Retiring on Multiple Streams of Income
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:
|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.
|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.
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