(For those of you who follow the stock market’s performance, the inspiration for this post came seven 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 retirement 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 retirement 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?
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