Military long term care insurance (part 2 of 2)

April 21, 2011 by · 4 Comments

The last post discussed the different forces that cause people to pay ever-higher prices for long-term care insurance– at the same time when the industry may be less likely to be able to actually pay their claims.

Those problems haven’t been solved yet, and it may be another 25 years before they’re properly addressed. We can’t afford to wait.

“Conventional wisdom” is that the cost of long-term care could easily be $75K/year, and over $100K/year in high-cost major cities. Many Alzheimer’s patients can be in care for 10 years, and other dementia patients for over a decade. Long-term care inflation is running 5-10%, a rate that’s substantially higher than overall inflation (measured by the Consumer Price Index) and even higher than the average CPI over the last 30 years. A patient’s care at a private facility could easily cost $1M-$1.5M.

It’s difficult to accept a cost that exceeds the net worth of many military early retirees. However the long-term care infrastructure is patched together with a number of payment systems where the “private pay” and insurance companies are subsidizing a portion of the care facility’s budget for their Medicaid patients. There’s also a huge difference in the quality of care between a “warehouse” and a facility that staffs a memory-care unit with stimulating activities. Many more families of dementia patients manage to put together a system of home care with paid help (or no help at all). Admittedly if you’re suffering from dementia then much of the quality difference may not be noticed by you, but you’d prefer to not suffer and to not to be a burden on your family. A million bucks seems like a small price to pay for that level of care.

It’s worth remembering that insurance is designed to help the insured cope with a financial disaster– one that may never happen– by sharing the risks with many other people. Ideally, like fire or vehicle insurance, premiums would cost a fraction of a percent.  Unfortunately the reality is that many long-term care premiums for a person in their 60s can run $2000-$3000 per year for essentially a total of $300K of coverage limited to a three-to-five-year period. There are also a number of waiting periods, exclusions, deductions, and other caveats. As the last post pointed out, these premiums may actually be too low for the insurance company to make a profit and stay in business long enough to pay out on your own benefits. It’s difficult to know whether you’re paying the “right price” for your insurance coverage when the insurance companies can’t even confidently predict a profit. They just don’t have enough history with their products to be sure.

Financial advisers usually suggest that retirees with a net worth under $1M may want to skip the insurance. The theory is that the premiums would be unaffordable and unsustainable anyway. If long-term care was necessary, the family would quickly spend down their limited assets and then qualify for Medicaid. Although it’s a financial plan, this is not a very reassuring “solution” for a good quality of life and the surviving spouse’s peace of mind.  It’s just a safety net.

For retirees with a net worth between $1M and $2M, the financial theory is that insurance is affordable. The insurance might not cover all the costs but it would offer a reasonable quality of care while preserving peace of mind.

If your net worth is above $2M then the cost of long-term care is not considered a financial disaster. You can self-insure your long-term care risks and probably afford to buy life insurance for estate planning. However most families will always feel a little troubled about the “worst case” scenario, so this situation does not necessarily provide peace of mind. If peace of mind is more important than other retirement spending then the cost of insurance would not have a severe lifestyle impact.

How does the Federal Long-Term Care Insurance Program differ from the rest of the industry? First, it’s the nation’s largest pool of long-term care insurance.  This spreads the same risk across a larger crowd of paying customers. Second, the insurance company spends less money to market to the eligible customers and to sign them up. This reduces their costs and commissions, allowing the customers to (hopefully) pay lower premiums. Third, the plan choices are streamlined and heavily monitored. Price increases are subject to extensive justification and negotiation.  While this won’t avoid misconduct or higher premiums, it will hopefully offer enough oversight to minimize unpleasant financial surprises. Finally, the eligible customers (particularly the military) tend to be healthier and have access to a better quality of healthcare.  This would just seem to raise the probability that they’d survive long enough to make a claim, but it also raises the probability that they’d pay premiums for more years before making a claim. The insurance company would be more likely to make a profit and be able to pay out the claims.

This link summarizes the FLTCIP’s benefits and features.  Costs of the standard plans are summarized on this monthly premium chart  or through this premium calculator. The FLTCIP website also offers a benefits and features comparison worksheet to help assess other LTC insurance plans. Finally, if you’re a Texas resident, this website offers a comprehensive comparison of premiums for different policies.

The numbers in this post aren’t very reassuring, but it’s important to use long-term care insurance only to minimize the impact of a financial disaster. It’s still possible that neither you nor your parents will need to make a claim, and will pay tens of thousands of dollars over several decades for peace of mind. The key is to stay as healthy as you can, to keep an eye on the costs so that you can adapt your financial planning, and to focus on minimizing the financial impact. Once you’ve taken prudent steps to control the risk, then go out and enjoy your life.

Related articles:
Military long-term care insurance
During retirement: Healthy lifestyle
Military retirement spending: how much will I need?
Military retirement: how much can I really spend?

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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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COLA calculations

March 7, 2011 by · 4 Comments

 

 

The Department of Defense applies the Social Security Administration’s calculation for COLAs to military pensions. Although the money comes from different agencies, the numbers are the same.

The COLA for the following year (applied in January) is calculated from the third quarter of the current year. The Bureau of Labor and Standards (BLS) supplies the official inflation data for the Consumer Price Index and it’s averaged to determine the year’s increase. It’s compared to the last year in which a COLA was applied (not just last year!) and then the difference is converted to an annual rate.

2008 was the last year in which a COLA was applied to military pensions. The 2009 CPI actually dropped compared to 2008, but luckily the military retirement system does not provide for a “negative COLA”. However when 2010 CPI data was compared to the last year a COLA had been applied, the CPI had still not risen significantly over 2008. It actually started “in the hole” for 2009 and the CPI had to rise even further before exceeding 2008′s data.

The result was that there was no COLA for 2010 either. The 2011 CPI has started to rise above the 2008 data but July-August-September are the months that “count” toward a COLA to be applied in 2012.

Several veteran’s organizations maintain a “COLA watch” to track the CPI changes and predict the following year’s COLA.

It’s not exactly exciting drama, but retirees can forecast their COLA as soon as the September CPI data is added to the calculations. This is usually released by late October or early November.

Next post:  TIPS & I bonds.

 

Related articles:

Living with inflation

Effect of inflation on a dollar

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Living with inflation

March 3, 2011 by · 5 Comments

The last post described the long-term effects of inflation and explained how a COLA pension (plus a portfolio of equities) can stay ahead.

One of the issues with the COLA system is its reference: the Consumer Price Index, or CPI. Critics claim that the government manipulates the CPI to make each COLA as small as possible. Conspiracy or fact? Well, a little of both.

First, the CPI is made up of a number of smaller indexes, each with their own basket of goods and services. It can also be broken down into smaller portions like the “core CPI” for more detailed comparisons. The idea is to be able to compare effects consistently across the years while updating the index for changes in consumer choices and spending.

Next, although the CPI no longer includes the early 20th-century cost of whalebone corsets, it also may not include some of technology’s latest “necessities” like smart phones or late-model gaming systems. The Bureau of Labor and Standards periodically updates the goods and services that make up the CPI to ensure that they reflect broad consumer behavior.

Third, over the years the BLS has noted a number of consumer behaviors that affect the CPI. One of these is the “hedonic adjustment” caused by recessions or periods of high inflation. A family may usually enjoy a weekly steak dinner, but if the family wage-earner is unemployed or if the price of beef soars, then they may switch to a cheaper cut of meat– or even hot dogs. Another change in consumer behavior is known as the “Wal-Mart effect”. As Wal-Mart stores spread throughout the nation, their relentless focus on price-cutting is estimated to reduce inflation by as much as 15% of the annual rate. In other words, if inflation was rising at a historical 3%, the Wal-Mart effect can knock the price trends down to less than 2.6%.

These effects seesaw back and forth across the nation, from urban to rural regions, and from one year to the next. Their cumulative effects are subject to seasonal adjustments (like holiday shopping) and national phenomena like election years or the price of gasoline. As the BLS attempts to update the index or to accommodate the various effects, cynics and skeptics claim that the index is being mercilessly manipulated to reduce next year’s COLA– or even to raise it to pander to voter blocs.

How can an individual consumer adjust their portfolio savings and their spending to handle this fluctuation? It turns out that an individual’s spending doesn’t really have much to do with the CPI. If you’ve been tracking your spending for a few years then you may notice that certain restaurants have raised their prices or a pound of ground beef costs more at the grocery store. However you may also have changed your own behavior: you’re eating at different restaurants or trying different types of beef. Your own spending varies from one year to the next just as the CPI varies across the nation and different demographics.

The best answer for a retirement portfolio is to keep an eye on inflation trends and choose an asset allocation that will keep up with (or even exceed) the rate of inflation. That’s usually an allocation high in equities, which have been the only asset class to consistently beat inflation over the span of a retirement. The best answer for consumer spending is to continue to put your money where it matches your values, and to be ready to “pay the price” for your values. You may decide that you’d rather have a higher savings rate and achieve financial independence more quickly, or you may choose to extend your career for a few months to enjoy a higher standard of living.

How did Groucho Marx handle inflation?
He was once asked what he invested his earnings in, and he responded “Treasuries!”
The journalist commented “You can’t retire on just a portfolio of Treasuries.”
Groucho’s riposte: “You can if you have enough of them.”

Next post: How the military pension COLA is calculated, and why TIPS or I bonds aren’t such a good idea in a military retirement portfolio.

Related articles:
Effect of inflation on a dollar
Will Congress change military retirement?
Financial myths of retirement (part 1 of 2)
Financial myths of retirement (part 2 of 2)
The biggest benefits of a military retirement

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Retiring on multiple streams of income

December 15, 2010 by · 23 Comments

This topic isn’t tied to “The Military Guide” chapter on the Reserve/National Guard, but those military retirees frequently confront a retirement consisting of multiple sources of income. Veterans who retire from active duty will go straight to a pension, but Reservists/NG have to find some other source of cash flow between the time they apply for “retired awaiting pay” and their 60th birthday.

Here’s an example of a Reserve retiree who figures out how long to work and how to tap into the various sources of spending money.  For simplicity (and stable links to the reference websites) we’ll base these numbers on the military’s 2009 pay tables.

CWO2 Jane, age 40, has just completed her 20th “good year” of Reserve service.

She also has a civilian job, but she tentatively plans to retire from the Reserves at age 42. She’s going to continue working in her civilian career (for now) but she’s eager to retire from that, too– as soon as she can comfortably live off her assets and her pension(s).

She realizes that she’ll be able to completely retire somewhere between age 42 and age 65. Her confidence is boosted by knowing that at age 60 she’ll have the Reserve pension adjusted every year for inflation, plus very affordable Tricare. She currently has good health insurance through her civilian job, but she knows that Tricare Retired Reserve is also available (at a price) if she needs it.

Jane has spent many hours on her detailed retirement budget. It includes her living expenses and premiums for high-deductible catastrophic health insurance before age 60, as well as the replacement costs of vehicles and major appliances. She’s even added in a couple of fantasy vacations and a new roof. She’s estimated her property taxes and state/federal income taxes in her 15% bracket, although her military pension is free of state tax. She projects a basic budget of $35,000/year (including taxes) but she’d prefer to have at least $40,000/year to support travel and other entertainment.

She just received her official Reserve verification that she’s served 20 good years with a total of 3800 points. The maximum longevity pay at her rank is W-2>24 or $4935/month.

Her pension will be based on the military pay scale in effect at age 60, 18 years from her retirement date. Assuming that military pay keeps pace with the Employment Cost Index and the Consumer Price Index (admittedly a big leap of faith), in 2009 dollars she’ll get a pension (with a COLA) of 2.5% x (3800/360) x $4935 = $1302/month or $15,627/year.

Jane has no idea what future inflation will be but she knows that 20th century inflation averaged about 3.5% per year.

She estimates that her Reserve pension’s COLA will be the same as the CPI. To be conservative, she’ll estimate that her spending will rise at the same rate as the CPI. (For the purposes of this example, it keeps the results in equivalent inflation-adjusted 2009 dollars. A retirement calculator or a spreadsheet will be able to handle different rates of COLAs and inflation.) She knows that if necessary she could always cut her spending to her basic budget.

In addition to her Reserve pension, Jane also has $250,000 in taxable accounts. Her conservative mix of stocks, bonds, and cash pays a long-term average of 5% per year, although that fluctuates. Since inflation is rising at 3.5% per year, she knows that her taxable account’s after-inflation “real” return is only 1.5% per year, and she still has to pay taxes on its gains when she withdraws the money. These taxes are part of her basic budget.

Jane’s civilian employer does not offer a defined-benefit pension plan– only her defined-contribution savings. She has $75,000 in tax-deferred accounts such as a 401(k), a 403(b), and the military’s Thrift Savings Plan. These accounts can generally be tapped without penalty after she turns 59½ years old, and she must begin required minimum distributions shortly after age 70. She can also make penalty-free withdrawals using the Internal Revenue Service’s rule 72(t) system of “substantially equal periodic payments”.

Because she doesn’t have to pay taxes on these accounts until she withdraws from them, she’s hoping to let them compound their tax-deferred earnings as long as possible. She’s invested these accounts in higher-return more volatile assets such as equity indexes in small-cap value and international stocks. She expects to receive a long-term result of 7% per year, or 3.5% per year after inflation (and before taxes).

Jane has another $100,000 in her Roth IRA. $50,000 of it comes from her 20 years of after-tax contributions. She can withdraw her contributions anytime without penalty, and she can withdraw the earnings without penalty after she turns 59½. Again she’s hoping to let her Roth IRA compound its tax-free earnings as long as possible because it’s also invested in volatile assets and will hypothetically reach a higher value.

Jane is entitled to Social Security as early as age 62.  If she starts distributions before age 67, though, they’ll be permanently reduced by as much as 25%. She plans to delay SS to at least age 67 and, if possible, age 70. Based on her current earnings record and the Social Security online benefits estimator, at age 62 she’ll receive $1050/month ($12,600/year), at age 67 she’ll receive $1400/month ($16,800/year), and if she can wait until age 70 she’ll earn $1700/month ($20,400/year).

Jane begins by estimating her lifetime annual income if she retires at age 42:

Age Income Shortfall Comments
42 $0 $40,000
60 $15,627 $24,373 Reserve pension only

At this point she’d need $40,000/year to maintain her ideal lifestyle. Although her $250K taxable account may continue to grow at 5%, $40K/year is an unsustainable withdrawal rate. If it continues to grow at a steady 5% per year then it might last seven or perhaps eight years. However a bear market could cut her to less than five years, even if she drastically reduces her spending.

If she depleted her taxable investments by age 48 then she’d turn to her Roth IRA and her tax-deferred accounts. Her Roth’s contributions would give her another year of penalty-free withdrawals to make up her shortfall, but then she’d have to start withdrawing the rest of the accounts (through a 72(t) SEPP plan). The tax-deferred accounts would have grown during the years that she was spending down her taxable assets and her Roth contributions, but she’ll almost certainly deplete her Roth IRA and her 401(k)/TSP before her Reserve pension begins. That’s not going to work.

She realizes that her retirement is in jeopardy between ages 42 and 60. But when her pension starts, will she have enough for the rest of her life? Conventional wisdom (from the Trinity Study) claims that she can begin withdrawing up to 4% annually of her remaining assets (and raise that amount every year for inflation) for 30 years.

Age Income Shortfall Comments
60 $15,627 $24,373 Reserve pension only
62 $28,227 $11,773 Reserve pension + 25% reduction in SS.
67 $32,427 $7573 Reserve pension + full SS.
70 $36,027 $3973 Reserve pension + maximum SS.

A shortfall of $24,373 at age 60 requires a portfolio of $610,000 to support a 4% withdrawal rate ($24,373 divided by .04, or multiplied by 25). However by age 62 she only needs a $295K portfolio to support that shortfall on a 4% withdrawal rate, and by age 67 it’s under $200K.

At age 42 Jane will only have $425K in assets, but she can see that by age 62 she’ll have more than enough to retire even if she doesn’t save any more in her taxable or tax-deferred accounts. If she continues working (and saving) for the next 18 years then she’ll be able to retire no later than age 60, when her Reserve pension starts.

There’s a safe haven between the two extremes: (1) retiring from both the Reserves and her civilian job at age 42 and consuming her investment portfolio, or (2) working until age 60 and retiring on several streams of income.

The simplest option would be to:
- continue serving in the Reserves and her civilian career until her portfolio is big enough to bridge the gap. Even another five years of Reserve drills would add at least 375 points to her total and 10% to her pension.

Another option might be to:
- invest a portion of her portfolio in rental real estate to generate additional cash flow, although landlording involves additional risks.

A conservative option might be to:
- continue her full-time civilian career and Reserve drilling for another 5-10 years before retiring from one, and then consume her portfolio until her Reserve pension starts (with employment income and enough portfolio left to make up the shortfall).

A fourth option would be:
- working part-time, or on a series of temporary jobs, to allow her to semi-retire and enjoy some extended travel before age 60.

Jane can fine-tune her retirement date by running spreadsheets and retirement calculators. (See the Recommended Reading section for websites and other products.) The biggest factor under her control is maximizing the amount she saves in her tax-deferred and taxable accounts. Another factor is gradually reducing the equity risk of her taxable account when she gets ready to spend it– she doesn’t want to have to cash out in the middle of a bear market. Finally, staying healthy is a big incentive to reduce the cost of health insurance. She can’t do anything about her genes or catastrophes but she can maintain healthy habits and avoid “lifestyle” syndromes like tobacco or weight gain.

In this example, Jane could afford to retire in her mid-50s and perhaps even in her late 40s. Her situation is a simplified version of real life. Real-life planning becomes much more complicated when raising a family, paying a mortgage, and saving for a kid’s college education. It becomes even more difficult if a divorce, a stock-market meltdown, or prolonged unemployment derails the plan. The key to success is deciding what brings value to life– spending money or saving it for retirement. There’s a balance between the two, just as there’s a balance between a Reserve/National Guard career and a civilian career. We’ll revisit that work-life balance concept in a later post about saving for early retirement.

Related articles:

Military retirement spending: how much will I need?
Retirement finances: what will I spend?
Retirement budgeting

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Comparing an E-7 active-duty pension to an E-7 Reserve pension

December 9, 2010 by · 5 Comments

Consider two 18-year-olds who join the military on the same day.  One stays on active duty for 20 full years to retire as an E-7. They’ll base their pension on 2.5% x 20 years = 50% of their High-Three retirement system. Under the current High-Three* rules, their pension would be 50% of the average of the highest 36 months of base pay.

The second 18-year-old serves eight years on active duty while advancing to the E-6 pay grade, and then separates for a Reserve billet. Over the next 12 years as a drilling Reservist they complete their “weekend a month, two weeks a year” of drills and active duty, while also mobilizing for two separate year-long deployments. They promoted to E-7 at about the same career point as their active-duty counterpart. Upon reaching 20 years of total service (eight years of active duty plus 12 “good years”) they request retirement awaiting pay.

Both E-7s are the same age, the same rank, and subject to the High-Three rules.  However the active-duty E-7 retires and immediately starts drawing a pension. If they retired in 2010 then this calculator sets their pension at $1957/month or $23,489/year.

Their pension includes annual cost-of-living adjustments that are roughly equivalent to the Consumer Price Index, the government’s official measurement of inflation.  These COLAs will continue for as long as they (and their survivors, if they chose a survivor benefit plan) draw their pension.

When the second servicemember joined the Reserves, their active-duty time was credited to their Reserve point count at the rate of one point for each day. Each year-long mobilization would earn at least another 365 points. By serving “a weekend a month, two weeks a year” over their other 10 “good years”, they can conservatively be expected to average another 75 points each year.  These are average numbers– some Reservists will earn more points, some will earn less.

At retirement the Reservist would have a point count of eight years of active duty, 10 years of drills, and two one-year mobilization periods.**  Their total would be at least 8×365 + 10×75 + 2×365 = 4400 points. The current instruction converts points to equivalent years by dividing into 360 (not 365). The percentage earned toward a Reserve pension would be 2.5% times the point count divided by 360, or 30.5%. Although they were mobilized for two of their 12 years in the Reserves, at this point the Reserve E-7′s pension eligibility is only about 60% (30.5%/50%) of the active-duty E-7′s pension.

The Reservist’s pension also doesn’t start until they’re age 60– another 22 years. The good news is that because they “retired awaiting pay” instead of “resigning” from the Reserves, their pension will be calculated using the E-7 pay scale and maximum E-7 longevity in effect at age 60.

It’s very difficult to predict how E-7 pay will change over the next 22 years, but it would be nice to have some numbers to refer to before making a decision to stay on active duty or to transfer to the Reserves.   One pay assumption would be that it would keep pace with the civilian equivalent of their E-7 specialty.  In that case the military’s E-7 base pay scale would rise by roughly the Employment Cost Index. Hopefully in 22 years, Congress and the Department of Defense will agree that an E-7′s salary should have about the same purchasing power that it has today. In that case the ECI would roughly keep pace with inflation and the Consumer Price Index.

The reality is that it’s impossible to confidently predict future pay scales, the ECI, the CPI, or pension COLAs. However since the all-volunteer force began in 1973, the only proven way to retain servicemembers has been to keep military pay competitive with its civilian equivalent.  (Otherwise we wouldn’t have volunteered!)  Congress has attempted for several years to raise military pay at the same rate as the ECI (even greater for some ranks) and the pension COLA calculation closely tracks the CPI. Despite the uncertainties of predicting the next 22 years of pay raises and pension COLAs, it’s reasonable to assume that future E-7 pay will have roughly the same purchasing power as today’s pay.

While awaiting retirement pay for those 22 years, the Reservist will also be credited with the maximum longevity in that E-7 pay grade– 26 years– even though they only served for 20 years.  In the 2010 military pay tables, the pay for E-7>26 is over 13% higher than E-7>20.  So although the Reservist’s pension eligibility only had about 60% of the equivalent active-duty pension when they retired awaiting pay, by the time they’re drawing that retired pay their longevity pay scale has risen another 13%. The result is that by age 60 the amount of the Reserve E-7 pension has risen to nearly 70% ([30.5% x (1+13%)]/50%) of the active-duty E-7′s pension.  If all of the pay assumptions are reasonably correct (and that’s a mighty significant “if”), then in today’s dollars they’d receive about $1350/month or $16,217/year.

Now that we’ve gone through the calculations the hard way, you could build your own spreadsheet to tinker with various ECIs and CPIs.  Or you could try out your own assumptions with one of the pension calculators here or here.

The biggest difference between active-duty and Reserve pensions is that the active-duty E-7 immediately started drawing their pension at age 38 at 50% of their High-Three pay average in effect at retirement. The Reserve E-7 would have also retired at age 38 but had to wait 22 years for their pension, calculated at the maximum longevity and pay table in effect during the year they turned 60. If their pension at age 60 preserved its purchasing power at least as well as the active-duty E-7′s pension, then their first pension payment would be almost 70% of the active-duty E-7′s pension payment– even though the active-duty E-7 has been receiving a pension for over two decades.

When the 60-year-old Reserve E-7 finally starts drawing their pension, that income stream will continue to rise with the same annual COLA as the active-duty E-7′s pension. Their pensions will be one component of a retirement made up of tax-deferred accounts, taxable accounts, and any pensions from other (civilian or civil-service) careers.

The next post will show how to plan a retirement with multiple streams of income.

[*A couple of final notes for the expert reader: we could make this post a lot more complicated by having these E-7s choose the REDUX retirement plan, but I'm saving that analysis for a separate post.  For now let's just say "Don't do it."]

[** This post assumes that the Reservist's deployments did not make them eligible for an earlier retirement.  Under current legislation if those deployments had happened in 2008 or later then they may have been eligible to start receiving their pension as early as age 58.]

Related posts:
The Reserves and National Guard
Mobilizing with the Reserves and National Guard
Retiring from the Reserves and National Guard

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