Developing a Pension Maximization Strategy

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This paper is the second part of a two-part series. In the first part, we discussed the considerations involved in evaluating different pension options. As follow-up, this second part will discuss whether there is a benefit to including life insurance as part of the pension evaluation decision.

When presented with an option to take a single life or joint life pension, several different analyses should be prepared to analyze each of the alternatives and related variables. When considering a single life pension, as an alternative to taking a joint and survivor pension option from a law firm part of the analysis is to consider taking the higher single life pension and buying life insurance to provide income at your death for your surviving spouse.1 This strategy is commonly called “Pension Maximization.”

According to Investopedia, “Pension maximization is a risky retirement strategy for couples that seeks to secure the best annuity payout and balance that risk with life insurance.”

In order to assess whether this strategy mitigates or contributes to risk and/or is right for a family, this article is intended to discuss the issues and provide a framework to analyze important factors in the decision-making process.

How Does Pension Maximization Work?

A typical pension election for married couples is to select the joint and survivor benefit. In this case a partner and their spouse receive one pension amount while they are both alive and a surviving spouse receives a continuing pension (possibly reduced) subsequent to the death of the partner.

A pension maximization review analyzes whether it makes sense, instead of choosing a joint and survivor benefit, to elect the higher single life payout coupled with the purchase of a life insurance policy with some portion (or all) of the incremental after-tax cash flow. The goal of pension maximization is it to replace the spousal pension payout with a death benefit that will provide a payment stream greater than or equal to the after-tax amount that would have been paid by the survivor pension following the death of the partner.

What are the Advantages and Disadvantages of Pensions Maximization?

If a pension maximization strategy “works,” the family will have more funds available to spend in retirement when both spouses are alive without foregoing (or perhaps even increasing) the funds available subsequent to the death of the partner. If a spouse predeceases the partner, the insurance can be cancelled, leaving the partner with more available cash flow as he/she will no longer be paying for life insurance. If the partner dies before their spouse, the spouse would have the life insurance proceeds to invest and/or use for ongoing lifestyle expenses. In some circumstances, the life insurance benefit could provide for better financial security than the survivor pension payment.

If the strategy does not “work”, the amount of life insurance purchased would have been inadequate to replicate the pension payment foregone. The family would not be better off selecting this life insurance option.

In order to determine whether the strategy is appropriate, an analysis of the numbers helps to provide an answer.

A Look at the Numbers – Deciding When to Pursue a Pension Maximization Strategy

To demonstrate the variables when reviewing a pension maximization strategy, three fact scenarios are described below. In order to establish a baseline for the comparisons some assumptions must be made:

  • John Smith is age 55 and his wife Joan is age 53 and both are in good health.
  • John’s life expectancy is age 87 and he will retire at age 65.
  • If he chooses a Single Life pension (i.e., if he dies his wife will receive no further pension) he will receive $400,000 per year.
  • Assuming they are in the 45% tax bracket, the after-tax pension would be $220,000.

We have assumed that if John chose a single life pension which provided no benefit for his wife and purchased a life insurance policy, the insurance death benefit should decrease over time. That is because the longer John lives the less insurance is needed to provide a “replacement” pension for his spouse who now has a shorter life span. In this example we will utilize insurance products that are a mix of term life insurance and universal life (cash value) life insurance.2 We also assume that insurance premiums are paid each year starting at age 55.

Note that we could have waited until just before John’s retirement at age 65 to perform this analysis and begin paying life insurance premiums. Waiting until age 65, however, has financial costs and health risks. The cumulative and present value premium cost of every alternative considered is higher when premiums begin at age 65 vs. 55. At age 65 annual life insurance costs are greater due to shorter life expectancy although payments are for fewer years than at age 55. Perhaps more importantly, good health (and insurance rates) at age 55 is not assured to be available at age 65.

While there are several key variables that impact these comparisons, the first and most important is the relative reduction in payments from the Single Life Pension to a Joint and Survivor Pension. This shows us how much money is available to fund insurance and the size of the survivor pension we are trying to replace. Although there are an infinite number of scenarios that could be run, we illustrate the results of three scenarios shown below with their respective reductions in payments from a Single Life Pension to a 100% Joint and Survivor Pension. The first Scenario shows the steps involved in the analysis.

Scenario 1: 10% pension reduction

  • Step 1: Begin with the baseline assumption of a Single Life Pension of $400,000 pre-tax and $220,000 after-tax.
  • Step 2: Reduce the above pension by 10% for a 100% Joint and Survivor benefit. This results in a pension of $360,000 pre-tax and $198,000 after-tax. Note that these are the amounts received while alive and that the spouse receives after the employee’s death.
  • Step 3: Identify the additional after-tax funds that are available between the choice of the higher Single Life Pension and the Joint and Survivor benefit pension to determine the “budget” for life insurance. $220,000-$198,000=$22,000 additional per year beginning at age 65 when the pension begins.
  • Step 4: Assuming John lives to his age 87 life expectancy, what is the cumulative total of the additional dollars received? John would be in his 23rd year of retirement. (23x$22,000)=$506,000
  • Step 5: Identify the cumulative cost of owning life insurance until John’s life expectancy in order to provide a survivor income benefit at least equal to the joint and survivor pension John gave up. Cumulative life insurance premiums from age 55 to age 87 for life insurance benefits that decrease over time in order to provide benefits equal to the survivor pension foregone: $1,019,760
  • Step 6: Compare the cost to own the life insurance with the extra cash flow available to John and determine if the family is better or worse off owning the life insurance. $1,019,760-$506,000=$513,760 in additional costs.

Conclusion: John would be $531,000 worse off if he purchased the insurance. Clearly the math in this scenario indicates this strategy does not work as there is not enough additional cash flow provided by the Single Life Pension to purchase sufficient insurance to replace the spousal benefit.

Scenario 2: 20% pension reduction

Assuming a 20% reduction in John’s 100% Joint and Survivor Pension, the annual payment would be $320,000 pre-tax and $176,000 after-tax, resulting in an extra $44,000 after-tax per year vs. the Single Life pension payments. At John’s life expectancy he will have received an additional $1,012,000 in payments vs. an insurance cost of $906,898—so he is ahead by $105,102.

Note that insurance costs are lower than in Scenario 1 because in Scenario 2 you are trying to replace a lower survivor pension benefit. While the numbers narrowly show that this scenario “works” caution is indicated as there are several important considerations—detailed below—that should be considered before moving ahead.

Scenario 3: 30% pension reduction

Continuing the scenarios above, John’s Joint and Survivor Pension would be $154,000 after-tax. If John elects the higher single life pension he will receive an extra $66,000 per year. At age 87 he will receive a total of $1,518,000 in extra cash flow compared to $795,583 in insurance costs. Similar to above, in Scenario 3 insurance costs are lower because the pension replaced is lower. Therefore, John will be ahead by $722,417. In this case the Pension Max strategy works.

Other Factors in the Pension Maximization Decision-Making Process

Health considerations:

  • If an individual has serious health problems and were either uninsurable or insurable at significantly higher costs it is intuitive that taking the Joint and Survivor pension would likely be the recommended action. If a spouse has serious, long- term health issues likely to decrease his/her life expectancy then Pension Maximization is worth serious consideration. Longevity continues to be the most important mathematical consideration in the process of pension maximization.
  • Should either of the employee or their spouse significantly outlive or predecease their life expectancy based on initial assumptions, the conclusions drawn may be incorrect as the base analysis generally is calculated to expected mortality. Because of the uncertainty of actual mortality ages, Pension Max involves taking on some risk that the strategy will work vs. a Joint and Survivor Pension. If the numbers are not substantially supportive of Pension Max and/or one or both spouses expect a long life a Joint and Survivor Pension is the likely recommended outcome.

Reasons to spend more money on Pension Maximization could include:

  • Leaving a family legacy via life insurance vs. joint pension options that end at death.
  • Providing the surviving spouse the option of managing/consuming liquid investments vs. a surviving spouse pension benefit.

Reasons to not pursue a Pension Maximization strategy could include:

  • Not being comfortable to move forward unless there is a material financial benefit, e.g., Scenario 3.
  • Preferring the certainty of the joint and survivor pension vs. the uncertainty of Pension Maximization—a Scenario 2 for example. This is particularly the case when factoring in the uncertainty of life expectancy and its impact on Pension Maximization if the assumptions end up being incorrect.
  • Being concerned about relying on the financial stability of insurance companies. Likewise, it is imperative to evaluate the financial security of your pension as part of this exercise—how much of it is funded vs. unfunded, for example. If some or all is if unfunded it is necessary to assess the long-term financial stability of the firm providing the pension.

How We Can Help: Independent Pension Maximization Review

This second of two pension related articles is intended to raise awareness of what issues one should consider well in advance of retirement.3 As stated at the outset of this paper as well as Part One of this series, there is no clear-cut answer and at the end of the day, “it depends” is the real answer.

As a follow up to Part One of this series, the conclusion to Mr. Smith’s story is interesting. Fortunately, he did use a portion of the additional cash from the single life pension to purchase a portion of the recommended amount of life insurance. Unfortunately, though, given his younger than normal age at his death and the amount of life insurance he purchased, it did not provide the maximum amount of wealth to the family. However, having some amount of insurance helped reduce the financial pain.

To make the most informed choice we recommend you speak with your Round Table Wealth Management advisor who can help by preparing the proper analysis. It is worth noting that RTWM does NOT sell life insurance, so we have no conflicts in evaluating the Pension Maximization strategy. Please contact Bruce Hyde at 908-374-2573 or Bruce@roundtablewealth.com for further assistance.

Notes:

  1. This article assumes there is no option to rollover the pension balance to an IRA. If that option was available, you would need to compare the lump sum option to the pension and determine which was more advantageous.
  2. Insurance products used in these schedules include 20 and 30 year-term insurance and No Lapse Guaranteed Universal Life at preferred risk pricing. Insurance death benefits were used to buy Single Premium Immediate Annuities of decreasing amounts for the surviving spouse at ages 52, 63, 73 and 83. Insurance carriers used are all approved for sale in New York State and have a Comdex score of 90 or above. Comdex is a scoring service that considers four different ratings services and provides an aggregated score with 100 being a perfect score.
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2019-08-27T21:49:10+00:00

About the Author:

Bruce Hyde is a partner, Chief Compliance Officer and Wealth Advisor at Round Table Wealth Management. Read Bruce's Biography >