Factors to Consider When Making a Major Retirement Decision
We are as transient of a workforce as ever before. With these transitions come change and decisions. New jobs offer different incentives and that can be tricky. Comparing the numbers is certainly a part of it, but it’s important that we understand the context of the numbers for your specific situation. This post will use facts focused on my military retirement, but these same ways of thinking can be used for anyone choosing between different compensations. I’ll do my best to give you some context, some mathematical base to backup assumptions, and my thought process as we go.
The Biggest Changes In Decades
For the first time in decades the United States Military is getting a retirement overhaul. The last time there was any change worth noting was 1986, which changed how they calculated pensions. They began to average your highest three years of salary instead of simply basing it off your final paycheck. That in of itself was not that big of a deal, but it also brought about a retirement plan option that gave the government a bad name. That plan was the CSB/REDUX which was a terrible choice for the member. In return for a bonus, the member had to sacrifice 20% of their monthly retirement income and almost eliminate inflation adjustments, all while still requiring a 20 year career to receive any money. That’s just some history to show you how unprecedented this change is and also to frame the perception most military member have to changes like this.
Now members are presented with a new plan and unfortunately many won’t even consider the change due to the lost trust from previous offerings. This new plan, called the Blended Retirement System (BRS), is an entirely different beast. This change introduces the ability to get some compensation without doing 20 years, it puts responsibility on the service member, and it introduces a matching system similar to most civilian 401ks. It doesn’t lower your inflation adjustment (2.1%), which is much more valuable than most realize. There’s been a lot of great work out there on the straight math comparison, but I’m going to look at the math along with context that I think many of us overlook.
Reduction in Guarantees, Addition in Flexibility
Normally a military pension involves getting paid 50% of your 3 highest base pay years if you do 20 years. The member did not have to contribute anything, there was no variability, and 19 years wasn’t worth a penny. The new plan reduces the payout from 50% to 40% and adds up to a 5% match. The 5% can be taken with you if you don’t make 20 years so essentially you are trading some guaranteed money for additional flexibility. Keep in mind that a drop from 50% to 40% of salary is an actual pay reduction of 20%, I often hear that misquoted. It’s important to note that these pensions begin immediately at your retirement date. That means most will be eligible to draw their pension as early as 38-43 yrs old depending on when/how they joined. For the new system, much like a standard IRA or 401K, you’ll probably be waiting until 59.5 to touch your 5% match. There are some ways to touch that money early that can be a little more tricky but totally doable. You can read all you want to about that at The MadFientist.
Laying Some Ground Rules
For my situation and the 16 years I have remaining, I would receive ~$65k in today’s dollars from the matching contribution as long as I also contributed 5%. This would grow to around $135k upon leaving the military and then on up to ~$373k by age 59.5 when it was eligible to be used. To help with comparisons I also used something referred to as a Safe Withdrawal Rate (SWR). This rate is an estimate of what we can collect from our nest egg so that it will last all the way through retirement. In most cases, this SWR will allow you to hold on to your entire nest egg and often times it even grows over your life.
(Sorry About the Math…)
The simplest way to calculate a SWR is to take the rate of return you expect from your investments and subtract the estimated rate of inflation. (SWR= %Returns - %Inflaton). I have chosen to use 7% as my estimated returns and 3% average inflation which leads to a 4% SWR. To get 7% returns you’ll probably want at least a mixture of 75% stocks and 25% bonds. I tend to believe in an even higher amount of stocks regardless of age. You may be more comfortable using a 3% SWR if you don’t trust the markets, but I wouldn’t go any lower than that.
Just to make sure we’re on the same page going forward remember this: For every $1 in an account, I assume that it will be worth $1.07 ($1 + 7% return). When I begin to take my money out, I assume that something valued at a $1 will cost $1.03 the following year (that’s the 3% inflation). The difference between the $1.07 and the $1.03 is 4 cents or 4%. And that is the money we’re going to be spending in retirement. So if we desire $40k/yr in retirement, we’ll save up a $1 million nest egg. The $1 million will earn $70k, inflation will take $30k, and we’ll have $40k of interest to spend without even touching the $1 million. To see how much you need to save for retirement, check out the equation just below. If you want even more info on SWR you can again visit the Mad Fientist.
(You will never get 7% avg returns if you are not heavily invested in stocks)
Looks Like a Winner Is Emerging
Using the philosophies described above coupled with an 86 year life expectancy. I calculated that the new plan would pay out $2.145 million over the course of my lifetime, plus a $372k lump sum. Remember, that lump sum will continue providing ~15k ($372k * 4%) per year of income indefinitely. The old plan would pay out $2.178 million over my lifetime with no lump sum. See the following figure
It’s starting to sound like the new plan is a no brainer, but there are some potential gotchas that need to be addressed. From age 43 until 59.5, I’ll have to deal with a 20% reduction in pension income while I’m waiting on my retirement accounts to open up. That means the new plan will pay ~40k/yr until 59.5 then jumps to ~$55k/yr when I begin drawing off my 4% from the lump sum, while the old plan is a consistent ~50k/yr until death.
I’m already putting away $24k/yr ($18,500 in TSP and $5500 in IRA) in retirement accounts which means I’ll have more than enough when I’m 60, but potentially slim margins during those prime years that we all dream of. How much better would my prime years be if I had $50k/yr with the old plan instead of $40k/yr with the new one?
There’s a Big Problem With This Thinking
Now it’s starting to sound like I need to stick with the old one. Who wants the money to rain in when they’re 60, but scrape by in their prime retirement years? Is there some way I could average the spending out so that it isn’t so backloaded? This is when it’s important to look at your entire portfolio.
Let’s say I know I need $65k/yr in retirement. I already have a $40k/yr pension with the new plan, but I still need the additional $25k/yr. I have $250k in my non-retirement account available now and $750k in my retirement account. Some believe that with this setup, I can’t satisfy my $65k/yr need. They used the 4% rule on the $250k non-retirement account, which comes out to be $10k/yr. The $40k pension + $10k interest from the non-retirement account would only be $50k/yr, that’s way short of $65k/yr. There’s a big problem with that line of thinking. You have to look at your entire portfolio along with the timing. In reality I could pull $25k/yr from my non-retirement account, satisfy my $65k/yr need, and completely empty it at that magical age of 59.5.
Did I Just Break The 4% Rule?
Wait a minute…Didn’t I just break the 4% rule and completely wipe out principal? Not when you look at it holistically. While you were bleeding out that non-retirement account for 17 years, your retirement account grew from $750,000 to $2.2 million (remember compounding interest). The reason this works is because by taking out $25k you were actually only using a 2.5% SWR on your total portfolio of $1 million (remember $250k + $750k).
For my specific scenario I also plan to have a nest egg large enough to generate as much or more than I need before considering my pension. I decided to do this as overkill just in case something happens and I don’t receive a military pension. It’s important to have back up plans and bridges of money to get you from one point in your life to the next.
I Heard Free Money
Now that I’m looking at my total portfolio, and the fact that I’m such an aggressive saver, I just can’t imagine how I’m going to miss the differences in my pension payout. Even if the markets perform poorly and my accounts don’t grow as much as I’d hoped, I know I’ll at least have my 40% and a large nest egg with the new plan. I could have 50% and a somewhat smaller nest egg in the old plan, but either way, I’m golden.
The scenario where the plans do make some difference is if I got let go at year 15. Remember that the old plan is an all or nothing system that kicks in after 20 yrs. The new system has part 20 yr pension and part matching. The matching can be taken with you prior to 20 yrs. You’ve essentially gotten a 5% raise above and beyond any peer that leaves the military before 20 yrs and remains under the old system.
So if I was let go at year 15, I’d have about $76k* in “free money”. That free money comes from the 5% government match plus compounding interest for the next 11 years. I could take this with me under the new plan instead of zilch with the old plan. That’s not a lot but it’d buy a house in Mississippi ha. The last thing we all have to consider when making these pension discussions is not all money is created equal.
The Most Underrated Aspect of Investments
In my opinion, match money and pension money are both free money. And if anyone loves free, it’s this guy. The only thing better than free money, is free “forever” money. When I say forever money, I’m talking about money you have complete control over such as the match money. If handled properly this forever money can be used for generations. The gains are harvested and the principle is left for the next group. In contrast, when you and your spouse die, the pension dies with it. So by creating a nest egg large enough, you have essentially created an eternal pension. I have never heard anyone mention this when comparing the two plans, but to some, legacy is a huge part of their financial goals.
We Have a Winner
I’m so glad I forced myself to write this article. I hope it didn’t get too confusing with the examples, but the tangible scenarios are exactly what I needed to help me make up my mind. With the safety of knowing that either of the choices gives me more than enough, I see no big upside with the old system FOR ME. If I get a pension, I’m good regardless and if I don’t, I’d like all the help I can get. With the new plan I definitely see some upside. I get slight insurance in case I don’t get to make it all the way through a 20 year career, and I get more of that good ole forever money either way. I didn’t just look at the strict value of each. I played out MY scenario, and I made what I believe is the best decision for ME.
Ask Yourself the Tough Questions
Consider your situation. Compare options based on your total life. Compare them at moments you project to be most critical in your life. Ask yourself the tough questions: Are you able to save enough outside of your retirement accounts to create a safe bridge between your early retirement age and the age when your retirement accounts can be used? How long is that bridge? Do you wish to leave behind money? If both of your choices were to fail in the future, which one would fail harder? Are you willing to risk going back to work someday? Can you stomach a portfolio full of stocks for decades? These are all good questions to focus on when making these huge and stressful decisions.
Don’t just take my word on it. Do your own research and use the help of some of these other great resources listed below:
MilitaryDollar.com (Fantastic 4 part series)
The complete list of numbers associated with my calculations are below.
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