Pension Maximization Strategies for Retirees

August 30, 2012
Share |

by Ana Maria Martinetti-Katz, MBA, CFP®, CPA – August 2012

As financial advisors, clients who are lucky enough to have a retirement pension through their employer often ask us which income option is best.  This is a very important decision to be made as a change in the option is not allowed and there are long-term effects to one’s beneficiaries.  The question of which income option to choose isn’t dependent on annual income amounts only.  An educated decision includes providing for survivors, other sources of income, existing debts, etc.  As such, it is important to fully understand the options and devise strategies to help you effectively provide for you and your loved ones during retirement.

In order to devise appropriate strategies, it is first important to understand what are the different income options available to pensioners.  These options include:

  • Single Life Annuity option: pension income is received for the life of the employee whether he/she lives for 2 or 20 years.  This option has the highest payment amount.  When the employee dies, the pension income ceases.
  • 10 Year Certain option: pension income is received for the life of the employee.  However, if the employee dies three years into receiving benefits, for example, his/her beneficiary would receive the same amount of income for the following seven years.  If the employee collected benefits for 11 years and then dies, the beneficiary receives nothing.
  • Joint and Survivor option: this payment option lasts for the lives of both the employee and the beneficiary so if an employee collects benefits for 10 years and then dies, the beneficiary can continue to collect benefits at the same amount until his/her death.  The amount received under this option is less than that of the lifetime income option but it continues on for the beneficiary.
  • Joint and Survivor (adjusted) option:  under this option, the retiree and joint annuitant receive a reduced monthly benefit while both are living.  Upon the death of either, the monthly benefit amount to the survivor is reduced by a percentage (usually 2/3).

An individual’s pension income amount is dependent on a number of factors including years of service, average final compensation (typically, the last three, five or even eight years of earnings), a percentage value (determined by the employer and applied to years of service), and a COLA adjustment, if applicable.

Let’s look at an example of how the single life annuity option and the joint and survivor option benefits differ in annual income.  Let’s assume that an individual worked for an organization for 18.58 years and the highest years of compensation were $65k, $70k, $75k, $80k and $85k.  The average of these five years’ earnings is $75k.  Let’s also assume that based on the years of service and age, the percentage value per year that is applicable for this individual is 1.6%.  Based on this example, the retiree can expect to receive an annual pension of $22,297.50 under the single life annuity or $17,125.92 under the joint and survivor option.  This is a difference of $5,171.58.

Now that we understand what the income options are and how they are calculated, let’s discuss strategy.  Pension Maximization is a strategy whereby the pensioner opts for the lifetime income option in order to obtain the higher payout.  However, that person does not spend his/her full monthly amount.  Instead, the dollar difference between the higher lifetime income option amount and the joint and survivor benefit amount is used to purchase a life insurance policy that will provide for the spouse.  Upon the death of the pension recipient, the spouse will receive the life insurance proceeds tax-free so long as the premiums for the policy are paid up.  In our previous example, the pensioner would purchase a life insurance policy for the maximum benefit amount that a $5,171.58 annual premium would buy.  The trick to ensuring this strategy works lies in applying for life insurance coverage before choosing a pension payout option.  This allows one to be sure he/she will (1) qualify for coverage that is (2) sufficient to make up the loss of income for the spouse, and that it (3) is “affordable” according to the differential in payment amounts.  After all, as previously mentioned, once you choose the payment option, it is typically irreversible (except perhaps within 30 days).

Another factor to consider when applying this strategy is to make sure that the amount that you are purchasing in life insurance is equal to or greater than the total income that your spouse is foregoing by choosing the single life rather than joint and survivor income option.  In our example, the spouse is foregoing $17,125.92 of annual income should the retiree choose the lifetime income annuity options.  Should the pensioner collect the greater amount for 10 years and then pass away, how much in life insurance should he have purchased to provide for his wife in the same manner as if he had chosen the joint and survivor annuity method instead?  Well, assuming the wife lives for another 20 years and the cost of living adjustment for the pension is 2.5%, the amount of life insurance needed would have to be equal to approximately $270,000.

The greater the pension amount, the greater the value of life insurance that is needed, obviously and the higher the premium to purchase that policy will be.  One can conclude that this strategy would not be appropriate for someone who cannot afford enough insurance coverage to make up for the lost pension income or for someone whose spouse would lose medical insurance coverage if they were not part of the pension income strategy.  Additionally, the pensioner must be disciplined enough financially to make sure that life insurance premiums are timely paid so that there is no accidental lapse in coverage.  Allowing the policy to lapse could be catastrophic for a couple with minimal investment assets whose sole source of income is the pension income and life insurance proceeds provided by this strategy.  Lastly, should the pension maximization strategy be utilized, the life insurance proceeds would need to be invested in such a way to provide enough growth to keep up with inflation so that the survivor does not outlive the assets.

One of the benefits of the pension maximization strategy is the potential for assets to remain for heirs after the spouse passes on.  If a pensioner chooses the lifetime income or joint and survivor pension option, once one or both spouses die, so does the stream of income which may leave children and grandchildren without an inheritance.  Though this may not be an issue for some individuals it is worth considering for others.

If you are fortunate enough to have worked for an employer that provided a pension benefit and you are at the point in your life where you need to decide on which income option is best, speak with a competent financial advisor that will be able to give you advice tailored to your particular situation.  This is not a one size fits all strategy and the repercussions of choosing blindly can have longtime negative effects for your loved ones.