**Click Bait**

Like what I did there with the title? I created what’s called click bait. Most of the time my titles are boring, other times they are obscure. This time though I created an “action” title to capture readers’ interest in the Gap Number Method, because it gained some recent publicity. That’s about as creative as I get, adding the word “action” in all caps to a title.

Yes, I know. You’re wondering how, with only two readers who aren’t related to me, did I gain any publicity? Well, it turns out I have a face built for radio — or podcasting as the case may be. Not so sure about the voice though.

In any case, on a recent (and so far my only) podcast interview on ChooseFI, the hosts asked me to explain my concept of the Gap Number. For those of you who need a refresher on the Gap Number, you can find the post where I coined the term here. In general, the Gap Number is the difference between your fixed income in retirement and your expenses. Expressed mathematically it looks like:

- Gap Number = Annual Expenses – Fixed Income

An example would look like:

- $25K = $75K – $50K

The importance of the Gap Number is that it tells pensioners how much money they need to generate annually from investment income during retirement to fill the gap. A person can then research an appropriate Safe Withdrawal Rate (SWR), which is the rate at which they can withdraw their money from investments with a low probability of exhausting it prior to death. Once they determine their preferred SWR, they can use it to determine the overall amount they need invested by the start of retirement (i.e. their nest egg) with the Gap Number.

In most FI circles, the default SWR is 4% based on the Trinity study. However, I typically like to use 3.5% based on the research of ERN McCracken at Early Retirement Now.

Thus, in the example above, a person needs to generate $25K annually from their investments. In order to calculate the nest egg size that would allow withdrawals of 3.5% annually (prior to death and with a low-probability of failure), take $25K and divide it by a 3.5% (.035). In doing so, we arrive at a nest egg size of approximately $715K. Mathematically it looks like this:

- $25,000 ÷ .035 = $714,285

Now I didn’t invent the idea of the Gap Number when it comes to retirement finances. Nor did I discover the importance of what a Gap Number can tell you. In fact, I’m fairly certain I lifted the idea from a combination of Jim Collins, Darrow Kirkpatrick, and DJ Whiteside as I read their books and began my own retirement calculations. No, I simply put a name to it and applied it to Financial Independence (FI) and pensions.

In my previous article where I coined the term Gap Number, I provided a few generic examples like the one above. Unfortunately, I didn’t provide any real-world examples of how to apply this idea. However, I recently researched a suggested topic from a follower of my Golden Albatross FaceBook Group and quickly ran into a real-world application for the Gap Number. Not only that, but since the Gap Number came up on the podcast, I thought I’d also take some time to explain some finer points that we didn’t have time to discuss. Let’s get to it!

**Research Night**

Every Tuesday or Wednesday night, I research topics to write about on the blog. One of my Golden Albatross FaceBook Group members recently suggested I write a post about the use of a pension as the bond portion of your investment portfolio. It sounded like a good idea so I researched topic this past Wednesday night.

I wasn’t too far into the research when I came across several similarly themed articles on the topic. Those articles all advocated that pensioners (or future pensioners) ** should not** treat their pensions as the bond portion of their investment portfolio. The articles generally made similar arguments against valuing a pension as bonds within a portfolio. Rather than repeat their justifications, I listed the articles below for review at your leisure. I sub-bulleted a few of the main points:

- CNN Money — Is a pension like a bond?
- Inflation
- Lack of liquidity / no ability to rebalance
- Overexposure to market volatility
- Disregards the

- Oblivious Investor — Social Security: A Bond in Your Asset Allocation?
- Lack of liquidity / no ability to rebalance
- Overexposure to market volatility

- The Balance — If I Have a Pension, Should I Put Less in Bonds?
- It depends on your money plans

**The Action Part of the Story**

Now we can discuss the merits of the arguments in each article at a different time. The point I would like to make is what the articles suggest a reader do* instead* of valuing their pension as the bond portion of their portfolio. Each of these articles (in their own way) advocate that a pensioner treat their pension as income, much like I do in my Gap Number method. The CNN article summarizes it best:

*Start by figuring out how much annual income you need to live in retirement. Let’s say, just for argument’s sake, that figure is $60,000. From that figure subtract the amount you’ll get from Social Security and then the amount of your pension. Let’s assume your combined income from SS and your pension is $30,000. That means you must get the remaining $30,000 a year from your retirement investments.*

Bingo! That’s the Gap Number right there: $30K. Proof, not that you needed any, that my creativity in the personal finance space is limited action titles and giving popular concepts a name. The articles go on to discuss (again in their own way) the value the Gap Number provides in determining the SWR nest egg number, kind of like I did above in my $715K example. In fact, I’ll do the math right here using my method but CNN’s $30K and my preferred 3.5% SWR.

- $30,000 ÷ .035 = $857,142

After that, and only after that point, the articles then tell the reader to determine a stock-to-bond ratio that sustains the SWR without too much risk or volatility.

That’s something of a personal preference though because as Big ERN McCracken at Early Retirement Now shows, there’s some leeway in optimal stock to bond ratios depending on your goals and how flexible you’re willing to be. Other than the choice of stock to bond ratios though, that’s about it. The Gap number in action. Tadaaa!

**The Pernicious Mugger**

Nothing I just explained above is complicated or hard. In fact, during the ChooseFI interview Brad Barrett (one of the hosts) easily grasped it and provided his own simple example within about 5 minutes of us discussing it. However, I’d be remiss if I didn’t at least mention a few higher level considerations, many of which I’ve subsequently learned a lot more about since writing my original Gap Number article.

Let’s start with inflation. In Brad Barrett’s simplified example, he purposely stated he was leaving complicated factors, like inflation, out of the equation. He wasn’t wrong to do so. Inflation’s effect is complicated in connection with the Gap Number. However, if your pension **doesn’t** come with a cost of living adjustment (COLA) that offsets inflation, it’s extremely important to understand inflation’s effect on your pension over time.

In short, inflation devalues a non-COLA pension over time. How does this impact your Gap Number? Well, it means your Gap Number *increases* a little bit every year. As a simplified example, pretend a hamburger costs $1 when you retire and inflation is 2% annually. The first year your dollar buys 100% of the burger, but the next year it only gets you 98%. The third year $1 buys 2% less of that 98% hamburger from the year prior. On and on it goes. That’s your Non-COLA pension getting smaller in real terms year after year.

What does this mean, exactly? In a non-COLA pension scenario, it means you would need to rely more and more on your investment income stream to make up the difference. Did your original SWR rate calculation, based on your Gap Number, take a 2% annual devaluation of your fixed income stream into account? Probably not if you followed my method above.

What should you do? The most obvious thing would be to reduce the SWR you use to make your nest egg calculation.

Which means what, exactly? You’ll have to save more money before retirement. For instance, as shown above, a $30K Gap Number divided by a 3.5% SWR equaled a $857K nest egg. Drop the SWR down to 3% and the required nest egg shoots up to a cool $1 million.

Well, that … sucks.

Yes, inflation sucks, and I don’t like saving more because of its effect any more than you do. In fact, look up inflation quotes on BrainyQuote, and you’ll find some choice one-liners that numerous famous people have uttered about its effect. This is one of my favorites:

*Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man. — Ronald Regan*

As a result of inflation, the straightforward application of the Gap Number method proves less useful. Whether or not it proves unworkable remains to be seen.

**What to Do About Inflation?**

So what to do you do if you have a non-inflation linked COLA pension? I would love to say that I either know of, or have written, a simple math formula or spreadsheet calculation that reduces a pension’s value over time while transferring the increased monetary burden over to a nest egg annually, but I’m not that smart. In fact, when I googled “How to devalue a pension inflation” one of my own articles popped up in the top returns — which is a little surprising … and disheartening.

It’s surprising because one of my articles actually triggered enough search terms to rank high enough on Google’s front page without searching for Grumpus Maximus. It’s disheartening because it’s the wrong damn article!

That’s right all hope is not lost because I actually teamed up with a reader (George) and ERN McCracken to essentially solve this problem. For Part 7 of the Pension Series: How To Create Your Own COLA, I asked Ern McCracken to help solve a reader’s request to build his own COLA mathematically, and then I wrote an article about it. It doesn’t provide you a nice simple formula, but it does provide a step-by-step method for calculating the amount a non-inflation linked COLA pension loses due to 2% inflation and then shows how to combat it. As a result, a pensioner who follows that method will know how much *extra money* they’d need to be saved and invested by day one of retirement just to combat inflation’s effect on their pension.

I must admit, it’s a pretty sweet article. So sweet in fact, that I completely forgot I wrote it! Sometimes instead of PTS, I think I contracted CRS (Can’t Remember Sh1t) syndrome.

**The Immediacy Effect**

There’s one other complicated issue that I’d like to discuss, and that’s the Immediacy Effect. The Immediacy Effect is a term I coined (see the pattern here) for Big ERN McCracken’s work in Part 17 of his SWR series. Yes, I know I refer to this article a lot. However, I wrestled while growing up. If there’s one thing wrestlers get drilled into their head, it’s the importance of repetition. Maybe it’s my hope that if I reference ERN’s article enough times, I will finally grasp the mathematics behind it myself! Not likely.

In his article on what I call the Immediacy Effect, ERN demonstrates (mathematically) that the further from the retirement point a person’s pension starts, the less of an impact it plays on their overall SWR (and therefore their targeted nest egg total). Now, I can’t explain why the Immediacy Effect works in a mathematical manner like ERN, but I think I can explain the broad strokes. Although embarrassingly, I contacted big ERN last night with some math questions about his article, only to realize I was way off base! Sorry ERN.

In any case, if you have a pension that starts later in retirement, I also think it’s important you understand the broad strokes as well. Thus, the gist of ERN’s Immediacy Effect is this: if you retire early with a pension that doesn’t start payments until later, don’t presume that your future pension payments will impact your overall SWR on a dollar for dollar basis once it starts.

In other words, don’t presume for every pension dollar you receive in the future, it’s one less dollar from your nest egg you need to save now. The time value of money doesn’t work that way, and neither does the Gap Number method. Big ERN’s math shows that a 1 for1 correlation only exists if your pension starts immediately upon retirement and has an inflation-linked COLA. That’s the exact scenario I built my Gap Number calculations. As we saw with inflation, the further a pension starts from the retirement point, the more complicated things get. In fact, Big Ern’s math shows that pensions without a COLA that start at some point in the future never experience a 1 for 1 correlation.

ERN built charts for both COLA and non-COLA pensions which display the decay in the correlation between pension payments and SWR across different retirement time horizons, different stock to bond ratios, and for three different pension safety scenarios. You can find the COLA linked pension chart here, and the non-COLA pension chart here. They probably won’t mean as much without the context of his article, but you can get the gist just by looking at the colors. Green means good, red is bad!

**The Gap Number vs. The Immediacy Effect**

What does the Immediacy Effect ultimately mean for Gap Number calculations on pensions that start later in retirement? In truth, it makes the Gap Number method a lot less useful.

Since Gap Number calculations only work from the point at which a pension starts; in a future pension scenario, you’d have to build two different sets of calculations if you really wanted to use it. You could only use it if you determine the size of one nest egg at a time:

- A first nest egg needed prior to the pension kicking in
- A second nest egg needed after the pension kicks in

For the first nest egg, you’d have to make normal SWR calculations on your spending. For example, if you retired at 40, but your pension kicked in at 60, and you projected $60K in annual spending, you’d need if $1.714 million if you used a 3.5% SWR. Although, for a 20-year horizon, I’d probably use a 4.0% or 4.5% SWR since the Trinity study was built for a 30-year scenario and demonstrated it was easily doable with a low failure probability. Thus, using a 4% SWR you’d only need $1.5 million, and with a 4.5% SWR, you’d need $1.33 million.

You could then use the Gap Number and SWR methods I demonstrated above (way above at this point) for the second nest egg calculation. $60K in spending minus $30K in pension equals $30K Gap Number. Divide $30K by 3.5% (presuming you will live past 90, if not use 4%) and you get $857K as the total needed (in today’s dollars) for your second nest egg. Assuming you do nothing with that $857K other than mitigating inflation (by investing in Treasury Inflation-Protected Securities (TIPS)), you now have an ultra-conservative estimate of the two nest eggs required.

But why do that? This method is super clunky. The time value of money alone makes your future calculations suspect and overly conservative. Also, ERN provides a totally different, and simpler, method in Part 17 of the SWR Series that allows a person to calculate one SWR (and therefore one nest egg size) over their entire retirement span, specifically for a pension (or Social Security for that matter) kicking in later in retirement. I equate using the Gap Number in a situation like trying to shove an oval peg into a round hole. It looks like it fits, but doesn’t quite. Best to stay with the expert on this one. Use ERN’s method.

**Conclusion**

I hope this deep dive into the Gap Number’s finer points proved useful. I must admit, I was pleasantly surprised to find real-world retirement advocates using the Gap Number method (if not the term itself) for retirement planning and advice. It shouldn’t surprise me though because it’s a relatively straightforward concept.

With regards to the discussions on inflation and the Immediacy Effect; I understand if long-time readers are sick of me harping on these two issues. However, I keep writing about them because they are crucially important to understanding what a pension can and can’t do in retirement for someone seeking Financial Independence (FI). To be honest, I continue to learn as I write a lot of these articles, so they are concepts I am repeating to myself as well.

In fact, I only grasped the root importance of Big ERN’s Immediacy Effect while completing this article. It took me citing (and therefore reading) the article numerous times for my previous articles … and asking him a stupid question late last night … before the light bulb finally clicked in my head. But I got it now! At least until my CRS Syndrome kicks in again.

Finally, in my first Gap Number article, I plainly state your Gap Number is a probabilistic number at best, and that no one should fall in love with their *one number*. That was prior to any mention of inflation or the Immediacy Effect. My position after writing this follow-up hasn’t changed in the least. In fact, my growing knowledge about the pernicious effect of inflation alone only reinforces that previous belief. The Gap Number is a planning tool, nothing more, nothing less. My suggestion is to update it at least annually so you can see how it changes over time based on inflation and events in your life.

Good luck and let me know if this helped.

I heard you on the ChooseFI podcast and thought it was a great episode. I am working through all the various scenarios in my own plan. The current plan is for my wife and I to stop working three about 2.5yrs before she can draw a teachers’ pension and 5-10 years before Social Security kicks in depending on when we choose start collecting. Our gap number will change at least twice so there is various scenarios to play out. Thank you for the post and outlining this concept!

That’s awesome. I hope you find my website useful in your planning. If not let me know what I need to put on there to make it more useful. Thanks again.

Love the article!

I am an Army physician living on Oahu also.

In any case I have been thinking about this exact topic for a while. Military pension is COLA and immediate, thank heavens, so I don’t have to deal with this myself. When discussing the BRS with my residents, I keep getting asked about the value of a Reserve retirement if they leave before 20 but join the reserves. That retirement has some immediacy issue but has some COLA. This topic is very confusing, but with you and big ERN I am wrapping my head around it.

Hi ArmyDoc,

Have you joined the ChooseFI Honolulu FB Group yet? You should. It may help you make some connections to people that can help you figure out the asnwer to the Reserve questions you keep getting asked. I know Doug Nordman is an expert on this stuff, and he’s part of the group. We are trying to plan a meet-up with Doug in MAR or APR so he can give us a lecture on all topics FI. See you there?