Debt must be a wonderful thing. Just look at how much debt the good Ole USA has—and we are the largest economy in the world—by far. If the richest, most prosperous nation in the world is also the one that borrows the most money, then is it a leap to think that what debt has done for the US can also do for our personal finances? The answer in a word is, no; a big NO as a matter of fact. In this edition we are going to look at how to improve our personal Balance Sheet.
Mutual Funds are everywhere! They are in your retirement accounts, your personal investment accounts, your pension system, they dominate TV and radio commercials, and entire magazines are dedicated to tracking their performance. But just what exactly is a Mutual Fund? Chances are your financial future is somehow affected by the selection, performance and quality of a Mutual Fund, so perhaps it’s a good time to go over some basics regarding this popular investment vehicle. Besides, the best time to review or talk about a “basic” concept is when it is so “understood” that everyone assumes everyone else already knows about it.
As I write this during the third week of October 2008 the world’s equity markets are in the midst of a sharp decline—some are calling it a “melt‐down.” Many mutual funds have fallen over 40% for the year and there seems to be no end in sight.
Warren Buffet says “Investing is simple but not easy” and in today’s market that statement is truer than ever. Investing boiled down to its essential elements is very simple, buy something at one price and sell that thing later at a higher price. Buy low and sell high. But while intellectually investors know what to do—emotionally investors often do the opposite. Studies have shown that investors invest more money when the market is up and take money out of the market when it is down—basically buying high and selling low.
About a year ago I was talking to a retiree I used to work with in CVED and I asked him how retirement was treating him, he said, “Marty, have you ever heard of the term ‘The Golden Years?’ Well, just drop the G.” We laughed and then he ticked off a litany of nasty medical issues he and his family were experiencing. He was not enjoying retirement—well, actually, he was not enjoying the human aging process.
I don’t think the human body is designed to live as long as we do these days. Advancements in medicine and our affluent lifestyles have managed to extend our time on Earth for a much longer period than the physical body was designed for. 2000 years ago the average life-span was 24 years—about the time most of us graduated from the police academy. Today, many of us will make it well in to our 90’s.
Traditionally, every July and December mark the end of many State Police careers through retirement. Retiring is a wonderful thing—I retired last year after 26 1/2 years. Driving off the Quartermaster parking lot in my personal vehicle after returning my equipment was a once in a lifetime event I hope every Trooper has the chance to experience.
The other once in a lifetime experience for recent retirees is getting your DROP check (Deferred Retirement Option Program). There are just not enough times in life when you receive six-figure checks in the mail. Just what you should do with that check is the subject of this article.
The first thing to realize is that the amount on the check is, well, a bit overstated. Your DROP account is a qualified plan, which means that the money accumulated taxdeferred. Your money grew so quickly because no income taxes were paid before they were deposited in the account. Also, no taxes were paid on the 6% annual interest earned. One of the two unavoidable things in life—the more pleasant one I might add, is paying taxes; and you must pay income taxes on the DROP money upon withdrawal.
So for example, if your check is $150,000—think of it as somewhere around $112,500 in take-home money1. Moreover, if you immediately take the cash (or in IRS terms—take a non-qualified distribution) before the age of 59 ½, you are assessed an additional 10% penalty. (There are some rare exemptions to paying this penalty, but they are indeed rare.) The bottom line, the money is very nice, exceptional in fact, and you are not likely to be able to save this amount ever again in such a short period of time, but it is not as much as you first think.
One of the first pieces of information you are sent when you retire with the DROP is an IRS publication (8 pages long) titled, Special Tax Notice Regarding Plan Requirements– Safe Harbor Explanation. You will need to read this form several times before being able to decipher the meaning. The narrative is as archaic as a Tom Dentry liberal-leave, early-dismissal-due-to-inclement-weather teletype! But since the form warns of the penalties and income tax issues regarding your account—you must read it carefully. Most importantly, the form explains that to avoid a penalty and immediate payment of taxes you must roll the check over to a “qualified” plan, for example, a traditional IRA.
As I mentioned earlier, retiring is a wonderful experience. Personally, I had the luxury of taking a few weeks on comp-time before my actual departure date. I soon became aware of how few times in our working lives we awaken at 6am with absolutely nothing to do. I just as quickly realized that I was not going to be able to do this for long. Actual retirement—i.e., sitting around the house with little to do, is highly overrated. Fortunately I was able to turn a lifelong hobby and interest into a second career. With a newly minted Loyola MBA, I studied and passed the required certification tests (Series 7 & Series 66) and began work as a Financial Advisor for an independent firm in Chestertown; Chesapeake Investment Advisors. After a training and mentoring period I began managing my own client’s investments.
There are, literally, millions of investment products on the market. And there are loopholes; pitfalls; restrictions; opportunities; and risks in every kind of investment and generally, people don’t know what they don’t know. That lack of knowledge, and the self-delusion that if we just read a few brochures, check the internet, watch an investment television show, we can learn the market, leads to bad decision-making, bad investments and lost opportunities and, most often, lost money. There’s a TV ad running lately where the company tries to convince people to invest with an on-line broker, the ad’s closing statement says something like, “you can do this”. True enough, you can invest without professional help—but why would you want to? I could probably change my own oil too but I guarantee that over time I would miss something and in the end, my frugalness would cost me a lot of money.
Those same kinds of risks abound when investing on your own. A 2005 study2 by DALBAR, Inc. showed that the returns realized by the average investor from 1984 to 2004 were a paltry 3.70%, while the overall S&P 500 returned 13.20%–meaning that the average investor missed over 9% more earnings if they would have just invested in a vehicle that tracked the S&P 500. The pressure of investing your own money often proves overwhelming for the individual investor and they end up buying stocks while their price is high and selling them when their price falls; the exact opposite of the ideal.
Many of you became painfully aware of the truth behind the NASD (National Association of Securities Dealers) disclaimer that “Past performance does not guarantee future results” when in March of 2000 the market’s “tech-bubble” burst. Up until that point most Deferred Comp (457 & 401K) investments made money—some made more, some made less, but they always seemed to go up. We should never forget, however, one other very important NASD warning, “people can and do lose money when investing in the market”. And I can tell you, anecdotally, within MSP, between March 2000 and October 2002, hundreds of thousands of investment dollars were lost3.
One problem is that the information Troopers receive about investment options doesn’t even scratch the surface of what is required to make responsible financial and investment decisions. If we were lucky, someone came into the academy class and discussed the benefits of joining what we call deferred comp; they talked about how important it was to save money tax-deferred in the State’s 457 or 401K plan. Where to invest that money– within the plan–was left up to you. We were given the list of available mutual funds and that was about it. And true enough, at $25 a paycheck it’s wasn’t overly important that you chose the best investment—it was important that you began saving, but whether you got 5% or 6%, or even 10% didn’t make a lot of difference early on. Later, as your account grew, the value and gravity of your choices increased.
The same can be said about the DROP program—where to invest the money is not important when you are deciding whether to get in or not. In fact, the State doesn’t give you an option of where to invest—they will pay you 6% annually, hold your money until you leave, and that’s that. The tough decision about where to put your DROP and your 457 money comes when you retire. And that’s when you need the services of a Financial Advisor.
Financial Advisors have a fiduciary responsibility to their clients, which means that by law, the Financial Advisor owes their client duties of good faith, trust, and confidence and must act in their best interests. Surprisingly, sales people at many major brokerage firms are not Financial Advisors and thus do not have the same fiduciary obligation to their clients. It is important to choose your Advisor well, ask for references from other retirees, trusted friends, etc. This is your future—you need someone who you can trust. The good news is that with quality investment advice you should do very well financially speaking. Just one advantage of being a State Trooper are the fringe benefits—including, if only just recently, our retirement benefits. With a stable and inflation-protected defined benefit retirement plan (our pension)–coupled with some very good defined contribution plans (457 & DROP), you can retire quite comfortably. But for sanity’s sake, prepare ahead of time, find a hobby, educate yourself for a new career, do something, sitting around the house doing nothing is not what you worked all those years for.
1Calculated at 25% tax bracket—the actual tax amount will vary.
2DALBER, Inc., “Quantitative Analysis of Behavior,” 2005
3On 2-1-00 the DJIA was 11,041.05; on 10-7-02 it was 7,528.40 (-31%) Source: Commodity Systems, Inc.
Marty Knight, MBA, is a retired Captain from the Maryland State Police and is a Financial Advisor with Chesapeake Investment Advisors, Inc. Chestertown Maryland; he can be reached at 410-810-0735 or mknight@chesadvisors.com. Securities and Advisory Services offered through Geneos Wealth Management, Inc. member NASD/SIPC
The decision over whether to enter, or not enter the DROP (Deferred Retirement Option) is one of the most important career decisions will ever make as a Maryland State Trooper. To make matters worse, to DROP or not to DROP is also one of those decisions that almost everyone has an opinion on—and unfortunately, not many opinions are alike. To be sure, this is an emotional decision, a financial decision, a career decision, and finally, a family decision, so seek advice from your spouse and/or family.
This month’s article will give you a good financial base from which to make your decision—other issues are person-specific and must be evaluated by the individual, taking into consideration all the various personal factors unique to their situation. But the financial factors are fairly straight forward mathematical number-crunching, and though you may have overheard water-cooler talk, or spoken to someone who talked to someone else who apparently “ran the numbers,” do you really understand the value of the DROP? Here we’re going to estimate, on paper, once and for all, what it means in dollars, longterm, to enter the DROP.
Perhaps the easiest way to clear up the fuzziness of the DROP is to use a demonstration Trooper and run the numbers for a hypothetical trooper. Then during your decision making process you can substitute your salary into the example and you should come away with at least a rough estimate of the monetary value if you do DROP. This article will also talk about the timing—there is a limited window when you can DROP—you must have at least 22-years on the job, and you can’t stay in the DROP after your 28th year.
We will call our hypothetical Trooper Al Goodman. TFC Goodman began his career in the Maryland State Police 22 years ago at age 21, making him eligible to enter the DROP. He wonders if he should DROP and if so, exactly when will it most benefit him.
In this scenario we use several assumptions that remain consistent and are equal for all decision paths. TFC Goodman’s current salary (without overtime) is $60,000; his last two years were $58,500 and $57,037 for a 3 year average of $58,512. We’ll always use a 2.5% riser for his salary if he stays on the job and we’ll always use a 2.5% Cost of Living Allowance (COLA’s) on retirement checks. TFC Goodman has 2,112 hours of sickleave— or an extra one-year credit on his service-time (22 days sick leave = 1 month of credit). He’s a healthy person and will not use anymore sick-leave (S/L) during the example. Saving S/L is an important and valuable decision by TFC Goodman since S/L increases his retirement percentage multiplier without cutting into his DROP time—this increases his monthly payout for the rest of his life, and even Mrs. Goodman’s life if she outlives him.
By crunching the numbers on an Excel spreadsheet we can estimate the value of each decision point, year-by-year for the next few years of TFC Goodman’s career. I’ve calculated the lifetime income received until TFC Goodman reaches age 82. Why 82 you might ask, well we have to stop sometime—we all stop sometime–and if you asked Al right now if he’ll take age 82, he’ll happily say yes!
We do not factor in the time value of money or tax issues—both concepts are beyond the scope of this article—but neither would adversely affect one strategy over the other. We all have to pay taxes and a dollar today is always worth more than a dollar next year.
Now, one of the first things you notice when you DROP is an increase in your paycheck—you no longer pay your 8% contribution into the Maryland State Retirement account—that bonus is calculated in the numbers. (Often overlooked by administrators is that the State of Maryland also stops paying into your retirement—quite a benefit to Maryland too.)
So, without further ado, here are the results of about 5 hours in an Excel spreadsheet:
TOTAL ACCUMULATED VALUES OF PENSION, DROP AND SALARY Year Retires DROP Value @ Age 82 (Assuming 6% APY1) Pension & Salary Cumulative @ 82 Total Value at Age 82 22 $1,475,215 $2,235,523 $3,710,738 23 $1,558,126 $2,387,221 $3,945,347 24 $1,574,451 $2,544,715 $4,119,166 25 $1,193,350 $2,640,929 $3,834,279 26 $826,295 $2,560,737 $3,387,032 27 $416,242 $2,701,821 $3,118,063 28 $0 $2,787,123 $2,787,123
You will notice that the value of the total payments made to you through the pension steadily increases the longer you stay on the job–$2.23 million to 2.78 million–this is due to the increase in the pension multiplier (2.55% per year capped at 71.4% @ 28 years.) Going “out-early” definitely decreases the overall value of the pension payments. But the total value hits the financial sweet-spot with a retirement after 24 years of service, and four years in the DROP—with the total value reaching $4.11 million ($1.57 DROP + $2.54 Pension).
And here’s the reality of pension payments—you will spend what they send you—salary and pension payments of $2.78 million is a lot of money—but this is the lifetime accumulation of your monthly pension checks—if you are typical, you will not save much of this money—if it hits your checking account on Wednesday chances are by Friday it’s all but gone, mailed off to pay the credit card, the mortgage, junk from the KMart, the kids tuition, etcetera. Ask yourself, with the day-to-day bills and demands on your checking account now, do you actually save any real money. It’s no different when you’re retired. The next chart shows the true value and benefit of the DROP:
DROP VALUE AT THE END OF PARTICIPATION End of Year 1 Year 2 Years 3 Years 4 Years 22 $37,081 $77,315 $120,914 $168,102 23 $39,799 $82,981 $129,774 $180,420 24 $42,629 $88,881 $139,002 $193,249 25 $45,575 $94,000 $146,472 X 26 $48,642 $101,420 X X 27 $51,089 X X X
Even if you DROP for just a year, when in your life have you been able to save $51,089 in one year? And no matter how frugal you are, has any Trooper been able to save $193,000 in any four-year period? I don’t know anyone.
Good ole Al can walk away from the Department at age 47, with a pension for life, and an IRA with a starting balance of $193,249. And if Al invests his IRA in a vehicle that averages 6% per year, Uncle Al can leave his family an IRA worth about $1.5 million dollars. Or better yet, Mr. and Mrs. Goodman can use the money for the retirement they’ve always dreamed of. While the Government just made it is possible for Al to access the funds when he turns 50 without penalty2, the longer he waits the greater the account grows—by letting the magic of compounding interest take over, he can truly have a very comfortable retirement.
I hope this article helps with your decision—remember, this only covers the math of the decision; there are many other factors to consider. Please keep in mind that you are leaving one of the finest law enforcement agencies in Maryland, you are leaving your law enforcement authority behind, and you are leaving probably the best job you’ll ever have. In the end, you have to decide if you’ve really had enough of MSP; it’s not just a financial issue.
Financially speaking though, the best possible scenario is to enter the drop with as much sick-leave as possible, at the end of your 24th year, complete 4 years in the DROP and then start your second career with a nice monthly pension check and a lot of money in the bank!
1This article does not promise or guarantee 6%, but merely uses the number as a tool for comparisons of options—all options use the same 6% assumption.
2Recent legislative changes permit public safety employees to access funds from a defined benefit plan at age 50 without penalty—see Pension Protection Act of 2006
Marty Knight, MBA is a retired Captain from the Maryland State Police and is currently a Financial Advisor with Chesapeake Investment Advisors, Securities and Advisory services are offered through Geneos Wealth Management, Inc. Member NASD/SIPC.
