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Saturday, October 6, 2007

Value of a military retirement

Simply put, the value of the retirement benefit depends on the life expectancy of the veteran. According to the Social Security Administration, a male retiree 45 years old will live for about another 32 years(http://www.ssa.gov/OACT/STATS/table4c6.html). If he retired from the military as an O-5 with 22 years of service, his retirement benefit would be $3686.50 before taxes an any deductions (including the survivor benefit plan).

So, what is the current value of an annuity that pays $3686.50 each month for 32 years? The problem is simplified because the monthly retirement amount is adjusted for inflation, unless the veteran selected the REDUX program. With the adjustments, you calculate the present value by multiplying the monthly benefit by the projected number of payments, in this case 384 monthly payments. When you do this math, you come up with the amount of money you'd need to put away to pay the benefit:

$1,415,616!

The military made this retiree a millionaire!

The enlisted retiree isn't that far behind. A retired E-7 with 22 years of service receives $1907.40 monthly. If he retired at age 40, he'll receive more than $844,000!

If you want to get an even better idea of what the value of a military retirement is, consider using the Vanguard Annuity Quote tool. Your retirement is a stream of guarenteed income just like an annuity.

4 comments:

Dan Darnell said...

This calculation is *horrendously* incorrect. In calculating a Net Present Value (NPV), one must also calculate an opportunity cost for not investing that money, also known as a discount rate. After applying a very conservative discount rate of 8% (what one could expect to earn in stock/bonds over that time period), the supposed 1M+ for the retired O-5 is actually only worth ~$690,000. With a more aggressive plan to invest yielding 10%, this O-5's retirement drops to a NPV of $555,000.

The military retirement is decent, but let's keep the facts straight and calculations honest.

Rhett said...

The post is not far off at all. This is a classic "PVAD" or present value of an annuity due. There is no opportunity cost either because their is no alternative investment. If you work 20 years you will be given "x" dollars every month for the rest of your life, an annuity. The longer you live the more your annuity is worth.

Now, since the average person will not be able to put in real terms the future stream of payments due (which is an annuity) we use a financial calculator to compute what those future dollars will be worth today.

How does this apply to you! What is the alternative to the pension?

One would need to put away $25,526 earning 8% a year to get to the $1,415,616 figure in 22 years. What if they could only do $15,000/yr, then it would take almost 28 years. Or $10,000, almost 33 years. Even then, what if the return isn't 8%, maybe 5%, in 22 years one would need to put in almost $37,000/yr to make up the difference.

You can replicate all this yourself by buying a $15 financial calculator and starting with these figures:
FV (future value) = 1,415,616
n (# of periods) = 22
i/yr (return rate apr) = 8

Then hit the "PMT" key, and you get the amount you must pay yearly to get the same return!

Notice, you must take all the risk in the investment scenario, also, you will be paying taxes as the investment grows, which will make the principle you need to put in more time to grow.

Now, who is to say you can't save your military pay while you are putting in your 22 years. Maybe you can save another $5,000/yr at 8% during that time, you would accrue an additional $277,000, or $722 more dollars/mo. for the next 32 years after you retire.

Final conclusion, the military pension is a way to take all the risk of investment (at least for that portion of your retirement) out of the picture, a guaranteed amount with no risk! And best of all, it has a cost of living adjustment each year so the purchasing power doesn't whither away.

Maleah said...

Dan, I think for retirement savings, the best discount rate to use is the risk free rate (i.e. 30 year treasury bond). That historical return is around 6%, although this rate has been steadily trending down since the 1980's highs of 10%-12% and today stands at under 4%. I think using a benchmark such as the historic return of the market as a discount rate is problematic because the market has shown that it can vary drastically from the average rate of return over long periods of time. For example, consider the 90's inflation adjusted rate of return was 16%, while if you started investing in 1999, your real rate of return would be -1.65%. So, the conditions of the market when you start makes a huge difference in your expected return.

So, back to the value of a military retirement. Current O-5 salary at 20 years is $7959. Which yields monthly retirement of $3979.50 or $47,754/year. This will grow at the rate of inflation, around 3% recent historical average. Retire at 42 and you should live about 35 more years on average. Given these inputs, you will collect $2.88 million in cash payments. Discounting at 6% gives NPV of $1 million. Discounting at current 4% risk free rate gives NPV of $1.37 million.

So, to put this in perspective, if your military career started today, you'd have to save $22,000/year or $1833/mo compounded at 8% annual return to have $1 million when you retire. If current rates are the new norm, then at 4%, you'd have to save $30,000/year or about $2,500/month to have $1.37 million when you retire.

Now, let's make this more realistic. Say you have done a 4-year commitment and are considering whether or not to get out. Regardless of how much you have personally saved, it was like the military was saving that $1833 or $2500 for you and socking it away for an annuity. You are also a little more conservative and decide to invest your retirement in AAA bonds at 6% rate of return. Well, now you'd have to sock away about $43000/year to get to $1 million. Your new job will have to pay over $3500 more per month than what you made in the military!

Quite honestly, it is extremely difficult to make an equivalent military salary on the outside. Most people only consider pay. A few will factor in tax benefits of BAH and BAS. However, average health care insurance for a family in 2009 was $13500. The military has the equivalent of a $1 million annuity set aside for your retirement, so depending on time left to retirement, compute how much more you'll have to make to get $1 million. The minimum would be about $22,000 per year. So, factoring health care and retirement your new job needs to pay a minimum of bout $33,500 more than your military salary.

James said...

There are a couple of factors left out of the final remarks - true it is very hard to find a civilian equivalent... but a very low percentage of military members stay for the entire 20 years. They give up a lot of "freedom" to make sure we have our freedom...
I agree that it is very valuable - I'm retired and it was the best decision I ever made to stay all the way through. Also - many who stay the full 20+ yrs end up with disabilities that earn pay from the VA- which is a pension that is not taxable... complicating the present value computation a bit, but making it fun to contemplate. Of course, I'd give up all the VA disability to be able to sleep at night! You mention the value of the medical care and an average cost - that is a good thing to add in - the annual value of that plus salary times estimated years of life remaining would represent an annuity base amount that one could then say is the present value.
PLUS - not many retired military people are actually "retired"! As mentioned in the example - we are normally in our 40s... so we have decades left to earn good salaries and put away more - while drawing the retired pay. If not for "life" - the all too common divorce splitting the pay, child support etc. - it might be possible for one to put away the entire retired pay and live off their salary - earn more interest and therefore magnify the value of the retirement benefit even more.

Join the military... but know the risk to your life, the limits placed on you (which I argue are good things, but allow that there are some that would have a good case to argue differently), and the fact that to get that great retirement benefit you have to serve the entire 20 years...

J