Here’s my in-depth answer with 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:

How You Can Invest Your Retirement Portfolio

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.

Part Two – Your Human Capital is More Valuable Than You Think

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.

Part Three – Your Pension and Social Security Allow You To Take More Investment Risk

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%).]

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