB is usually only a good deal for the DoD.

At first a military pension doesn’t seem to be worth very much. Even a relatively large pension of $3000/month is only about $100/day. A soldier just ending their 10th year of service might not be very motivated by the thought that they’ll have to work another 10 years for that guaranteed cash flow of inflation-protected income. Emotionally, $100/day just doesn’t seem worth the sacrifice– even though the payout rises with inflation for the rest of their life.

The challenge behind analyzing a lump-sum question is to figure out how much money has to be invested to yield the pension’s stream of income. One challenge to the analysis is that the military pension includes a cost of living adjustment, so the amount of the income stream has to rise every year by the rate of inflation. Another problem is that no one knows how long the pensioner will live, so it’s difficult to predict how long the pension will be paid out. Finally, the calculated lump sum has to be invested in a safe and stable asset to make sure that it survives for decades. Unfortunately the safe and stable assets have a very low yield, so it takes a larger lump sum to produce an income stream big enough to pay the pension.

The answer to these puzzles involves the mathematical process of “discounting”. Accountants and actuaries devote entire careers to studying asset yields, human longevity, and other risks. They calculate the statistical probability that a certain lump sum will be able to pay a particular pension for the necessary number of years. The good news for pension recipients is that the calculations are much more accurate when the analysis is simultaneously applied to hundreds of thousands of pensions as a group. Even better, the Department of Defense can rely on the number-crunching skills of another giant bureaucracy of inflation-adjusted payments: Social Security.

The mathematical details of discounting an inflation-adjusted annuity are well beyond the scope of this post. There’s not an easy formula to convert that $100/day pension to a precise lump sum. However there are a few simpler estimates that are reasonably close to the more complicated methods.

The easiest estimate assumes that a military pension keeps up with inflation. This eliminates the more complicated factors of correcting future dollars for inflation. If a military pension keeps up with inflation then the pension’s value in today’s dollars stays constant. The lump-sum value of the pension is the total amount to be received during the rest of the veteran’s life:

  • Lump sum = (annual pension amount) * (remaining life expectancy)

A 38-year-old veteran receiving $3000/month with a COLA might reasonably look forward to 35 more years of life. The estimate of the present value of their pension would be

  • Lump sum = ($3000/month) * (12 months/year) * (35 years) = $1,260,000.

The life-expectancy estimate ignores other discounting factors in favor of simplicity and speed. Its main advantage is that a veteran can quickly estimate a lump sum for their own personal expected lifespan. Veterans in good health with long-lived ancestors may decide that they have 40 or even 50 years of retirement, raising the current value of their pension.

Another quick estimate is to assume that the pension is the income stream from a lump sum of Treasury Inflation-Protected Securities (TIPS). TIPS are an extremely safe and stable asset with built-in inflation protection. The market for buying and selling TIPS is huge and liquid so their prices are fairly accurate. One flaw of this estimate is that, unlike a military pension, when the pensioner dies there’s still a lump sum of TIPS generating a stream of income. Another drawback is that a TIPS’ maturity (now a maximum of 30 years) is usually less than the pensioner’s remaining life expectancy. The advantage of this estimate is simplicity and speed:

  • Lump sum = (annual pension) / (TIPS annual percentage yield)

A January 2009 Treasury auction sold 20-year TIPS at an inflation-adjusted annual percentage yield of 2.5%. So for that $3000/month pension,

  • Lump sum = ($3000/month) * (12 months/year) / (.025/year) = $1,440,000.

Another estimate of the lump-sum value of an inflation-adjusted pension is a commercial annuity. The annuity market is generally regarded as liquid because insurance companies compete to offer the “best” price without losing money. However they still charge more than the actual value of the annuity to make their profit. Insurance companies could be unable to make annuity payments or even go bankrupt and should be considered a riskier source of annuity payments than TIPS or other government bonds.

One of the “less risky” annuities comes from an agency sponsored by the federal government– the Thrift Savings Plan. TSP annuities are actually purchased from an insurance company and are not guaranteed by the federal government, but the insurance company is presumably charging a smaller fee (to sell a large volume of annuities) and the annuity’s cost would be closer to its value.

TSP annuities are priced each month and do not offer full protection against inflation. The advantage of estimating a pension’s lump-sum value from a TSP annuity is its lower price and the TSP website’s calculator.  Assuming that the $3000/month pension is paid to a 38-year-old veteran and limited to 3% annual inflation:

  • Lump sum (TSP website annuity calculator) = $1.4 million.

$1.4 million is the price that a veteran would pay in the market to buy a TIPS portfolio or an annuity that would yield their inflation-adjusted pension of $3000/month for the rest of their life. Other research analyzes the theoretical cost of annuities and discounted values– only the cost and not its market price.  (This includes a research paper on military pensions– the citation is in the book.)  These estimates range from about $1 million to $1.2 million. They’re only theoretical estimates. These annuities can’t actually be purchased like the assets of the other estimates, but they’re a more conservative estimate of the probabilities of longevity and other risk factors.

Let’s get back to the veteran who’s just finished 10 years of service and is wondering if it’s worth staying in the military for another decade. After an analysis of the pension’s present value, which sounds more compelling now: $100/day, or lifetime income of over $1 million?

Related articles:
Retired Pay Differences Rise
Does military service still pay?
Military retired pay calculator
Military pension inflation protection
TIPS and I bonds for military retirement?

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Saving base pay and promotion raises

March 16, 2011 by · 9 Comments


(Thanks to SamClem of Early-Retirement.org for the story that led to this post!)

Financial independence and retirement are accelerated by saving as much as possible in the Thrift Savings Plan, IRAs, and taxable accounts. Aspiring early retirees have two ways to accelerate their ER: earn more or spend less.

Military earnings rise with each new pay table, longevity raise, or promotion– but it’s all too easy to let lifestyle spending suck up the higher income. The raises in each year’s annual pay tables generally go up at the rate of the Employment Cost Index, hopefully keeping up with inflation but rarely exceeding it. Just boosting TSP contributions by the annual pay increase is not enough for ER.

Aggressive savers should invest as much as possible of both their base pay and every promotion’s pay raises while holding their spending below the previous pay grade. ER saving would be easy if an E-7 could hold the expenses of an E-1, but this is unrealistic. (It’s deprivation, too!) A more achievable E-7 goal would be holding spending at the pay grade of an E-6 and banking the pay difference between E-7 and E-6.

The graph below shows how quickly that savings can compound. It uses the 2009 pay tables and assumes that military pay keeps up with inflation over a 20-year career. It assumes reasonable promotion gates for E-2 through E-7 and O-2 through O-5. It also assumes that the member saves (only!) 10% of their base pay at one pay grade below their current rank, and 80% of their pay raise from their latest promotion.

Savings are invested over 20 years and compounded at a conservative 3% over inflation in the TSP, IRAs, and taxable accounts. 3% over inflation is a reasonable rate of return for an investment portfolio concentrated at least 80% in equities.

Here are the assumed promotion gates, which may vary by service and specialty:
Rank Years of service when promoting to that rank
E-2     1
E-3     2
E-4     4
E-5     7
E-6     10
E-7     16

O-2     2
O-3     4
O-4     10
O-5     16

The military pay tables include raises for both longevity and promotions, so members earn longevity raises every 1-2 years in addition to promotion raises. However these savings assumptions don’t include the longevity raises, so veterans will be able to use longevity raises for spending– or more savings.

Here’s an example of the savings goals for an E-5 in year 9 of their career. Their promotion to that rank occurred in year 7 and they’re attempting to live as though they were still receiving E-4 pay. They’re saving 10% of E-4 base pay and 80% of the pay raise (between E-5 and E-4 pay) from the “over 8 years of service” column of the pay table.

Next year (year 10) that E-5 promotes to E-6, but the graphed results conservatively assume that the pay raise takes effect at the end of the year. Their longevity hasn’t changed because they’re still over eight years of service but not yet over 10. So the same “over 8″ pay scales are in effect and the member is saving the same as in year 9.

Next year (year 11) the recently promoted E-6 uses the “over 10″ column for E-6 & E-5 pay grades. They’d save 10% of E-5 base pay and 80% of the pay raise (between E-6 and E-5 pay) from the “over 10 years of service” column of the pay tables.

Other conservative assumptions include:

  • No money is saved during the first year of a 20-year career, which really hurts from a compounding perspective but is a reasonable fact of life.
  • Active-duty military savings and compounding rates occur at the end of each year instead of at twice-monthly paydays.
  • Tax-free allowances like Basic Allowance for Housing are not included in the savings rate, allowing them to be used for higher housing and utility costs.
  • Special pay and bonus pay are not included, although a frugal ER would save both when possible.

The graphs show results for two different cases:

  • Saving 10% of base pay (at the previous pay grade) and 80% of the promotion pay raise.
  • Saving 20% of base pay (previous pay grade) and 100% of the promotion pay raise.

Note that a small increase in savings percentage has doubled the size of the final investment, even though the biggest raises occurred late in each career.

Graph of Saving Base Pay and Promotions Raises

The portfolio will grow even faster if more money is invested from early career savings, longevity raises, higher allowances, special pay, and bonuses.

If the chart above isn’t displaying correctly, here’s another link to a PDF:
Graph of Saving Base Pay and Promotions Raises

Related articles:
How many years does it take to become financially independent?
Frugal living is not deprivation
Start saving early
Military retirement spending: how much will I need?
Military retirement: how much can I really spend?
COLA calculations

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Effect of inflation on a REDUX military pension

March 14, 2011 by · 3 Comments


Veterans entering the service after July 1986 are eligible to choose between two different retirement systems. The first system, High Three, offers a multiplier of 50% at 20 years of service and raises it 2.5%/year to 75% at 30 years of service. Each year after retiring, the pension is raised by a cost of living adjustment (COLA) that’s an estimate of last year’s increase in the consumer price index (CPI). This COLA is intended to keep up with inflation, which the government typically measures with the CPI.

The second retirement system, CSB/REDUX, starts its multiplier at only 40% for 20 years of service but raises it 3.5%/year to 75% at 30 years of service. It also includes a COLA, but the COLA is capped at 1% less than the CPI. When the retiree reaches age 62 their REDUX pension is “reset” to the value it would have reached with a full COLA. After age 62, though, the REDUX COLA returns to its cap of 1% less than the CPI.

The biggest difference between the two systems is the Career Status Bonus (CSB) paid during the 15th year of service to servicemembers choosing REDUX. If the entire after-tax amount of the bonus is invested and the veteran stays on active duty long enough, then under certain optimistic assumptions their total CSB and REDUX pension lifetime value will be greater than if they had opted for the High Three pension without the CSB. At most ranks and years of service, though, the High Three’s full COLA grows faster than the CSB can compound.

Even worse, every year the CSB program has lost ground to inflation. 10 years after the REDUX system was modified, the CSB is still $30,000. Even if inflation was only an average of 3%, the CSB has already declined in “real” (inflation-adjusted) dollars by over 25%. As military pay and pensions continue to rise, inflation will continue to erode the CSB program and make it less valuable to a REDUX retirement.

The Department of Defense REDUX calculator is difficult to evaluate without adjusting its numbers for inflation. The following chart is based on a spreadsheet that adjusts each year’s pensions (both High Three and REDUX) for inflation. (If the Scribd chart isn’t displaying on your browser then a PDF link is included at the bottom of this post.) If the CPI equals the actual rate of inflation, then the High Three pension’s COLA keeps up with inflation and the inflation-adjusted value of the High Three pension stays constant. The REDUX CPI, however, is capped at 1% below COLA. The inflation-adjusted value of the REDUX pension loses 1% every year until age 62. At age 62 the REDUX pension is reset to its original inflation-adjusted value. After age 62, though, the REDUX pension again loses 1% per year for the rest of the veteran’s life.

The chart assumes that the REDUX retiree invested their entire after-tax REDUX bonus ($25,500) in a mutual fund yielding a realistic 3% after taxes and inflation. The invested CSB compounds for five years before both veterans start their pensions at age 38.

At retirement, the REDUX retiree starts with a lower pension ($15,576/year instead of $19,470) but an inflation-adjusted CSB value of $30,448. He has more money than the High Three retiree until both are 46 years old, when the High Three retiree’s total pension pulls ahead. The REDUX reset at age 62 slightly reduces the widening gap but by age 70 the High Three retiree has received 17% more money– nearly $100,000.

The DoD’s REDUX website shows several case studies for different lengths of service and ranks to conclude that the CSB can produce more earnings than the High Three pension. However the DoD calculation assumes that the entire CSB (after taxes) is invested at a very optimistic rate of return (8% before taxes) and is saved for passing on to the veteran’s heirs. Even with these liberal assumptions, the REDUX pension earnings don’t pull ahead until the veteran is 75 years old. The payoff? $4000 out of more than a million dollars. Other military-media websites have more criticisms of the REDUX system and its effect on veterans who don’t clearly understand its risks.

For those who seek more detailed examples, the DoD website shows that most REDUX retirements lose out to their equivalent High Three retirement– even if the Career Status Bonus is invested. (The sole clear REDUX winner is the E-9 retiring with 30 years of service.) When using the REDUX calculator for your situation, consider using a lower rate of return from investing the Career Status Bonus. Even the E-9 example may not be a significant amount of money over the rest of a lifetime.

The CSB decision is not just about the math. Whether or not you “know” that you’ll be retiring after 25-30 years instead of 20 years, consider whether you’re willing to risk the happiness of yourself and your family if your situation changes after the 15-year point. When you accept the CSB, you’re essentially telling the assignment officer that you’re willing to do anything, anywhere, anytime. You lose the flexibility of resigning before 20 years unless you pay back the CSB. More importantly, you lose the flexibility of leaving active duty for the Reserves or National Guard. The odds are probably in your favor, but this “bet” involves a risk of “losing”– one that you don’t want to have to endure.

PDF of the Scribd link:
Graph of High Three pension vs REDUX

Related articles:
Military pension inflation protection
COLA calculations
Living with inflation
Will Congress change military retirement?
Redux Bonus: Bad Deal Gets Worse
Redux Bonus Repeal Sought
As I See It — REDUX “Career Status Bonus” — A $30,000 Scandal

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Military pension inflation protection

March 10, 2011 by · 9 Comments

 

Let’s consider some of the details behind a military pension and its COLA.

First, just like active duty pay or drill pay, the pension is paid in arrears. In this case it doesn’t show up until the first of the month and it’s only paid once a month. The first payment may even be delayed a week or two if the computer network at the Defense Finance and Accounting System had a delay or an error in processing that month’s new retirement data. In case of a rare delay, new retirees should have enough cash on hand for the first two months of retirement. The system will eventually catch up.

Next, except for extremely unusual circumstances requiring individual DFAS processing, the pension will be paid by electronic direct deposit to the account of your choice. (The federal government does not want to mail paper checks.) If it’s the same account you’ve always used for your pay then there’s no change and no problem. If you’re planning to use a different bank or credit union because you’re moving to a new area then you might consider delaying that shift until you’re moved in and settled. DFAS’ pension-processing system requires a week or two to change to the new financial institution, and you don’t want to compound a relocation with bank problems.

Finally, keep an eye on your service’s electronic pay system for the first few months of retirement. New (or corrected) pay statements may be posted as your service closes your pay accounts and formally transfers your records to the Department of Defense. In addition to your last pay statements, make sure any new pension deductions and allotments are correct and promptly notify DFAS of any problems.

Retirees are not required to have federal (or state) income tax deducted from their pension, and you can adjust your withholding as necessary. The more complicated you make your pension distribution, though, the more chances for problems. It may be easier to have the entire pension payment deposited to your financial institution and then set up your automatic deductions from that account. It’s probably a lot easier to reach your local credit union on the phone or by e-mail, too.

In December or January after your retirement, DFAS will distribute tax forms. These can be mailed if requested but usually default to online display on your service’s pay website. The W-2 should reflect your active-duty or drill pay as well as any leave (base pay) that was sold back during retirement. If the W-2 doesn’t appear to have the right amount then contact DFAS or your local pay office to check the calculation. If there was a processing error (especially with retirement leave) then DFAS’ computer systems will eventually catch up– and issue a corrected W-2. Murphy’s Law means that will happen the week after you file your tax returns.

Estimated taxes are another issue for your retirement year. You not only refer to your W-2 but also to your 1099-R pension distribution statement. Military retirement pay is subject to federal tax and is still taxed in some states. If you sold back leave as part of your retirement then that (base pay) is also subject to tax and estimated taxes may not have been withheld. Check your estimated taxes using the IRS worksheet and make sure that enough estimated tax is withheld (or paid by you) by the January deadline. Late tax payments are not only fined– you also pay interest on the balance.

After the first year your pension payments and withholding should settle down to a routine. You’ll download your 1099-R each year and perhaps adjust your tax withholding as necessary. Ideally it’ll be dull and boring and you’ll have trouble remembering your login and password.

Military retirees have two other issues to consider in their pension COLAs.

In January of the first full year of retirement, High Three retirees will not receive the full COLA. The High-Three pension system pro-rates the official COLA to a smaller amount for your pension depending on the month of your retirement. This reduced COLA only occurs during the first full year of retirement and the full COLA will be received in subsequent years.

If you’re one of the very few retirees who chose REDUX then you have a different challenge. Not only will your first full year’s COLA be pro-rated, but all of your pension COLAs will be reduced by 1% below the CPI until you turn age 62. A special “catch-up” adjustment is applied to the REDUX pension at that age, but you have to have faith that no legislative changes will occur to the system before then. After age 62, though, the COLA returns to its cap of 1% less than the CPI. If you retire at age 37 on 40% of your base pay (instead of High Three’s 50%) and give back 1% of your COLA for the next 25 years, then by age 62 your pension will only have 62% of the purchasing power of its High-Three equivalent. Your REDUX pension will receive its projected catch-up adjustment but will then resume losing ground on its inflation protection for the rest of your life.

The next post will go into greater detail on REDUX pensions and show a graphical comparison between REDUX and High Three pensions.

Related articles:
COLA calculations
Living with inflation
Effect of inflation on a dollar
Will Congress change military retirement?

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