financial planning

How Much Is Your Military Pay Really Worth?

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Financial posts are some of the most popular on this site, so I figured I would share a great article that summarizes a lot of the financial benefits of being active duty:

How Much is Your Military Pay Really Worth?

Guest Post: Supplemental Disability Insurance for Active Duty Physicians

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(EDITOR’S NOTE: While we have great benefits in the military, one area where our benefits fall short is disability insurance.  If we were to be disabled on active duty, our disability pay would not reflect our physician bonuses and higher income.  For years I struggled to find supplemental disability insurance.  I used the American Medical Association plan because they’d give me up to $2500/month of additional coverage and it was all I could find.  That was until I contacted Andy Borgia at DI4MDs.com.  He was able to get me the amount of coverage I needed when many, many other people couldn’t.  For some reason many disability insurers don’t want to cover active duty.  Below is a post from Andy about supplemental disability insurance.)

May is disability insurance awareness month and also the time of the year a number of physicians transition into new positions due to the completion of most training programs July 1st. As a result, it is an excellent time to examine protecting the most valuable asset any physician has, their ability to practice and earn an income. Whether you are a military physician with a number of years left to serve, soon to be exiting the military or currently in a residency/fellowship program, it would be prudent make certain you are adequately protected in the event you become disabled and unable to practice due to a sickness or accident. Statistics, which can be found all over the internet, including our site, indicate approximately 1 in 3 people will be disabled during their working career, which can be the cause of financial ruin. Disability insurance for physicians is universally recommended.

Being active duty military, you may think you are already adequately protected. This is far from accurate since military disability benefits only cover base pay and do not include incentive, special or bonus pay, allowances or private earned income. These extra forms of income usually provide the majority of a military physician’s pay and should and can be protected. If you are about to leave the military, the day after you are discharged, any military disability coverage will cease and you will be completely unprotected. Establishing an individual disability insurance policy can take up to 4 months, since medical records must be obtained so to be adequately protected requires advanced planning.

To make certain you and your family are protected, establish an individual disability insurance
policy. The individual policy contractual provisions should protect you in your chosen medical specialty for the entire benefit period, provide both total and partial disability benefits, allow for an increase in coverage upon completion of duty without additional medical requirements, and be noncancelable and guaranteed renewable (policy cannot be cancelled, premiums changed, coverage altered by the insurance company). Residents and fellows may be eligible for discounted polices if established prior to completion of training and should be taken advantage of.

Contact an experienced insurance agent that represents a number of companies and is familiar with contractual provisions and underwriting procedures, it does make a difference, to explore your
options. Please visit our website www.DI4MDS.com to obtain our Military Physician Disability Insurance Guide. This will provide an educational first step.

For a complementary personal disability insurance consultation please contact me directly (Andy G Borgia CLU, andyb@di4mds.com, 888-934-4637).

Old vs New Retirement System Explained

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I already discussed the value of a military pension, but this article from the Military Officers Association of America does an excellent job of explaining the old and new systems, so I wanted to reblog it for anyone who’s interested to read:

The New Service Retirement Program

How Valuable is a Military Pension?

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Two recent events led to this post.  First, this article about becoming a multimillionaire in the military appeared on military.com.  Second, I was having a discussion with some other officers about this topic and they thought my opinion on the subject was different from what they had heard before.  Because of this, we’re going to examine the value of a military pension.

How Much of a Pension Do You Get?

Let’s look at two likely scenarios for a physician.  First, someone who stays in for 20 years and retires as an O-5.  Second, someone who stays in for 30 years and retires as an O-6.  Their pensions in today’s dollars based on this calculator would equal approximately:

20 year O-5 = $4,102.50/month or $49,230/year

30 year O-6 = $8,053.50/month or $96,642/year

Remember that your military pension payments are adjusted annually for inflation, a very valuable benefit.

How Much is This Worth?

The easiest way to answer this is to examine the pension and figure out how much money you’d need to have invested in order to pay yourself exactly the same amount of money inflation adjusted for the rest of your life.  Unfortunately, this is not a simple issue.

Military.com Article “Can Military Service Make You a Millionaire?”

The aforementioned military.com article states, “The Defense Department puts the value of the monthly check of an O-6 retiring today with 30 years of service at $2.2 million…The DoD made a number of assumptions, but the idea was to put a price tag or value on the monthly military retirement check a military retiree will receive.”  This article doesn’t go into the assumptions made, but let’s just take it at face value.

My MBA Finance Professor

In 2013 when I was taking my MBA, I asked my Finance professor this very question.  I asked him how he would value a 21 year O-6 pension, another common circumstance for a physician.  At the time this pension was approximately $53,400/year.  Here is what he said:

“If you looked at this as an ‘endowment’ where one would not spend the principal, then take the annualized benefit $53,400 ($4,455 x 12) and divide by a long-term rate such as the 30 year T-Bond rate (3% in 2013) $1,782,000.  In other words, if you had that $1,782,000 and put it all into 30 year T-Bonds at 3% you would get your $4,455/month.  Of course, the issue is whether the 3% is a good number for the long-term.  If, however, you were to look at this as an ‘annuity’ where you would spend down the principal until time of death, then you have all sorts of demographic stats issues (e.g., expected life after retirement, future interest rates, variability of the annuity investment, cost of living adjustments, etc.).  In a nutshell, it can get quite complex. There are a number of websites available often through reputable firms such as Fidelity, Vanguard, etc., that you can perhaps access that have such calculations available already (instead of having to create your own model).  You can plug in your what if’s and see what pops out.”

Using the 30 year T-bond (Treasury bond) rate from 3/18/16, which was 2.68%, here is the valuation with his methodology:

20 year O-5 = $49,230/2.68% = $1,836,940

30 year O-6 = $96,642/2.68% = $3,606,044

The problem with this analysis is that a regular 30 year T-bond is not inflation adjusted, so in my opinion you’d have to compare it to TIPS (Treasury Inflation Protected Securities).  A recent yield on a 30 year TIPS bond is 1.12%, which would value the two pensions we’re considering at:

20 year O-5 = $49,230/1.12% = $4,395,536

30 year O-6 = $96,642/1.12% = $8,628,750

Keep in mind that the lower the Treasury bond yields go, the more valuable your pension is because you’d have to invest more money to get the same payout.  Since today’s Treasury yields are at historic lows, these valuations are probably as high as they’ll ever get.

Annuity Websites

If you go to annuity websites and try to purchase an annuity for these two amounts, here is how much they would cost:

Fidelity Guaranteed Income Estimator:

For a 20 year male O-5 who is 50 years old, lives in Virginia, and wants to earn $4,103/month or $49,236/year with a 2% annual income increase (equivalent to the inflation adjustment of your military pension) the pension would cost $1,322,826.

For a 30 year male O-6 who is 60 years old, lives in Virginia, and wants to earn $8,054/month or $96,648/year with a 2% annual income increase (equivalent to the inflation adjustment of your military pension) the pension would cost $2,103,257.

The 4% Rule

The 4% rule is a commonly accepted retirement “rule” that says you can take 4% out of your retirement nest egg every year, annually adjusted for inflation, and never run out of money.  In other words, for every $40,000/year of income you need in retirement, you need to have $1 million saved for retirement.  Whether the 4% rule is valid in today’s low yield environment has been debated, but let’s just assume it is still valid (because I think it is).

If you divide the annual military pension by 4% it would give you the size of the nest egg you’d need to withdraw that amount:

20 year O-5 = $49,230/4% = $1,230,750

30 year O-6 = $96,642/4% = $2,416,050

Keep in mind that your government pension is guaranteed by the federal government but the assets used in the typical application of the 4% rule, like your retirement accounts and other assets, are not, making your pension a much safer bet that is probably worth more than the numbers above.

Unquantified Value

There is some value in the military pension that people tend to underestimate.  First, it is guaranteed by the US government, which makes it “risk free”.  The only option discussed above that would offer this same value is the valuation comparing the pension to Treasuries.  Even an annuity from an insurance company is not risk free because insurance companies do go out of business.  (I will admit, though, that this is a rare event, and you could diversity by purchasing annuities from multiple companies, so an annuity can be pretty close to “risk free”.)

Second, you can’t screw it up.  Investors are their own worst enemy.  They buy high, sell low, trade too frequently, don’t save enough, over estimate how high their returns will be, pay excessive investment fees, and other errors that can very easily screw up your well planned retirement.  You can not screw up your military pension.

Third, some states don’t tax a military pension.  You can find that info here on-line or here in PDF form.

Fourth, and this benefit is HUGE for me.  I see my military pension as equivalent to a massive pile of TIPS.  This allows me to take much more risk with the remainder of my investment portfolio and net worth.  How much risk?  Overall my asset allocation is 90% in stocks, which is a lot more risk than most people would recommend at my age of 40.  Because of my pension, though, I don’t think I’m taking too much risk.

The Bottom Line

As you can see, a military pension is risk free, inflation adjusted, and can be quite valuable.  Can you make more money as a civilian, save well, and accumulate even more than this?  Yes, but this is all determined by your civilian salary, discipline as an investor, and rate of return on your investments, which no one knows since they can’t predict the future.  A military pension is a very valuable and underappreciate financial asset that is probably worth somewhere between $1,200,000 and $2,500,000, depending on how long you stay in and what rank you achieve.  If you try to match the risk with Treasury bonds at today’s rates, it is worth a lot more.

Have Student Loans? Check This Out

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Although personal finance is a hobby of mine, I’m nowhere near an expert when it comes to student loans because I never had them.  That said, I know there are a lot of Navy physicians who do have them and might want to refinance.  Anyone who does have loans should check out the White Coat Investor because it is probably the best resource on the web for information on dealing with student loans (and other financial topics).  Here is his latest post:

What Should I Do With My Student Loans?

The 5th Step to Financial Freedom – Invest in Stock and Bond Index Funds

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Investing in stock and bond mutual funds (not individual stocks and bonds) is the simple way to get higher investment returns than more conservative investments like bank accounts, money market funds, or certificates of deposit (CDs).  By owning stock funds, you own businesses, and the long-term return of these businesses is what will increase your investments and net worth.  In addition, it is the only way you can invest and stay ahead of inflation.

If you put your money in a savings account that earns 1% (the highest rate you can get nowadays) but inflation is 3% that year, you just lost 2% of purchasing power.  With a historical inflation rate of approximately 3%, you can’t even keep up with inflation and break even without taking some risk and earning a return of at least 3%.  The long-term return of the stock market is approximately 9.5% per year.  Adjusting for 3% inflation, $1 of purchasing power invested grows to: (Bogle, 2007)

  • $1.88 in 10 years
  • $3.52 in 20 years
  • $6.61 in 30 years
  • $12.42 in 40 years
  • $23.31 in 50 years

When it comes to selecting stock and bond mutual funds, you will have to take a look at the investments offered by your financial institutions and select from that menu.  The principles to guide you should be:

1. Favor index funds over actively managed funds. An index fund is a fund whose goal is to mirror the performance and composition of a standard basket of investments, like the Standard & Poor’s 500 (S&P 500) Index. An actively managed fund means that a fund manager is buying/selling investments as they see fit in an effort to beat “the market” or a comparable index.  We’re investing for the long-term, and over this time frame almost no actively managed funds will beat their index.  In addition, because past performance does not predict future performance, there is no way to predict which of these very few active funds will beat their index.  Index funds are low cost, tax efficient, simple, and give you a higher return.  Don’t try to beat the market, join it by investing in index funds.

2. Favor mutual funds with low expense ratios. What is an expense ratio? An expense ratio is the percentage of a fund’s assets that is used for expenses.  In other words, if you invest in a mutual fund with a 1% expense ratio and that fund makes 10% in 2016, you’ll only get a 9% return on your investment because 1% goes to pay expenses.  The less of your return you use to pay expenses, the more you get to keep.

What is an average expense ratio?  An average stock mutual fund has an expense ratio of about 1%, but the expense ratios for mutual funds that are similar in their composition can vary wildly.  For example, if you look at a list of S&P 500 index funds offered by investment companies, you’d find expense ratios as low as 0.05% (Vanguard S&P 500 Index Fund Admiral Shares, VFIAX) and as high as 0.6% (Great-West S&P 500 Index, MXVIX).  While 0.55% does not seem like that large of a difference, keep in mind that costs last forever and that small differences compounded over years will cost you a lot of money.

What is an average expense ratio?  An average stock mutual fund has an expense ratio of about 1%, but the expense ratios for mutual funds that are similar in their composition can vary wildly.  For example, if you look at a list of S&P 500 index funds offered by investment companies, you’d find expense ratios as low as 0.05% (Vanguard S&P 500 Index Fund Admiral Shares, VFIAX) and as high as 0.6% (Great-West S&P 500 Index, MXVIX).  While 0.55% does not seem like that large of a difference, keep in mind that costs last forever and that small differences compounded over years will cost you a lot of money.

Let’s pretend that when you are 25 years old your grandparents give you $10,000 to invest in a S&P 500 index fund for 50 years, during which you earn a 9.5% return.  If you invested in the Great-West index fund with the 0.6% expense ratio, you would have $683,000.  If you invested in the Vanguard index fund with the 0.05% expense ratio, you would have $902,000.  That 0.55% difference in the expense ratios cost you $219,000!  Small differences in expenses can make huge differences in long-term investment returns, so you need to pay attention to the expense ratios of your investments.

The expense ratio should be less than 1%, preferably less than 0.5%, and optimally less than 0.25%.  If you want to keep this really easy, just invest in the index funds offered by the Thrift Savings Plan (TSP) or Vanguard as they all meet these criteria.

3. As previously discussed, in order to beat inflation over the long haul, you’ll need to invest some of your portfolio in stock index funds. Investing in stock and bond funds is not for the weak hearted because you can lose money. Over the long term, though, assuming higher risk leads to a higher return.  As you progress toward retirement, you will decrease your investment risk by decreasing the amount you invest in stocks and increasing the amount you invest in bonds.

The optimal asset allocation of investments depends on your age, financial situation, risk tolerance, and how soon you will need to utilize the investment.  If you are young, you have longer to ride out the inevitable market swings.  The more financially secure you are, the better you can deal with the swings as well.  Your asset allocation should also reflect the amount of risk tolerance you have.  My opinion is that you should take as much risk as you can tolerate.  If you can’t sleep at night because you are worried about your investments, it is time to dial down the risk, but you should take as much risk as you can up to that point.  More risk yields a higher return over the long-term.

A number of guidelines for asset allocation from trusted references are discussed below:

Malkiel & Ellis suggest this as a conservative asset allocation:

AGE GROUP PERCENT IN STOCKS PERCENT IN BONDS
20-30s 75-90 25-10
40-50s 65-75 35-25
60s 45-65 55-35
70s 35-50 65-50
80s+ 20-40 80-60

They also suggest a more aggressive asset allocation, which is my personal favorite due to the protection offered by our inflation adjusted military pension (assuming you stay in for 20 years):

AGE GROUP PERCENT IN STOCKS PERCENT IN BONDS
20-30s 100 0
40s 90-100 10-0
50s 75-85 25-15
60s 70-80 30-20
70s 40-60 60-40
80s+ 30-50 70-50

John Bogle, the founder of Vanguard, suggests as a conservative asset allocation rule that your percentage of assets in bonds should equal your age. In other words, at age 30 you should have 70% in stocks and 30% in bonds.  A more aggressive version is to subtract 10 from your age, so at age 30 you’d have 80% in stocks and 20% in bonds.

One very easy way to let someone else make this decision for you is to pick target retirement funds as your investments.  Many investment companies offer these, including the TSP and Vanguard.  You just pick the approximate year you plan to retire or start using the money, that year will likely be in the name of the fund (Target Retirement 2035, for example), and invest in that fund.  Your investments will gradually get more conservative as you age without any action on your part.  Just make sure that the target date funds you use are composed of index funds with low expense ratios (again, using the TSP or Vanguard funds makes this a no-brainer).  A target retirement fund composed of actively managed funds with expense ratios greater than 1% is a target retirement fund to avoid.

When investing you need to keep this truth in mind…the market will go down, and when it does you need to resist the temptation to sell investments or stop investing.  The best time to buy an investment is when it is cheap and you can get the best deal.  When the market recovers, which it will, you will reap the rewards.  Focus on the long-term and just keep investing.

Every time you get a raise, bonus, or income tax refund, use it to increase the amount you invest for retirement.  You should save at least 15% of your gross or pre-tax income for retirement, but if you want to be rich or retire early you’ll need to save 20-30%.  If you find it difficult to save, set up an automatic investment plan so that the money is automatically removed from your pay and you never get a chance to spend it.  The TSP makes an automatic investment plan easy to implement.

REFERENCES

Bogle, J. C. (2007). The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. Hoboken, NJ: John Wiley & Sons, Inc.

Malkiel, B., & Ellis, C. (2013). The Elements of Investing: Easy Lessons for Every Investor. Hoboken, New Jersy: John Wiley & Sons, Inc.

5 Tips for Physicians to Achieve Financial Freedom

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Here is a great article by the author of The White Coat Investor, probably the best financial planning site for physicians on the web:

5 Tips for Physicians to Achieve Financial Freedom