The number of workers that have access to defined benefit pension plans has fallen drastically over the years. However, we continue to come across a substantial number of pre-retirees that will be receiving these pensions. When we do, one of the first issues that comes up is: How to maximize pension benefits while still protecting a surviving spouse in the event that the pensioner passes away early in retirement.
Typically, defined benefit pension plans offer survivor benefit options upon retirement. Unfortunately, the maximum pension benefit alternative (a straight life benefit that would be completely eliminated in the event of the death of the pensioner) is often much greater than the alternatives that provide continued benefits for survivors. Different plans have different formulas for determining the various pension benefit options, but almost all cases result in high embedded costs for survivor protection.
Oftentimes, different permanent life insurance plans can provide protection equal to projected lifetime pension benefits. Unlike pension payments, a payout from a life insurance plan will go to the beneficiary free of income taxes. This makes it easier for insurance to replace the value of a lost pension. Under optimal circumstances, the goal of insurance would be to fully replace the project lifetime after-tax pension benefits for the surviving spouse. Unfortunately, this can often be expensive.
When the costs of permanent life insurance place too great a burden on the household’s retirement budget, term life insurance may be a more limited but cheaper alternative. A term life policy doesn’t provide lifetime benefit for survivors (like the pension’s survivor options or permanent life insurance), but in many cases, this disadvantage can be mitigated by selecting a proper term period. Specifically, there are three milestones which the span of the term policy should try to overlap in order to provide a measure of protection for the pensioner’s family: (1) the repayment of the mortgage on the family’s primary residence, (2) financial independence of any children, and (3) the attainment of full Social Security retirement age for the surviving spouse.
To understand this better, consider the following hypothetical case: A 49-year old plans to retire at age 55; He wants to make sure that his wife, age 47, is protected in the event of his death, but a pension benefit that offers her continued survivor benefits would provide $13,000 less in annual income than the maximum benefit option and permanent insurance alternatives were also deemed too costly; The couple has 18 years left on their 30-year mortgage, and have three children that are ages 18, 15, and 12.
In this case, a 20-year term life policy would be worth considering because while this type of insurance doesn’t provide lifelong protection, it does cover some very important financial landmarks. Consider that at the end of the 20 year term, the mortgage will be completely repaid (thereby lowering the household budget), the youngest of the children will be 32 (and hopefully financially independent!), and the spouse would be eligible for full Social Security benefits (or, if necessary, full widow's benefits). In sum, the financial situation is much different than at present, and the spouse's financial needs and reliance upon the pension have changed significantly.
Obviously, every situation is different, and there are several missing pieces to the example above including a life insurance needs assessment that would help dictate the amount of coverage that is needed. So by no means is this a general call to run out and get life insurance. The takeaway here for unionized and other workers that are looking forward to a defined benefit pension is to consider these issues prior to retirement and while still in good health. The passage of time and a deterioration in health status can increase the potential cost of coverage, and limit choices and retirement strategies.
Contact me at andrew@lpastrategic.com if you have any questions. You are also invited to join us at our free Investors' Wine & Paint Night on June 28th at 7 PM at the ArteVino Studio in Freehold. Please reach out at (732) 462-1180 to reserve your spot if you are interested — space is limited.