*** Updated 1/2/2013 with the ‘Fiscal Cliff Deal‘, updates in italics ***

Fiscal Cliff Deal Notes (Part Two) –

As promised, I’ve run the numbers on what the Fiscal Cliff (aka Sequestration, aka Taxmageddon) will cost Joe and Jane Sixpack.

There’s no chance of a deal being worked out by the lame duck Congress.  Both sides are too far apart and there are too few work days left in the year.  If you disagree with me, then I’ve got some arid mountain land to sell you in Florida.  (Update 1/2/2013, I was right about the Year, but wrong about the lame duck congress not making a deal before the new congress being sworn in).

So it’s time to brace for impact.  Crunching the numbers as promised, here are the assumptions:

  • Mid-grade Federal Employee, married w/2 kids, living on the West Coast or an expensive area like Washington DC (this covers over half of active Federal Employees).
  • Itemized deductions of $31,000 (reasonable assumption for areas with expensive mortgages).
  • 4 exemptions claimed
  • Annual Long Term Capital Gains of $8000.
  • Annual Qualified Dividends of $2600.
  • Health Care Flex Spending Account election of $5,000 in 2012 (capped at $2,500 in 2013).

Here are the calculations:

Holy Schnikes!  Looks like I’ll be paying Uncle Sam another $4k $3k next year for the same amount of work.   Note that these calculations can apply to just about anyone in the current 25% marginal bracket- just knock of the anticipated 0.4 percent hike in FERS annuity contributions.  (1/1/2013 Update Notes: still plenty of uncertainty about FERS contributions, still some uncertainty with the Executive Order-ed 0.5 percent pay increase for federal employees).

Feel free to plug in your own numbers plug in the new numbers to see how the ‘Fiscal Cliff Deal’ Sequestration will affect you.  Enjoy!

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There are some items about the TSP I do not like (limited investment choices), but the pluses of the TSP far outweigh the minuses.  In fact, as long as I live, I swear I will NEVER pull 100% of my funds out of the TSP.

Why? Even if you leave Federal Service before your minimum retirement age (i.e. you resign or quit), you are still eligible for LIFE to retain the benefit of your TSP account (as long as you keep a minimum account balance of $200 in the TSP).

Here’s why you should NEVER completely exit your TSP:

  • At retirement, the TSP can be easily be converted to an annuity, with industry-leading low expenses.
  • If you are no longer working for Uncle Sam, you may roll money OUT out of the TSP at any time to an IRA or your current employer’s 401k (in tax jargon this is a “Trustee-to-Trustee transfer”, a non-taxable event).  If this is your case, roll some money out of the TSP if you would like more flexibility in investment choices (IRA) or if you like the investment options and expenses of your current employer’s Qualified Plan (i.e. 401k).
  • The TSP will permit you to roll retirement funds back IN to the TSP at any time from an IRA or Qualified Plan.
  • TSP has the G fund, which is the best vehicle anywhere to park your short-term money. The G-fund gives you guaranteed returns equivalent to a 3-year CD combined with the liquidity of a money market fund. There’s no other financial product like it available.

Bottom line: even if you leave the employment of Uncle Sam, don’t leave the TSP.

For further reading on the many methods of withdrawing TSP funds: Withdrawing Your TSP Account After Leaving Federal Service

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Spoiler alert: You’re a bond.

Dr. Milevsky’s book presents new ways of approaching (and mathematical modeling) your savings for retirement.  The book was originally written in 2008 and updated in 2012 with new data and figures.  Dr. Milevsky’s book is divided up in to three parts.

Part One discusses the concept of Human Capital.

Human Capital is the future value of your earnings from work.  If you’re a race car driver, you are a “Stock”- you might have a few endorsement contracts (kind of like dividends) providing a bit of your income, but you only get paid in unpredictable, infrequent bursts when you win a race.   Once you get an idea of what the value of your Human Capital is (the net present value of your future earnings), you can use this number to bracket the upper value of a life insurance purchase.  The lower value of your life insurance calculation is the traditional “expense-based” model (pay off all your debts, send your kids to college, leave a bit more behind for your survivors).   The final answer to what your life insurance contract should cover will lie somewhere between the floor (expense-based value) and the ceiling (your Human Capital value at your present age).

As for figuring out if you are a Stock or Bond…

If you are a high-level executive at an investment bank, you’re a “Stock” – most of your compensation is in the form of bonuses and stock options.  Your compensation is not just tied to the stock market, but the daily value of your own company’s stock.  So don’t risk your retirement by piling more company stock (and stocks in general) in to your portfolio.

If you are a tenured Professor like Dr. Milevsky, or a “permanent” Government Employee- you’re a “Bond”.  Your compensation comes in regular ‘coupon’ payments like clockwork every month, just like a Bond.  Your earnings or rock-steady, but you’ll never hit it big with a huge payday when your employer goes public in an IPO or writes you a fat bonus check at the end of a banner year.  Your retirement savings should lean heavily towards stocks, and he even makes a compelling argument that “Bond” employees should buy highly leveraged equity products (like leveraged-equity ETFs) to INCREASE your exposure to the upside of equities.

Part Two discusses the importance of Asset Diversification using traditional  financial products (stocks and bonds).

Halfway through the chapter Dr. Milevsky demonstrates that many of the ‘Monte Carlo’ simulations being used during the accumulation phase of retirement are bogus.  He shows two competing mutual fund products, each with the same average rate of return and standard deviation only the sequence of the returns are backwards over a 20-year period.  He demonstrates that in the accumulation phase (saving for retirement) that it makes no difference what the returns are from one year to the next- that with the same average returns and standard deviation, both mutual funds are worth exactly the same value 20 years later.

But here’s where the ‘Monte Carlo’ simulation IS appropriate, and sometimes under-emphasized.  There is a severe hazard regarding the sequencing of returns when you begin taking money OUT in retirement. If you retire in to a bear market, you’re forced to sell more shares than necessary in a flat or up market, and the burn rate of your retirement portfolio accelerates.  This is why Dr. Milevsky makes a compelling argument in Part Three to annuitize or “Pensionize” part of your retirement funds, so that you have at least a minimum value to live off of in retirement.

Part Three of the book discusses the concept of PRODUCT  Diversification.

It discusses the PROs of purchasing annuity products- be they the media-hated Variable Annuities or not-so-hated Single-Payment-Immediate-Annuities (SPIAs).  Dr. Milevsky makes compelling points that even the Variable Annuities in some cases can add value in retirement if they have some kind of floor like a Guaranteed Minimum Income Benefit or Guaranteed Minimum Value.  He also demonstrates that in most cases it is cheaper to purchase this kind of ‘hedge’ from an insurance/annuity issuer than by purchasing option contracts on your own through your brokerage account.

If you’re a govvie, you can scan through most of the stuff on annuities, because much  like the French Knights guarding the castle in Monty Python’s Holy Grail, you’ve “already got one, and it’s very nice”.  In some cases you might even have two guaranteed annuities if you are a government employee retired from the military.

In all, the book is a great read and will present you with new tactics to approach saving for your retirement.  Just be ready for a few equations along the way.  I give “Are you a Stock or a Bond?” four out of five GubMints.

Moneywatch link to interview with Moshe Milevsky.

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