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.

How Does Pension Maximization Work?

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.

What Are the Advantages and Disadvantages of Pension 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 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.

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

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:

  • 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., his wife will receive no further pension when he dies), he will receive $400,000 per year.
  • Assuming the Smiths are in the 45% tax bracket, the after-tax pension would be $220,000.

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

  • 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 plan participant’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. In this instance, $220,000 – $198,000 = $22,000 additional per year beginning at age 65 when the pension begins.
  • Step 4: Assuming John lives to his life expectancy age of 87, what is the cumulative total of the additional dollars received? John would be in his 23rd year of retirement at 87 so 23 x $22,000 = $506,000.
  • Step 5: Identify the cumulative cost of owning life insurance until John’s life expectancy age 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 are $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 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.

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, taking the joint and survivor pension would likely be the recommended action. If a spouse has serious, long-term health issues likely to decrease their 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 the plan participant 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 maximization involves taking on some risk that the strategy will work. If the numbers are not substantially supportive of pension maximization and/or one or both spouses expect a long life, a joint and survivor pension is the likely recommended choice.

Reasons to spend more money on pension maximization include:

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

Reasons to not pursue a pension maximization strategy 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 versus the uncertainty of pension maximization—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 the pension as part of this exercise—how much of it is funded versus unfunded, for example. If some or all is 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 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.

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