Our advisors utilize their experience and expertise and that of their colleagues to develop the best solutions for your complex personal and professional financial situations.
Actionable planning strategies to inform and guide your decision-making.
Bruce A. Hyde
December 6, 2022
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 for law firm partners. As follow-up, this second part discusses 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 explore each of the alternatives and related variables. One part of the analysis when considering a single life pension includes the option of taking the higher single life pension and buying life insurance to provide income at the participant’s death for the surviving spouse.1 This strategy is commonly called “pension maximization.”
To assess whether this strategy mitigates or contributes to risk and/or is right for a family, we’ll explore the issues and provide a framework to analyze important factors in the decision-making process.
A typical pension election for married couples is to select the joint and survivor benefit. In this case, the plan participant and their spouse receive one pension amount while they are both alive and the surviving spouse receives a continuing pension (possibly reduced) subsequent to the death of the partner.
A pension maximization review considers whether it makes sense to instead elect the higher single life pension 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 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 their partner.
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 after 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 they 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. The family would not be better off selecting this life insurance option.
To determine whether the strategy is appropriate, an analysis of the numbers helps to provide an answer.
The three scenarios below demonstrate the variables when reviewing a pension maximization strategy. To establish a baseline for the comparisons, some assumptions must be made:
We also assume that if John chooses a single life pension, which provides no benefit for his wife, and purchases 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 utilize insurance products that are a mix of term life insurance and universal life (cash value) insurance.2 Additionally, we assume that insurance premiums are paid each year starting at age 55.
Note that the Smiths could have waited until just before John’s retirement at age 65 to 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 versus age 55. At age 65 annual life insurance costs are greater due to shorter life expectancy although payments are for 10 fewer years than at age 55. Perhaps more importantly, good health as well as good insurance rates at age 55 are not assured at age 65.
While there are several key variables that impact these comparisons, the first and foremost 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
Conclusion: John would be worse off by $531,760 if the Smiths 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 option 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 for the single life pension payments. At John’s life expectancy age, he will have received an additional $1,012,000 in payments versus an insurance cost of $906,898—so he is ahead by $105,102.
Note that insurance costs are lower in Scenario 1 than in Scenario 2 because in Scenario 2 we 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 taken into account before moving ahead.
Scenario 3: 30% pension reduction
Continuing the scenarios above, John’s joint and survivor pension would be $154,000 after-tax with a 30% pension reduction. If John elects the higher single life pension, he will receive an extra $66,000 per year. At age 87 he will have received 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 maximization strategy works.
Reasons to spend more money on pension maximization include:
Reasons to not pursue a pension maximization strategy include:
This article is intended to raise awareness of what issues one should consider well in advance of retirement. As stated at the outset of this paper as well as in part one of this series, there is no clear-cut answer when it comes to pension options and pension maximization, and at the end of the day, “it depends” is the real answer.
The conclusion to the Smiths’ story is interesting. Fortunately, John used 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 regarding pension maximization, we recommend you speak with your Cerity Partners advisor who can help prepare the proper analysis.
1 This article assumes there is no option to rollover the pension balance to an IRA. If that option is available, an individual would need to compare the lump sum option to the pension and determine which was more advantageous.
2 Insurance products used in these scenarios include 20- and 30-year term insurance and no lapse guaranteed universal life insurance 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 in the example 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 insurance ratings services and provides an aggregated score with 100 being a perfect score.
Cerity Partners LLC (“Cerity Partners”) is an SEC-registered investment adviser with offices in throughout the United States. Registration of an Investment Advisor does not imply any level of skill or training. The foregoing is limited to general information about Cerity Partners’ services, which may not be suitable for everyone. You should not construe the information contained herein as personalized investment, insurance, tax, or legal advice. There is no guarantee that the views and opinions expressed in this presentation will come to pass. Before making any decision or taking any action that may affect your finances or your company’s finances, you should consult a qualified professional adviser. The information presented is subject to change without notice and is deemed reliable but is not guaranteed. For information pertaining to the registration status of Cerity Partners, please contact us or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). For additional information about Cerity Partners, including fees and services, send for our disclosure statement as set forth on Form CRS and ADV Part 2 using the contact information herein. Please read the disclosure statement carefully before you invest or send money.
Please read important disclosures here.
Bruce A. Hyde is a Partner in the New Jersey office and has over 30 years of experience in the financial services industry. For the...
Ben Pace, Christian Thwaites and James Lebenthal
February 2, 2023 — Markets have recently been and will continue to be driven by three key influences: monetary policy primarily emanating from the Federal Reserve, China’s COVID reopening and the growth potential therein, and the earnings and guidance reported by leading S&P 500 firms. While we remain cautiously optimistic that inflation will continue to abate, rates will stabilize, and the global economy will not fall into recession, the market’s assessment of the three key influences will determine the short-to-mid-term path forward.
January 31, 2023 — Global equity prices rallied in January, as inflation continued to recede and investors’ hopes mounted for an end to central bank tightening cycles.
Michael B. Fischer and Frederic Behrens
January 22, 2023 — As part of Tax Cuts and Jobs Act of 2017, the U.S. federal estate tax exemption amount increased to approximately $12.92 million per individual or $25.84 million per couple (2023). As a result, many families are no longer subject to federal estate tax due to the high estate tax exemption amounts. However, several individual states […]
Steven J. Giacona
Partner & Market Leader
January 10, 2023 — As a CPA and financial advisor, clients often ask me for ways to reduce taxes. Since the enactment of the Tax Cuts and Jobs Act of 2017, which limited state and local tax deductions to $10,000, many clients, particularly residents of high-tax states such as New Jersey, New York and Connecticut, have raised the question […]
Theodore D. Schneider
January 10, 2023 — Our team at Cerity Partners is continually inspired by the efforts of charitable organizations and want to offer our assistance to boost planned giving campaigns. As experienced advisors in financial and philanthropic planning, we believe having focused discussions with potential donors regarding the following planned giving strategies are effective tools to encourage donors to complete […]
Curious about learning more? Let’s talk.
Tell us about yourself and your current financial situation without cost or obligation. Receive an introduction to a wealth management colleague, have a personal conversation, and get your questions answered.