Pension elections: Beware crafty insurance agents

(MoneyWatch) If you're one of those lucky people who will receive a lifetime monthly income from your employer's defined benefit pension plan, you have an important decision to make when you retire: Do you choose a pension that continues the monthly income to your spouse after you die by selecting a "joint-and-survivor" annuity, or do you elect a higher monthly paycheck by choosing a "life-only" annuity that stops after your death?

In my previous "just tell me what to do" series of posts, I advised that people who are married or in a committed relationship should elect a joint-and-survivor annuity to provide a secure income to the spouse or partner should the pension recipient die first. I cautioned against schemes from insurance agents who urge you to elect a life-only annuity and instead buy life insurance to protect your spouse. (I received a comment from a reader accusing me of "fearmongering." Really?)

Then I received an email from another reader -- let's call him Bill to protect his privacy -- who's approaching retirement and who'd been pitched such a scheme by an insurance agent. The agent assured Bill that the life insurance would provide a better retirement income for his wife after his death than the joint-and-survivor annuity under the pension plan.

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Bill provided me with the details of the life insurance and the annuity so I could analyze whether the offer would be a good deal for him and his wife. I concluded that he would have to die within a specific age range for this scheme to provide a higher income to his wife after his death. I also determined that the odds are pretty good that Bill won't die somewhere in the necessary age range, so that this won't be a good deal for the couple. Let's take a look to see how I reached my conclusions.

Understand the details

Bill is planning to retire at age 62; at that time, his wife would be age 64. If he elects a 100 percent joint-and-survivor annuity, he would receive a monthly pension of $1,209, with this amount continued to his wife after he dies. If he elects a life-only annuity, his monthly income would be $1,404 -- $195 higher per month than the 100 percent joint-and-survivor annuity -- but it would stop after his death.

Bill's insurance agent told him that $195 per month would buy an insurance policy that's guaranteed for life; the death benefit would be about $191,000 under a 20-year term policy. By buying such a term policy, the insurance company can't cancel Bill's policy during his lifetime, but after 20 years the premiums will increase to the cost of insurance an 82-year-old man would have to pay.

Bill is waiting to see if the insurance company will charge him a higher premium due to his medical history. If this turns out to be the case, $195 per month would buy a death benefit of less than $191,000.

Does this offer provide a higher survivor income?

If Bill elects the life only-annuity and buys the insurance policy, his wife will receive $191,000 as a death benefit. To generate a retirement income, she'll need to use the proceeds to buy a life-only annuity from an insurance company. If she decides to instead invest this amount to generate retirement income, her retirement income likely will be smaller than if she buys an annuity. (You can see why by looking at my retirement income scorecard series.) For this post, let's just assume she'll buy an annuity with the insurance proceeds.

My most recent retirement income scorecard shows that $100,000 will buy an annual life annuity for a single woman age 65 of $6,208 and an annual annuity of $6,957 at age 70. (These amounts come from Hueler's Income Solutions, an annuity shopping service that provides competitive, institutional quotes on annuities.) If Bill's wife uses her death benefits to buy an annuity with the agent's insurance company or if she uses another agent to buy a retail fixed annuity, she'll most likely receive an income that's lower than these amounts.

If we adjust these amounts for a $191,000 purchase price and divide it by 12, you'll see that if Bill dies when his wife is age 65, she'll receive a monthly income of $988. If Bill dies when she is 70, she'll receive a monthly income of $1,107. Both of these amounts are lower than the $1,208 in income she'd receive with the 100 percent joint-and-survivor annuity.

If Bill dies when he's 71 and his wife is 73, however, her monthly income from her annual life annuity would be about $1,230 -- higher than the $1,208 income under the 100 percent joint-and-survivor election. For every year that Bill survives after age 71, his wife's monthly income would increase, since annuity purchase rates are more favorable as you age.

Since there's a good chance that Bill will live beyond age 71, wouldn't it seem like a better deal for him to elect the life-only annuity and buy the life insurance policy? Not so fast.

When does he need to die, and how likely is this?

Remember that this is a 20-year term policy. When Bill reaches age 82, the premium needed to continue his $191,000 policy will skyrocket way beyond $195 per month. Then he'll either need to reduce his lifestyle expenses to afford the higher premium or reduce the amount of insurance, which in turn reduces the monthly income to his wife after his death, a particularly bad outcome when she is very vulnerable financially.

For this insurance scheme to work, Bill needs to die at exactly the right ages -- somewhere between age 71 and age 82. If he dies at any other age, his wife will receive a lower monthly income under the insurance option. According to the simple life-expectancy calculator sponsored by the Society of Actuaries, there's a 50 percent chance that Bill will live beyond age 83; this doesn't include that odds that he could die between ages 62 and 71. If you consider the odds, there's a very good chance that Bill won't die in the 71-to-82 age zone.

Employer-sponsored pensions usually a better bet

The strategy advocated by Bill's insurance agent is just one example of this type of scheme. While it's possible there's an insurance policy out there that could result in higher survivor income for the spouse, I have yet to see one.

And that shouldn't surprise you when you think about it. Pension plans and insurance policies are both designed by actuaries using the same principles regarding mortality rates and interest rates. Insurance companies don't have any special insight that's not available to pension plans. But insurance companies need to build margins for profits, administrative expenses, and commissions to insurance agents into their premium rates, while pension plans are operated "at cost." Most employers actually spend money to operate their pension plans as a benefit to their employees; their pension plans certainly aren't a source of profits. So it only makes sense that employer-sponsored pension plans will usually be able to offer a more favorable deal than a commercial insurance policy.

Another consideration is your health. Joint-and-survivor annuities with employer-sponsored pension plans cover all employees, even those who are in poor health. But insurance companies can charge you higher premiums if you have a poor medical history, or decline outright to cover you.

If you're interested in a similar insurance strategy, take the time to analyze if it will really provide an advantage to you and your spouse. Don't just take the assurances from an insurance agent that you'll be better off with such a a plan. If you'd rather not bother with the kind of analysis described above, hire an independent, qualified financial advisor to do it for you. Don't ask the insurance agent who's pitching you such a strategy to do it -- you can guess what his answer will be.

The elections you make when you retire are among the most important decisions you'll make for the rest of your life, so take the time to do the job right. And if urging readers to decline this type of insurance scheme sounds like fearmongering to you, then consider me a proud fearmonger.

[Kevin_Kroskey_CFP]

Steve, you wrote 'crafty insurance agent.' I disagree with 'crafty' because this person was more likely incompetent, unethical, or both. Further, your usage of the word 'scheme' is also out of line and sensationalistic.

Further, you completely ignored taxes in your analysis. This may be okay in your former life as an actuary but not in real life planning for individuals and families. Most families will be in the 15% marginal federal bracket in retirement when married filing jointly.

The surviving spouse will likely later find herself in the 25% marginal federal bracket just from pension income plus Social Security income, which starts at $35,350 of taxable income for a single filer in 2012.

You must run the numbers, design the plan well, and consider taxes. Using an immediate annuity with the tax-free life insurance proceeds does provide tax benefits. Details can be seen here:

http://www.investopedia.com/articles/retirement/07/immediate_annuity.asp#axzz23Wk6aKwz

When comparing apples-to-apples it often takes the worker to live just to their late 60s to early 70s to provide an equivalent, after-tax survivor income from the life proceeds and immediate annuity. This controls to only use the after-tax income differential when both are alive to purchase insurance, so it does not impair cash flow compared to a regular survivor option. It also assumes a fully-guarantee universal life policy is utilized and not term insurance, though term insurance may be suitable to blend into the design.

What is the probability someone with a standard health rating in their mid 50s to 60s will live to this age? From life expectancy tables: better than 85%. If interest rates increase from today's decades-low levels, the break-even point is even shorter. I like these odds a great deal if sufficient resources from savings, investments, and other sources of income (spouse's pension, Social Security, etc.) are present to protect in the event of death soon after making the life only pension election.

Maybe you are already aware of what I wrote but didn't convey it in your article for simplification. Regardless, the sensationalistic language is inappropriate and tax considerations should have been mentioned.

Regards,

Kevin Kroskey, CFP®, MBA
www.TrueWealthDesign.com

[Kevin_Kroskey_CFP]

I should note that a reduction of 15% from the single life pension to 100% survivor pension is a good hurdle rate when this strategy may work well and is of course dependent upon insurability. If the reduction is larger, if favors using life insurance and vice versa.

[ChuckYanikoski]

This concept is not a nefarious scheme -- it's simply an idea that might or might not work in any given situation. It has been 20 years since I worked with it on a regular basis, but at that time I discovered something that I am sure is still true, but almost nobody knows it (or if they know it, they don't think about it):
Pension plans are built on assumptions about investment and mortality and expenses (and other factors), and so are life insurance policies. In theory, the pension and the life insurance policy should be exactly equal, because they are doing the same job. In reality, however, this is not the case, because pensions and life insurance policies are priced by different people using different techniques and motivations -- so the only way to judge the value of this approach is on a case-by-case basis.
My own experience, which surprised me at the time, was that many pension plans either greatly overvalue or greatly undervalue the cost of the survivor benefit. I don't know why this is so, but it is. In effect, some plans subsidize the survivor benefit, and others penalize it. In the former case, no life insurance policy can compete. But in the latter case, life insurance often provides a distinctly better deal.
If you're a member of plan, the only way to know is to do the math. But if you're an insurance agent or other adviser, doing the math just a few times for people in any given plan will tell you whether members of that plan tend to be clearly better off with the survivor benefit or with life insurance, or whether it tends to be a toss-up.
Another relevant factor is gender. Pension plans typically use unisex mortality tables when calculating survivor benefits, while individual insurance policies almost always use sex-distinct rates. This means that, depending on the sex and age of the retiree compared to the sex and age of the beneficiary, the life insurance alternative might be a whole lot better or a whole lot worse.
I consider it to be no better to blanketly condemn life insurance as an alternative to a survivor benefit than it is to blanketly endorse it. As I think is almost always true when it comes to retiree choices: you have to do the math. Rules of thumb just aren't good enough at this stage of life, unless you have enough money so that you can afford to make big mistakes.

[stevevernon]

Hi Chuck - good to hear from you, and thanks for adding your thoughts. My take on this is that you'll get a pretty good shake on J&S annuities from your employer's pension plan, which isn't a profit center for your employer. It's possible that you might improve your situation from a pension optimization scheme, but you'll have to do the math to see if you're one of the few people who will benefit. My post shows one way to do the math. Don't rely on claims made by insurance agents; with the case study in my post, the insurance agent's claims were incorrect. Yes, there can be insurance agents with integrity, but be absolutely sure that their trust has been earned. If you don't have the time or patience to do the math, then just pass on the scheme. You'll still get a good deal from your employer.

Thanks again, Steve

[Plan2Retire]

Don't you also have to consider the fact that Bill won't actually have $195 to spend on insurance? He will have to pay taxes on that $195.

[get_down]

"Insurance companies need to build margins for profits, administrative expenses, and commissions to insurance agents into their premium rates. So it only makes sense that employer-sponsored pension plans will usually be able to offer a more favorable deal than a commercial insurance policy." In 2009, I retired from the IT Company which I worked for more than 29 years and I selected the "joint-and-survivor" annuity option which meant after my death, my better-half will receive 50% of my pension payment every month. In addition to that, she'll receive my Social Security benefit. In addition to those two, she'll take over close to 1 mill asset. She's a happy camper. This is a great article. Mr. Steve Vernon's 30 years of financial expertise truly shown here.

[stevevernon]

Hi Financial_Foodie

I appreciate your point of view. If you can send me the real life specifics of a pension maximization strategy that indeed improves a retiree's situation, I'd be glad to analyze it in the same way as in the article, and then write about it. From my perspective, such schemes need to demonstrate actuarially that they will benefit the client. General claims and assurances that pension maximization works is not enough.

Respectfully, Steve

[financial_foodie]

Mr. Vernon: I am an insurance wholesaler who works with a variety of professionals and I must say I am offended by your article. While I will concede there are less than ethical insurance agents out there, a segment of our industry truly values doing what is right for our clients, regardless of whether we make a commission or not. The "insurance scheme" you refer to in your article is called pension maximization and a properly designed plan incorporates permanent insurance in lieu of or addition to term insurance. As I've told the advisor who forwarded me your article, prior to 2008 it was more common that pension max did in fact create a better position for the client in retirement. Since 2008 declining rates on annuities have made pension plans generally more favorable, but not in every case. In my experience with pension max cases over the last few years I would say 10-20% of them can still improve the client's position in retirement. It is irresponsible of you to make a blanket statement urging your readers to even consider if such a "scheme" could create a better retirement for them.