Don't go work for this guy.Mmm- Yeah, I’m gonna have to ask you to save much more for retirement, okay?

Defined-Benefit Pension Programs (like your FERS Annuity and/or Military Retirement Pension) are headed the way of the Dodo Bird.  Here’s a recent example.

The State of California recently illustrated the difficulty of running a Defined-Benefit Pension program.   CALSTRS (the California State Retirement System) is a juggernaut of a pension fund that is designed to support almost 500,000 teachers, state employees, and municipal employees in retirement.

CALSTRS are using an assumed average rate of return for the Pension of 7.5 percent per year over the next 30 years (cough, cough).  If this assumption isn’t laughable, it’s at least in Bernie Madoff territory- Especially since the state of California can’t print its own money (like the Federal Government) to work its way out of a jam if CALSTRS runs short of funds.  One of the reasons CALSTRS is using this 7.5% return assumption is that CALSTRS will have to funnel more money (from taxes) in to the pension if they assume a lower projected return rate of 5 or 6 percent.

Aside from the lofty assumed return rate of 7.5%, what’s keeping the CALSTRS actuaries up at night is the importance of ‘Sequencing of Returns’ in retirement.

As the infographic below shows, you can have two different funds with identical average rates of return, but if you invert the timing of the random events (that is, you have ‘bad’ years at the beginning of the retirement instead of towards the end of retirement) a retiree (or CALSTRS) could easily run out of money.  Take a look at the bottom two bar graphs and note that the average returns of 10.34$ are identical, but the timing of the individual bars is a mirror image left-to-right.  The top two graphs then illustrate the remaining balance in the portfolio while 7% per year from the initial value (7% is a very aggressive withdrawal rate, but it proves the point nonetheless):


Rather than look this 800-lb. gorilla directly in the eye, CALSTRS is investigating products that will move in the opposite direction of the stock market in the event of a severe downturn (Hedge Funds and ‘Alternatives’).

Dr. Moshe Milevsky has demonstrated the same damaging effects of Sequencing of Returns is in his book ‘Are you a Stock or Bond‘- He illustrates that in the Accumulation (saving) phase of retirement that the Sequence of Returns is irrelevant as long as the average rate of return is the same over the savings phase.  However, in the De-cumulation phase (retirement), Sequencing of Returns can bite you if you have ‘bad’ years at the start of retirement.    Dr. Milevsky recommends smoothing out the sequencing risk by annuitizing part of your income while in retirement.

Or, as stated in a more folksy manner by Ray Lucia, CFP – “If Dollar Cost Averaging in the accumulation phase is Good, then Reverse Dollar Cost Averaging in retirement must be Bad”.

Fortunately, if you’re a Federal Employee or Retired Veteran you don’t have to worry about this.  You already have a gold-plated pension assured by the Federal Government in the form of your FERS Annuity and/or your Military Retirement Pension- Both of which go up in value every year with Cost of Living Adjustments (COLAs).  Use this as the cornerstone source of income in your retirement portfolio and then you have the luxury of dialing up the risk/return on the rest of your retirement investments.

For further reading: Dr. Milevsky’s book is a good read regarding asset allocation based on your occupation (or ‘Human Capital’ as he calls it).

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