What To Take Into Account When Considering Pension Maximization
Pension Maximization, commonly referred to as simply Pension Max, is a concept that has been around for years. Over time it has had more than its share of fans and detractors.
Its proponents see it as a way to benefit retirees and their spouses by boosting income in their retirement years. Its detractors see it as a scam to siphon off a retirees needed income into questionable financial products. As is often the case with many planning concepts, there is no right or wrong.
In many cases, Pension Max will be beneficial to a client; however, careful analysis is required. Determining what income needs are required and where Pension Max fits is more than a numeric analysis; some issues cannot be quantified. This article will consider these issues and look at some unusual approaches to Pension Max.
What is Pension Max?
Under a pure Pension Max analysis, a retiree elects the largest payout option from his or her employers pension plan, using some or all of the increased funds to purchase life insurance to handle a survivors income needs.
In a classic Pension Max, a retiree elects a single life payout, typically the largest payout option. Although such an election leaves their spouse without income in the years following a retirees death, the retiree replaces the lost pension through the purchase of life insurance. The insurance is often purchased with some of the increased pension income. The survivor would live off the income-tax-free death proceeds to enhance income in the years following the retirees death.
An example from the early 90s shows why Pension Max might be so attractive. In an example from 1992, a retiree was offered a single life pension payment of $2,000 per month or a joint and 50% survivor benefit of only $1,218 per month. By electing a strategy providing for two lives, the retiree took a $782 cut in retirement income. After death, the survivor would be further reduced to only $609 per month. All of these amounts would be subject to income tax.
With a Pension Max approach, a client would elect the higher $2,000 per month single life approach and purchase life insurance to provide the survivor with tax-free life insurance proceeds sufficient to boost the post-death retirement income over $609 per month under the joint life pension option.
|Determining if Pension Max is appropriate for your clients calls for a careful analysis.|
This same example, now nearly 10 years old, also suggested that during the pre-death years cash value from the life insurance policy could be used to supplement income during the retirement years. If the retiree died, the spouse would be cared for. If the spouse died first, the retiree would be able to continue the larger single life payout while retaining the life insurance death benefit for other heirs.
In the years following this example, a number of items happened that discouraged Pension Max marketing. Pensions, and the annuities supporting pension payments, became more competitive, so the wide discrepancies between single and joint life pensions became less dramatic. In the example from 1992, the survivor benefit was barely 30% of the single life. Now it is more typically 66%.
Retirees also became more cautious of using life insurance cash values during their living years, Qualified Domestic Relations Order made it more difficult for retirees to make unilateral decisions, and financial planners adopted a bias that was more investment-focused.
Nevertheless, in many instances a pension difference might still call for the use of Pension Max.
Where does Pension Max make sense?
There are many things to consider when looking to do a Pension Max analysis:
Quantitative analysis: Many software programs are available that allow advisors to do a quantitative analysis. This includes comparing the pension payout, or projected pension payout, and determining the amount of life insurance necessary to replace the lost pension at the retirees death. A thorough analysis would include a present value comparison of: a) the stream of single life payout less the life insurance premiums paid, and b) the stream of reduced joint life payments. The earlier such a strategy is adopted, and the lower the cost of the life insurance, the more attractive Pension Max will be.
Planning before retirement: As noted above, Pension Max works best if the strategy is adopted before retirement. Although many retirees might defer pension payout planning, and consideration of this strategy until they are about to retire, the younger the client, the better. A healthy 45-year-old can purchase life insurance at a lower cost than a retiree 20 years older.
Although planning years before retirement requires projections and may involve working with the employers HR department, earlier planning results in more leverage obtained from the life insurance. In todays economy, where executives may change employers several times, it is also more difficult to determine a final pension. Nevertheless, if reasonable projections can be done at a young age, Pension Max may be more viable than at retirement.