Military Financial Independence

Moshe Milevsky’s book “Are You a Stock or a Bond?” suggests that military on active duty can invest much more aggressively than many civilians. Milevsky’s concept of “human capital” grew out of his studies of investment and retirement plans.

He noted that every worker has the lifetime potential to earn different amounts of money, with varying degrees of reliability and predictability, depending on their potential occupations. Some careers had a high degree of continuous employment and steady income. Civil servants and university professors could all be expected to have relatively steady jobs which, while not paying large salaries, would earn a decent income with good retirement benefits. The modest yet predictable nature of their income was like a bond.

Other occupations, like Wall Street financier or professional sports, could generate huge payoffs in bonuses or options– but their likelihood of employment and the reliability of their income could be volatile. They could be laid off during any recession or a single injury could end their career.

Although they would probably earn a much bigger total than more steadily-employed professions, their income was not predictable and they might even have to arrange for their own retirements with tax-deferred savings and annuities. The wild swings of their employment and their income resembled a penny stock.

A military member’s “human capital” has the potential to earn millions of dollars over the years between school and retirement. With every paycheck, their years of training, skills, and experience are converted to investment dollars plus retirement and healthcare benefits. Even in a combat zone their pay, benefits, and insurance rise to cover the higher possibility of injury or death.  The military’s reliable predictability of employment is the equivalent of a steady stream of high-quality income. It’s as good as a portfolio of government bonds.

When you’re on active duty you’ll enjoy a steady stream of largely predictable income. According to Milevsky, the asset allocation of your investment portfolio can shift to stocks because your human capital already resembles bonds. You’ll still need an emergency fund and you’ll still want to save for specific goals like buying a home, but you don’t need to allocate much money to low-volatility assets like bonds or Treasuries or CDs. As long as you’re on active duty or drilling for Reserves/National Guard pay then you can take extra risks with your investments for an extra 1% of returns.

If you’re saving military paychecks for retirement, or if you’re retired on a military pension, then you can take extra investing risks! The income stream of your pension is based on one of the world’s highest-quality annuities resembling a portfolio of inflation-adjusted bonds or Treasuries.

If you had to buy these bonds to produce the income stream of your pension, it’s possible that their value would be greater the rest of your savings. In that case, the majority of your overall investment portfolio, including both your pension and your other assets, would be its bond component. Offset that bond allocation by investing the rest of your portfolio in larger portions of equities and real estate. The compounded extra return over 20 years will greatly increase your portfolio and speed your retirement.

The challenge of this financial analysis is its emotional turbulence. While your high-equity portfolio will earn a greater long-term return, it has much higher short-term volatility. If you can sleep at night despite a -25% year once a decade, and if you don’t need to convert the assets to cash within five years, then you could invest more aggressively. You could rely on the bond-like income stream of your paycheck or retirement benefits while raising your asset allocation in stocks, including small-cap and international equities, to enjoy greater returns.

If you find that an occasional 25% loss causes you enough emotional stress to consider abandoning your strategy at the worst possible time (despite its long-term rewards) then reduce your asset allocation of equities until the volatility is low enough to live with. Everyone swears that they’re able to tolerate a high degree of investment volatility, but that’s generally only true during a bull market. No one enjoys downward volatility, and selling equities at the bottom of a bear market will quickly wipe out those earlier years of extra gains.

If you’ve used your Reserve/National Guard career to reach retirement with a smaller pension, or if you retired with no pension at all, then consider using a portion of your savings to buy a no-frills annuity that provides a small percentage of your retirement income. (Milevsky’s book has more details on the types of annuities and their expenses.)

Annuities earned a (deservedly) bad reputation in the 1990s for their high sales commissions and expenses, but even Milevsky has been impressed by their recent improvements. Insurers have learned a lot about estimating their annuity risk, too, and their products are more likely to be backed by a strong company with adequate assets.

An annuity isn’t as highly guaranteed as a military pension, but your retirement annuity can support a “basic necessity” lifestyle. Keeping a few years’ expenses in money markets and CDs will allow you to ride out the worst of a bear market’s volatility while remaining confident that your overall portfolio has the resiliency (and the time) to recover from the inevitable financial roller-coaster.

Related articles:

Retiring on multiple streams of income
Retiring from the Reserves and National Guard
Retiring without a military pension

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Short post today, folks. It’s a straightforward topic and you’re probably busy getting ready for the holidays!

Before we start, here’s another reminder about getting on the road to financial independence:  are you tracking your spending yet? If you’ve been doing that for a few months, then have you put together a budget? Next let’s talk about how much of your spending & budgeting should be devoted to saving and investing.

Make it Automatic with Payroll Deductions

Financial advisers (and our parents) use dozens of sound-bite homilies to get our money out of our hot little hands and into an investment account before we’re subjected to temptation. “Pay yourself first.” “Out of sight, out of mind.” “You can’t spend it if you don’t have it.”

As annoying as that advice may be, it works. Frugality and budgeting help you align your spending with your values. If saving isn’t a top priority then it will never be an important part of your budget, and you won’t save enough to let compounding work its retirement magic.

Every day you’re confronted with spending choices– the $4 latté, buying lunch instead of bringing your own, maybe stopping at the exchange for a six-pack and a new DVD on the way home. But how often do we see our savings choices? Even if you happen to find a way to save money that day, you’re not going to run to the nearest ATM to deposit it into your savings account.

Instead of having to compare every daily spending decision against your savings goals, though, you can set a savings goal and then put it in autopilot. After you build your budget and decide how much you can afford to save, then use your service’s payroll deductions and allotments to make it happen automatically. You have five main choices to decide where to save and invest your money: your Thrift Savings Plan, your IRA(s), your taxable investment accounts, your savings account, and (if you have a civilian job) your employer’s defined-contribution plan (like a 401(k)).

After you set your savings goal, then try to start the investing process by maximizing your contributions to your Thrift Savings Plan. Next consider an allotment to a fund company for your IRA. When the rest of your paycheck arrives in your checking account, have an automatic deduction send some of it to a taxable investment account. Sweep more of it to your money-market or savings account.  Leave only that month’s budget in your checking account.

Whatever savings and investing goals you choose, let technology take care of it for you every payday so that you’re not tempted to “adjust” the priorities every month for a little lifestyle upgrade. When deductions whisk the money away before it’s in our hot little hands, it’s easier to conserve what’s left and make it last until the next payday. You won’t be tempted to rationalize yet another month of spending while feeling that you just can’t seem to save as much as you hoped.

Save the Special Pay and the Pay Raises

A huge opportunity comes with every annual military pay raise, longevity pay raise, special pay, bonus, and promotion.  For example, take a look at the military pay tables and imagine the “wealth effect” of a two-year longevity raise or a promotion.  If you don’t control your expenses to your budget (especially for “entertainment”) then this “extra money” just gets spent without planning for its effect on your financial independence. 

These are the windfalls that you may be able to learn to live without and can send straight to savings. Some pay raises are more permanent (annual raises, promotions) than others (combat pay, hazardous duty pay, bonuses). Inflation will also continue to eat away at a budget and a growing family will always grow more expensive. But instead of raising your spending in anticipation of more pay, try to raise your savings rate.

A good compromise between frugality and deprivation would be to attempt to save at least 80% of every extra pay. You’re giving yourself a little spending treat (10-20%) but the reality is that you’re trying to save almost all of it.  If you try that for a couple of months and it’s causing too much pain then you can reduce the savings percentage. It’s far less painful to ease up on the savings rate than to try to raise it!

The next post will go into more detail on the TSP, IRAs, and taxable investment accounts.  After that we’ll talk about how much to save, and for how long.

Related articles:

Retirement budgeting
Military retirement spending: how much will I need?
Retirement finances: what will I spend?
Military retirement: how much can I really spend?
Retiring on multiple streams of income

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