1 October 2012 0 Comments

Pension Maximization: Magic Or Myth? (part 1 of 2 this week)

Important information for anyone retiring in the near future with a pension income!

Life insurance companies created Pension Maximization.  Agents love it because it helps sell large amounts of insurance. Does that mean it’s bad for the consumer?  Not when it’s done right.  In fact, it can be a magical option for married couples deciding how to receive a monthly pension.

But, it doesn’t always work and when it doesn’t it can leave the spouse of a retiring worker in a bad position.  The magic turns to myth and the couple finds themselves headed down a one way alley from which there is no exit.

What is Pension Maximization?

Married workers retiring with a defined benefit pension are offered the choice of a maximum monthly pension paid out only during their lifetime with nothing continued to the spouse at their death—or—a reduced monthly pension with continuation of income to the spouse should they die first.  This is called the survivorship option.

Pension Maximization provides another option.  It uses life insurance on the retiring worker that will be used to continue income to the spouse allowing the worker to opt for the maximum pension benefit.

If the continuation of some income to the spouse at the death of the retiree is important, then Pension Maximization should be considered.  If premium for the life insurance is less than the pension reduction resulting from selecting the survivorship option, then Pension Maximization is a great deal!  Even if there is no increase in net income, there are some other major advantages to having life insurance proceeds in lieu of a fixed income.

The Unknowns

How much life insurance is needed to provide the spouse with income lost when the retiree dies? This is a question that has no absolute answer because of these unknown factors:

  • Age of spouse when the retiree dies;
  • How long the spouse will live;
  • Investment return earned on the life insurance proceeds.

How can you possibly calculate the amount of insurance needed with these variables?  One thing is certain:  it should be a reducing amount.   $1,000 per month lifetime income beginning at age 85 requires significantly less capital than had it started at age 65.  The longer the retiree lives after retirement, the less money is needed to produce income to the spouse who is also aging.

Beware of a recommendation to purchase a level death benefit policy that just happens to produce a premium slightly under the amount of increased income that will be received by opting for the maximum pension benefit.  If that amount is not enough, the surviving spouse can run out of money long before his or her death—and—once the option has been made to discontinue pension income to the surviving spouse, there is no turning back!

When only term insurance is being recommended, if both the retiree and spouse live beyond the duration of the term policy and the retiree then dies, the spouse is left with nothing.  If only permanent insurance is used, then either the premium is higher than it need be, or the amount of insurance is not sufficient in the event of an early death.

The conclusion to Pension Maximization: Magic or Myth? will be my next blog.

 

 Calculating the correct amount and type of insurance

So, how do you calculate the correct amount and type of insurance?  To answer these questions, we first make assumptions on what return is possible when the life insurance proceeds are invested. Immediate Annuities guarantee a lifetime income, just like the pension plan, so that is used as a measuring rod.

Immediate Annuities may not be elected by the surviving spouse, but they’re a conservative approach and also provide some tax advantages.  So, we calculate the Immediate Annuity premium required to guarantee the same after- tax income being replaced for the surviving spouse.  This calculation is made assuming the retiree dies in the year of retirement and at intervals following this date.  A series of term policies of different durations plus a lifetime guaranteed Universal Life policy are then used in amounts equal to the premiums required for the Immediate Annuity at these intervals.  Term insurance is used because it’s the most efficiently priced policy for the specific durations of time as the need decreases.  Universal life is used for the final duration because it is the most efficiently priced policy for a permanent need that takes us beyond the point when term is no longer available. The total premium should be guaranteed and reduce as each of the term policies reaches the end of its term.

It’s not a perfect formula.  The annuity purchase rates are based on what is currently available; tax brackets used to equate after-tax returns also use current assumptions and too much insurance is provided if death occurs at the end of each duration.  Not perfect, but it’s better than a seat-of-the-pants guess.

 

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