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The Pros And Cons Of Pension Maximization

Mark P. Cussen, CFP®, CMFC, AFC

Government employees who have put in at least 20 years of service can look forward to guaranteed monthly pensions when they retire. Married retirees, however, must also choose whether to receive single or joint life payouts. The latter option guarantees that after the death of the retiree, the spouse will receive a percentage (usually about half) of the retiree’s original monthly benefit for the rest of his or her life. This is definitely the best choice for retirees in some cases, but not always. Employees who are about to retire and have been informed of their exact monthly retirement benefit would be wise to explore their options using a pension maximization analysis.

What is Pension Maximization?
As the name implies, this strategy is simply a cash flow analysis that is used to determine whether a retiree’s pension dollars can be stretched further with the purchase of a life insurance policy. The goal is to replace the spousal payout from the pension with a death benefit that will at least equal the amount that would have been paid out on an after-tax basis following the death of the retiree. The retiree chooses to receive the single life payout and uses the differential dollar amount between the single and joint life payout to purchase permanent life insurance.

Fred has worked as a government employee for 25 years and is retiring in a few months. His single life payout from his pension is $6,000 per month. His joint payout would be $4,900 per month. He opts for the single life payout and uses the monthly $1,100 differential to purchase a $200,000 indexed universal life policy on himself with his wife as the beneficiary.

Pros and Cons
The cost of survivor benefits in most pension plans is very expensive. Many retirees face a reduction of up to 10% of their pension payouts in order to carry this protection. Pension maximization can be an excellent option for some retirees, but there are several issues that must be carefully considered before using this strategy, as inadequate planning in this area can have disastrous results in some cases. The key factors that are used in pension maximization analysis include:

  • The ages and projected longevities of the retiree and spouse
  • The health and insurability of the retiree
  • The dollar difference between the single and joint life pension payouts
  • The couple’s tax bracket and financial situation
  • Whether health insurance benefits are tied to the pension

Each of the factors listed above can have a substantial impact on whether pension maximization is the right choice. If the retiree is not medically insurable, then obviously it cannot be done. For this reason, an employee who wishes to pursue this option may be wise to purchase the policy at a younger age when premiums are lower. It is vitally important, however, to keep the policy in force and not let it become underfunded. If the policy has lapsed when the employee begins receiving a straight life payout, then the spouse may receive little or nothing after the employee’s death. Health insurance is another critical factor. If health insurance benefits will cease with the pension payout, then this is a very bad idea unless the surviving spouse has access to similar coverage elsewhere. For this reason, retirees whose health benefits are tied to their retirement pensions should probably never use this strategy unless their spouses also already have a pension of their own that provides them with their own health coverage. Replacing this coverage for surviving spouses is usually cost prohibitive and may be impossible.

Running the Numbers
If pension maximization is still a viable option after these issues have been considered, then the strategy essentially becomes a time value of money equation. The ages of the couple are used to determine the amount of insurance that will be needed along with the amount of the survivor’s pension. Of course, one of the trickier issues that must be accounted for is the difference in the amount of money that will be needed if the retiree dies sooner rather than later. If the retiree is considerably older than the spouse, then a larger benefit will be needed if the retiree dies soon after the pension payout begins. For example, assume that Fred from the previous example is 66 when he begins taking his pension and dies two years later. His wife is 48 and is projected to live for another 40 years. The joint payout would yield a total of $2,352,000 over the remainder of her lifetime (40 x 12 x $4,900). Replacing this much income with permanent life insurance will most likely be cost prohibitive for Fred. Using term insurance may be a wiser option, as it is usually cheaper than permanent coverage and the need for this protection may eventually disappear. A level term policy with decreasing protection may be a wise solution for Fred, who might be able to afford the premiums on coverage that is at least equal to perhaps half to two-thirds of the survivor benefit if he is in good health. (Fred would also be wise to purchase this policy when he is younger.)

Of course, if the spouse dies first, then the retiree can access the cash value in the policy for him or herself or may choose to let it lapse. This is one of the largest advantages of pension maximization, because once the survivor benefit is chosen, it cannot be reversed or changed if the spouse dies first. The retiree can only receive the lesser benefit for the remainder of his or her life.

Tax and Investment Considerations
A thorough pension maximization strategy will take the couple’s tax bracket and other retirement and investment assets into consideration. Pension income is always fully taxable, so in many cases the minimum amount of coverage that is purchased only needs to equal the after-tax stream of income that is collected. For example, Fred in the previous illustration may only need to purchase $1.5 million dollars of coverage that is then invested conservatively in order to replace the after-tax income that would be paid under the survivor’s benefit. And if the couple has substantial assets housed in IRAs or other retirement plans, then only a partial replacement of benefits may be necessary. A death benefit that equals the couple’s remaining debt may also be a practical limit. If the surviving spouse is not financially adept and does not want to deal with the ongoing tax and other issues that come with a pension payout, then a lump sum of cash that can be used to retire the mortgage and other obligations may be a sensible alternative.

The Bottom Line
Pension maximization can be an effective solution to the single versus joint life payout dilemma that many retirees face. Care must be taken, however, to ensure that the surviving spouse is guaranteed to receive an insurance benefit that will meet his or her needs, and thorough analysis is generally necessary in order to make a fully informed decision. Those who eschew professional help can use one of the sophisticated programs available for consumers; these break down all possible pension scenarios on a year-by-year basis and show what could happen if various events occur, such as the retiree or spouse dying in a given year with the maximization strategy versus without it. Consult your financial advisor for more information on pension maximization.