If your client has a defined-benefit pension plan, she should not only consider herself lucky but should also understand that a lifelong guaranteed pension can have a high economic value. Also, a defined-benefit pension plan in the private sector is protected by the Pension Benefit Guarantee Corp. And such a plan has an even higher value if it provides a guaranteed income for life for the retiree and her spouse.
Permanent life insurance is the economic workhorse of a structurally strong pension-maximization strategy.
For instance, I recently calculated the approximate value of a pension for a 57-year-old female government retiree. Under her defined-benefit pension plan, she qualified for a life pension of $57,000, which had the actuarial annuity or lump-sum economic value of about $806,207. At retirement, the retiree, who is married, had to choose from three options:
- The maximum income for life. However, no benefits would be paid to the surviving spouse if she predeceased her husband.
- A life pension of slightly less. But if she predeceased him, he would get a partial recovery of her plan contributions.
- A substantially reduced pension for life. However, the pension would cover her and her husband and guarantee both of them a pension for life.
Many retirees in this situation feel compelled to take the reduced lifetime income, commonly known as a joint and survivor pension. However, once they select this option, it cannot be changed in most cases.
Points to ponder
There are several important things your client should consider before deciding to take the reduced pension benefits:
- If the retiree lives a short time, the surviving spouse faces a lifetime of reduced pensions.
- If they both live a full life and die within a year or so of each other (which is not unusual), little benefit, if any, is realized after 20 or more years of reduced pension income.
- In either case, the children of the retiree and spouse will never inherit any benefits.
Let’s review the potential costs associated with the retiree who was considering the $57,000 pension for life. Keep in mind that this is only an example:
In conclusion, the pension survivorship option is just like expensive term life insurance that may never pay a benefit.
A better way
An alternative is pension maximization, under which your client buys a life insurance policy before she retires in an amount that would give the survivor or other heirs a similar monthly benefit. For example, your client could buy a universal life policy for about $471,000, which would fund a survivor pension/annuity option if interest rates are at 4.25 percent for the next 30 years. The annual premium or deposit into the life insurance would be $7,308 annually.
Conversely, a low-premium whole life insurance policy, which would guarantee the death benefit and provide cash values as an additional economic asset, would cost approximately $11,000 per year.
The best way
The best way to maximize your client’s pension if she is healthy four or five years before retirement is for her to buy low-premium whole life insurance for about $8,600 per year. This strategy is used throughout corporate America, and I have implemented a number of pension-maximization cases for my clients.
In one instance, a retiree’s spouse predeceased the retiree. The retiree still has the maximum pension. The life insurance proceeds are now directed to the retiree’s adult children—something that would not have happened under a traditional joint and survivor pension arrangement.
In another situation, a retiree has accumulated so much cash in her life insurance that she can now finance the purchase of her automobiles with her life insurance loans instead of using bank loans. She is still in excellent health, although her husband’s health is failing. The pension-maximization strategy we put in place years ago will work better for her adult children who are heirs to her estate.
Pension maximization does not work in all circumstances, however. Someone whose health has deteriorated is not a good candidate for permanent life insurance, which is the fundamental component and economic workhorse of a structurally strong pension-maximization strategy.
Here are some things to keep in mind as you consider pension maximization for your clients:
- Life insurance proceeds to the survivor are income-tax free whereas survivor pension benefits are fully taxable as ordinary income.
- If annuitized at an older age, the survivor will have a larger monthly income than he would under a traditional joint and survivor option. If life insurance proceeds are annuitized, a large part of that benefit will be income-tax free as a return of principal under the exclusion ratio.
- If a retiree and her spouse die simultaneously, insurance benefits could pass to other heirs, such as their children.
Life insurance can provide additional benefits such as long-term care insurance and accelerated death benefits if the policy owner has a terminal illness.
- If the survivor recipient of the pension predeceases the retiree, the policy can be put into a reduced paid-up mode, whereby no further premiums are required at a reduced life insurance benefit. The retiree could also surrender the policy for its cash value if need be, or borrow against it, even in a reduced paid-up mode.
- If the retiree’s spouse predeceases her and the retiree remarries at a later date, the new spouse can be named the beneficiary of the policy.
Barry J. Dyke is a member of NAIFA-New Hampshire and has been an agent and advisor for more than two decades. This article is excerpted from his new book, The Pirates of Manhattan, which is about the monetary system, finance and permanent life insurance. Contact him at 800-335-5013 or at firstname.lastname@example.org.