Pension Maximization: Will It Work for You?
At retirement, you have two ways of taking your pension: (1) Lifetime only: you get a higher monthly income, but it stops when you die. (2) Joint-and-survivor: you get a lower income, but it lasts for the lifetimes of you and your spouse.
A pension max salesperson will propose that you take the lifetime-only pension. To protect your spouse, you buy a life insurance policy. At your death, the proceeds of that policy can provide your spouse with a lifetime income.
This plan is potentially workable if: (1) your net lifetime pension, after paying the insurance premium, is greater than you would have received had you chosen the joint-and-survivor pension; and (2) after your death, the insurance proceeds are sufficient to buy your spouse a lifetime income at least equal to what the joint-and-survivor pension would have paid for life. Most proposals fail one or both of these tests.
The following worksheet will tell you whether a proposed plan will work or whether it puts your spouse at risk of running out of money. It was prepared by the late John Allen, J.D., of Allen-Warren in Arvada, Colorado. You and the salesperson should fill in the following blanks:
STEP ONE: To see if a pension max scheme will improve your income as a couple, while you’re both alive
1. Your monthly pension, if paid for your life only. |
$__________ | |
2. Your monthly pension after all taxes.* |
$__________ | |
3. Your monthly pension as a couple if you take a joint-and-survivor option. |
$__________ | |
4. The joint-and-survivor monthly pension after all taxes.* |
$__________ | |
5. Your spouse’s monthly pension after your death if you take the joint-and-survivor option. (This may or may not be the amount you reported on line 3.) |
$__________ | |
6. Your surviving spouse’s monthly pension after all taxes.* |
$__________ | |
7. The midpoint between lines 5 and 6. Use this as a rough target for the monthly lifetime annuity payment your spouse ought to get if you choose pension maximization.† |
$__________ | |
8. The size of the insurance policy needed to buy your spouse the appropriate annuity after your death. To calculate it, visit Immediate Annuities.com (www.immediateannuities.com). Enter your spouse’s age in the year you’ll retire‡ and the monthly income from Line 7. The calculator will tell you how much such an income will cost. |
$__________ | |
9. The monthly life insurance premium required to buy the size policy shown on line 9. |
$__________ | |
10. Subtract the monthly premium (line 9) from the after-tax income you’d get from a single-life pension (line 2). This gives you the disposable income that you, as a couple, would have left to live on. |
$__________ | |
11. Compare this with the income you’d get from a joint-and-survivor pension, after tax (line 4). |
$__________ | |
If your income after pension max is less than you’d get from a joint-and-survivor pension, stop here. It usually makes no sense to use the insurance scheme. |
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* Federal, state, and local. Don’t estimate from a tax bracket. Calculate the actual tax. |
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† The midpoint includes a tax adjustment. A professional planner will be able to target the amounts in lines 6 and 7 exactly. |
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‡ Your plan should protect your spouse in the worst case—namely, if you die immediately after retiring. |
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STEP TWO: If pension max provides you with more income as a couple, continue the calculation to see if it protects your spouse after your death.
12. Your spouse’s life expectancy, based on his or her age when you retire.* The number comes from the Life Expectancy Table on page 1205. |
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13. The portion of the spouse’s annuity income that will be excluded from income taxes. This is called the Exclusion Ratio.† Carry it to three decimal places. |
__________ | |
14. Subtract the Exclusion Ratio from 1.000. |
__________ | |
15. Enter the monthly annuity income you targeted from line 7. |
$__________ | |
16. Multiply line 14 by line 13. This tells you how much of the spouse’s annuity income is subject to tax. |
$__________ | |
17. Subtract income taxes‡ from the spouse’s annuity income (line 14) and enter that income after tax. |
$__________ | |
18. Enter the actual amount of net spousal income you need to protect (line 6). |
$__________ | |
* For safety, refigure for 5, 10, and 20 years ahead. Each year the spouse lives, his or her life expectancy improves. |
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† To get the Exclusion Ratio: Multiply the spouse’s monthly annuity income by 12. Multiply the result by the life expectancy (line 11). Divide the result into the size of the life insurance policy (line 8). |
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‡ Federal, state, and local. Don’t just estimate from a tax bracket. Calculate the actual tax. |
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If line 17 is larger than line 16, you need more life insurance to protect your spouse. Redo the worksheet using a larger policy. If the cost of the larger policy reduces your income as a couple to less than you’d get from the joint pension, pension max doesn’t work. This is the usual case!
If you start pension maximization earlier than retirement, you’ll need a “present value” analysis. This recognizes that $1,000 spent on insurance today is worth much more than $1,000 received in higher pension benefits in the future. A present value analysis tells you whether those extra pension benefits are worth their cost. Don’t buy from an insurance agent or planner who won’t (or can’t) do that calculation for you.
This worksheet does not consider the value of pensions with cost-of-living adjustments. You can simulate the analysis by estimating what your pension will be in 5, 10, and 20 years and using this sheet to see if the life insurance will indeed supply a comparable pension for the spouse.
If your pension has a cost-of-living benefit, you will need to purchase a much larger amount of insurance in order to provide your spouse with a similar amount of income. And even that might not be enough if inflation explodes.
If you buy a universal life policy or an interest-sensitive whole-life policy and interest rates decline, your plan may not work out. You might have to pay a higher insurance premium or accept a lower death benefit. Ask the agent to show you what happens to the pension max plan if interest rates drop to the policy’s minimum guaranteed rate.
If you buy a policy with a “vanishing premium” (page 392) and interest rates fall, your plan may not work out. You figured on paying premiums for a limited number of years but will have to pay them longer. That might reduce your standard of living.
At your death, annuity rates may have dropped. Your spouse may not be able to buy as high an income as you expected.
Inflation or unexpected expenses may eat away at your income. At some point in the future, you may not be able to afford the life insurance premiums. If you have to cancel the policy, and die, your spouse will lose that part of his or her income.
If you become forgetful, your insurance might lapse accidentally, leaving your spouse to do without. If the marriage goes bad and the husband owns the policy, he might cancel it or change the beneficiary.
Your spouse may get health benefits from your pension plan, which could be lost when you die and your pension stops. It is particularly unwise to sever all connection with a public-sector plan.
If your spouse dies first, the insurance can be canceled, leaving you with more disposable income.
If you want to continue paying for the insurance after your spouse dies, you’ll have a larger estate to leave to your heirs (although, if leaving a larger estate is important to you, you can carry extra life insurance without using pension max).
If there’s a divorce, the pension holder could cancel the policy (although the divorce settlement might require that the policy be kept in force).
If you and your spouse live for many years, you can—at some point— withdraw some cash from the policy. You will shrink the death benefit left for your spouse. But at later ages, less money is needed to provide the spouse with a lifetime income.
These advantages are speculative and don’t begin to compensate for the disadvantages. You are gambling with your spouse’s future security. Not a good idea.