Maximizing Your Pension with Life Insurance

Introduction

If you participate in a traditional pension plan (known as a defined benefit plan) with your employer, you may receive monthly benefits from the plan after you retire. These benefits are generally based on your age at retirement, as well as your years of service and your average earnings with the company. Depending on your plan’s provisions, you may have more than one payout option to choose from. You want to select an option that will provide you with sufficient retirement income. In addition, if you are married, you want to be sure that your spouse will have sufficient income in the event that he or she outlives you.

When you retire, a defined benefit plan must offer you and your spouse a joint and survivor annuity. If your spouse consents in writing, you can generally decline the joint and survivor annuity and elect a single-life annuity instead. Some defined contribution plans offer similar options, so consult your plan administrator or benefits department if you participate in one of these plans.

With a joint and survivor annuity, payments continue as long as either you or your spouse is alive. When one spouse dies, the benefits paid to the surviving spouse generally cannot be less than 50 percent (or more than 100 percent) of the joint benefits. By contrast, with a single-life annuity, payments last for your lifetime and cease upon your death. For example, if you received one payment after retirement and then died, the single-life annuity would provide no further payments from your pension. Your spouse would receive nothing.

So why would you choose a single-life annuity knowing that payments will stop at your death? One reason is that the single-life annuity generally pays a larger monthly benefit than the joint and survivor annuity. This is because the payments are designed to last for a smaller number of years (i.e., one life expectancy instead of two). Retirees who want to maximize their monthly income sometimes choose the single-life annuity for this reason. The retiree can then use the additional income to purchase life insurance with his or her spouse as the beneficiary, thereby protecting the spouse’s financial future. This strategy, commonly called pension “maximization” using life insurance, may be appropriate for you.

Caution: Be sure to seek qualified professional advice, since choosing a pension payout option and life insurance coverage can be complex and will impact both your financial future and your spouse’s.

Factors to consider

Difference in benefits between the two payout options

As mentioned, a single-life annuity pays larger monthly retirement benefits than a joint and survivor annuity. The amount of the difference is a key factor when deciding between the two payout options. This information is generally provided to you prior to distribution as part of the spousal consent/waiver process. If the single-life annuity pays significantly more than the joint and survivor annuity, then electing the single-life annuity along with the purchase of a life insurance policy may be a viable strategy. The larger the monthly benefits under the single-life annuity, the more income you will have to pay the premiums for the life insurance policy. However, if the difference between the two payout options is relatively small, it may be better to elect the joint and survivor annuity. This is especially true if the single-life annuity will not provide enough income to pay the insurance premiums.

Tip: Always consider the impact of federal and other income taxes on annuity payments when determining the net amount of benefits available for you (and your spouse).

Insurability and cost of insurance

If you are not insurable because of your health and/or other reasons, then electing the single-life annuity along with the purchase of a life insurance policy is not an option. If you are insurable, determine how much life insurance coverage would be needed to compensate your spouse for the loss of your pension income if you elected the single-life annuity. Then look at the cost of that amount of coverage, and compare it with your monthly income from the single-life annuity. This will help you decide if using the pension maximization strategy makes financial sense. If you are relatively young and in good health, the insurance premiums may be much more affordable than if you are older and/or in poor health. However, as the cost of the insurance becomes more expensive, using life insurance to maximize your pension payout becomes less attractive.

Cost-of-living adjustment

Some pension plans have a cost-of-living adjustment (COLA) feature that allows the monthly benefits to be periodically increased to keep pace with the rate of inflation. If your pension contains this feature, you may need to consider a larger insurance policy to protect your surviving spouse from the loss of your pension income (assuming you elect the single-life annuity). This is because your surviving spouse would receive an ever-increasing amount of annual income over his or her lifetime if you elected the joint and survivor annuity with a COLA feature, and the rate of inflation goes up over time. Thus, the presence of a COLA clause in your pension plan may be a factor against using life insurance to maximize your pension. You will have to work through the numbers to see if it makes more sense to elect the single-life annuity and buy an insurance policy, or to simply elect the joint and survivor annuity.

Health and life expectancy of your spouse

If your spouse is in poor health or has a short life expectancy, then selecting the single-life annuity along with the purchase of a life insurance policy often makes more sense than selecting the joint and survivor annuity. This strategy is more practical if your spouse is more likely to die before you. As the plan participant and the surviving spouse, you will then have the benefit of the higher monthly payout from the single-life annuity for the rest of your life. You can then choose to discontinue the life insurance policy, or continue to make the premium payments and name a new beneficiary (as long as an irrevocable designation of beneficiary has not been made).

Age difference between you and your spouse

If there is a large difference between your age and your spouse’s age (with you being much older), then opting for the single-life annuity along with the purchase of a life insurance policy may make more sense because the difference in benefits between the single-life annuity and the joint and survivor annuity will typically be greater. If your spouse is considerably younger than you, his or her longer life expectancy will be factored into the calculation of the joint and survivor annuity benefits, resulting in smaller monthly payments. This could leave you and/or your spouse without sufficient retirement income using a joint and survivor annuity. However, if you select a single-life annuity that ends because you die soon after retiring, your much-younger spouse may have to survive financially without the benefit of your pension for a long period of time.

Gender of the plan participant

If you (the plan participant) are female and insurable at an affordable cost, then selecting the single-life annuity along with the purchase of a life insurance policy may make more sense than selecting the joint and survivor annuity. The reason: All other factors being equal, women are statistically more likely to outlive men of the same age. You will benefit from the higher monthly payout under the single-life annuity while you are alive, and the life insurance coverage will protect your spouse in the event that you die first. By contrast, if you select the joint and survivor annuity and your spouse dies first, you may be stuck with a smaller payout for the rest of your life (unless the plan has a “pop-up” provision–see below).

“Pop-up” provision

Some pension plans offer their participants a “pop-up” provision specifying that if they initially select a joint and survivor annuity payout and the spouse dies first, they can then retroactively select a single-life annuity payout. This gives you flexibility to adapt if things do not go as planned. If your pension plan offers this option, you may not want to select a single-life annuity with the purchase of a life insurance policy. It may be better to initially select the joint and survivor annuity.

Advantages of maximizing your pension with life insurance

It may increase your retirement income

Most people who use a single-life annuity with life insurance to maximize their pension payouts are trying to increase their income during their retirement years. Under most pension plans (and depending on various factors such as the age of the two spouses), a single-life annuity will pay out substantially more per month than a joint and survivor annuity. Most people would like to have that extra income during their retirement years. However, most people are also concerned about providing for their spouses if they should die first. By selecting a single-life annuity along with the purchase of a life insurance policy on the participant’s life, some couples can increase their income during retirement and provide for the surviving spouse’s financial future.

It may work well even if the nonparticipant spouse dies first

Using life insurance to maximize your pension payout will work well financially if your nonparticipant spouse should die first. In fact, this strategy may actually produce greater financial benefits if your nonparticipant spouse does die first, because you (the surviving spouse) will receive the higher single-life annuity payout for the rest of your life. You can then either discontinue the insurance policy or name a new beneficiary and continue to pay the premiums.

It may provide assets for your heirs and beneficiaries

Another benefit to selecting the single-life annuity with the purchase of a life insurance policy is that there may be assets left over for your heirs and beneficiaries. If you and your spouse select a joint and survivor annuity, no benefits from your pension plan will be paid to your heirs and beneficiaries (e.g., your children) when the surviving spouse finally dies. If, however, you select a single-life annuity and purchase a life insurance policy on your life, some of the insurance proceeds may still be left for your heirs and beneficiaries after the death of your surviving spouse. This is especially true if your surviving spouse invests the proceeds wisely and does not spend them rapidly, or if your spouse predeceases you and the life insurance proceeds are paid to your beneficiaries upon your death.

Disadvantages of maximizing your pension with life insurance

The income earned on the insurance proceeds may not meet expectations

This strategy may not work well if, for some reason, the investment earnings on the insurance proceeds are too low to adequately provide for the surviving spouse. To illustrate, consider the following hypothetical scenario.

Example(s): Upon your retirement, you select a single-life annuity for your pension and purchase a $300,000 life insurance policy on your life with your spouse as beneficiary. Based on market conditions at the time of your retirement, you believe that the earnings generated by the insurance proceeds will provide sufficient income for the rest of your spouse’s life if you die first. You die three years later, when market conditions have deteriorated substantially. The life insurance proceeds may now not provide enough income for your surviving spouse.

Your surviving spouse may squander the insurance proceeds

Another potential problem with this strategy is that your surviving spouse may make poor investments with the insurance proceeds, spend them too quickly, or otherwise squander the money. If this happens, your surviving spouse may be in a difficult financial situation for the remainder of his or her lifetime. With the joint and survivor annuity, you minimize this risk because your surviving spouse would at least be assured of receiving the designated pension payout each year.

The life insurance policy may lapse

If you choose to maximize your pension with life insurance and then stop paying the insurance premiums due to financial problems or other reasons, the insurance policy may lapse. With no insurance proceeds and no pension benefits, your surviving spouse may be in a difficult financial position after your death. In this case, your surviving spouse would have been in a much better position if the two of you had selected the joint and survivor annuity for your pension.

When this strategy makes sense: a short case study

Example(s): Assume you are about to retire at age 65, and your spouse is age 62. Your pension plan gives you the option of either a single-life annuity or a joint and survivor annuity. If you select the single-life annuity, you will receive $4,500 per month for the rest of your life, but your spouse will receive nothing if you die first. If you select the joint and survivor annuity, you and/or your spouse will receive $3,000 per month as long at least one of you is alive. That’s an additional $1,500 per month (or $18,000 per year) with the single-life annuity.

That sounds attractive, but what will happen to your spouse if you select the single-life annuity and you die before your spouse? Your spouse gets no survivor benefit. Your spouse may need a way of replacing that lost pension income. One way to accomplish this may be to purchase a life insurance policy on your life, and name your spouse as the beneficiary of the policy.

You need to determine whether the extra $1,500 per month under the single-life annuity (less income taxes) will buy enough insurance coverage to produce a replacement income of $3,000 per month if you die before your spouse. That is the amount of income your spouse would have received had you selected the joint and survivor annuity. You also need to determine whether your spouse will live off of only the income from the insurance proceeds, or need to dip into principal as well. You must run the numbers to see what is affordable and what makes financial sense.

Income tax considerations

The monthly retirement benefits you and your spouse receive from your pension are generally treated as taxable income, subject to federal (and possibly state and local) income tax. This is true regardless of whether you elect a single-life annuity payout or a joint and survivor annuity payout. However, since the pension benefits are larger with a single-life annuity, electing this payout option will increase your taxable income during retirement.

If you elect the joint and survivor annuity payout, when the first spouse dies, the pension payout to the survivor will be included in the survivor’s taxable income. If you instead use the pension maximization strategy and die before your spouse, the life insurance death benefits will not be included in your surviving spouse’s taxable income. This is because life insurance death benefits generally pass free from income tax to the beneficiary of the policy. Of course, your surviving spouse may invest the insurance proceeds in taxable investments. Any earnings from such investments (e.g., interest, dividends, and capital gains) will generally be included in your spouse’s taxable income.

Caution: While life insurance proceeds are generally free from income tax to the beneficiary, estate taxes are another matter. If this is a concern, you should consult a qualified estate planning attorney for appropriate strategies.

Forefield Inc. does not provide legal, tax, or investment advice. All content provided by Forefield is protected by copyright. Forefield is not responsible for any modifications made to its materials, or for the accuracy of information provided by other sources.

What is it?

Marriage is an important step in anyone’s life and brings many challenges with it. One of those challenges is the management of your finances as a couple. The money decisions that you make now as a couple can have a lasting impact on your financial future together. Careful planning of your finances can ensure that together, you achieve financial success.

Budgeting your money

In general

When you were single, you managed your finances in a way that was comfortable for you and that you understood–no one had to approve or disapprove of your financial decisions. Now that you are married, however, both you and your spouse have to agree on a system for budgeting your money and paying your bills.

Discuss financial situations

You and your spouse must discuss your respective financial situations and expectations, and take stock of your individual assets (what you own) and liabilities (what you owe). Revealing your financial situation is an important step when budgeting as a couple. If either of you has a financial problem, it is best to identify it now and begin solving it together. This is the time to address questions such as what do each of you earn, and what additional sources of income do you have? What do you own? Will both of you work now that you are married? Who will hold title to property acquired before and after the wedding? In addition, be sure to disclose all of your financial commitments. If you pay child support, let your partner know the amounts. If you have to repay student loans, discuss that as well.

The worksheets that follow will assist you in determining your current financial situation.

After you discuss your financial situations, you should discuss your financial goals. You can start by each making a list of your short- and long-term financial goals. Short-term goals are those that can take anywhere from three to five years (e.g., saving for a down payment on a home or a new car). Long-term goals are those that take more than five years to achieve (e.g., saving for a child’s college education or retirement). When you have each determined your individual financial goals, you should review your goals together to achieve common objectives. You can then focus your energy on those common objectives and strive to attain those goals (short- and long-term) together.

Decide on the type of bank account(s) you will keep

Decide whether you and your spouse will have separate bank accounts or a joint account. Advantages to consolidating your checking funds into one account include easier record-keeping, reduced maintenance fees, less paperwork when you apply for a loan, and simplified money management. If you do choose to keep separate accounts, consider opening a joint checking account for household expenses.

Caution: When sharing a checking account, be sure to keep track of how much money is in the account at all times since both of you will be writing checks that draw from the same account.

Prepare an annual budget

The first step in developing a financial future together as a couple is to prepare an annual budget. The budget will be a detailed listing of all your income and expenses over the period of a year. You may want to designate one spouse to be in charge of managing the budget, or you can take turns keeping records and paying bills.

Tip: Make sure that you develop a record-keeping system that both you and your spouse understand. Also, keep your records in a joint filing system so that you can easily locate important documents.

• Begin with your sources of income–list salaries and wages, alimony and child support, interest, and any other form of income that you and your spouse may have.
• List your expenses. It may be helpful to review several months’ worth of entries in each of your checkbooks to be sure that you include everything. Put all the expenses that are paid monthly into one category, and put all other expenses (every other month, quarterly, semiannually, annually) into another. Some common expenses are:

Savings	Major purchases
Rent or mortgage payments	Insurance
Student loan payments	Car repairs
Groceries	Clothing
Pet care	Tax payments
Utilities	Medical expenses
Car payments	Gifts
Credit card payments	Automobile gas
Alimony/child support	Child day care
Household items	Entertainment/dining out
Personal care/grooming

• Estimate your expenses for each category. How much money do you spend on these items on a monthly basis and on an annual basis? Try to come up with a realistic amount for what you think you will spend in a year’s time. Add another category to the irregular expenses list, and call it Contingencies. This can be a catchall category for expenses that you might not anticipate or budget for. The amount to budget for contingencies should be about 5 percent of your total budget.
• Add your sources of cash and uses of cash on an annual basis. Hopefully, you get a positive number, meaning that you are spending less than you are earning. If not, review your expense list to determine where you can cut your spending. Consider using computer spreadsheets or programs like Quicken for assistance.

Create a cash flow system

After you have developed a budget, you should create a system for managing your monthly inflow and outflow of cash. It is a good idea for both you and your spouse to become involved in this process–at least at first–so that both of you have a clear understanding of the costs of running the family and household.

Cash flow systems like the one described below are simple and painless to operate. Once they are established, you will find that making financial decisions becomes much easier because you have done your homework.

• Separate your regular monthly expenses from irregular expenses (every other month, quarterly, semiannually, annually) by using a different bank account for each. Otherwise, you may be tempted to use money that has been earmarked for something else. You should limit the number of checking accounts that you have in order to avoid confusion.
• Each time you get paid, deposit some money into an account for irregular expenses. The amount of money you deposit should be equal to the total amount needed for the irregular expenses, divided by the number of paychecks you each receive annually. In so doing, you will have the money for the outlay when it arises. The rest of your pay should go into your checking account, to be used for regular monthly expenses and savings.
• One variation to this system of cash flow management is to establish one or two additional bank accounts for one or both of you for personal spending money. Allocate the budgeted amount for personal expenses (e.g., lunches, haircuts, gifts) to this account. This way, you are free to spend the money in this account in any way you like without having to worry about meeting regular monthly expenses. However, all of these bank accounts may have fees.

Saving and investing your money

In general

At some point in your married life, you will almost certainly encounter some large expenditures, such as a new home, your own business, or a college education for your children. Chances are, you won’t be able to meet these expenditures from your current income. You and your spouse must discipline yourselves to set aside a portion of your current income for saving and investing your money to ensure its steady growth or, at the very least, protect it against loss.

Save a percentage of your earnings

When figuring out your budget, savings should be considered one of your monthly expenses. Think of savings as a fixed payment (like a car payment) that must be made every month. If you don’t and you wait until the end of the month to save whatever you have not spent, you’ll find that nothing ever seems to go into your savings account. A good rule of thumb is for you and your spouse to save 4 to 9 percent of your combined gross earnings while you are in your 20s and then double that savings percentage as you reach your 30s and 40s. In some cases, a dual-income couple may be able to live off one spouse’s salary and save the other salary.

Example(s): Mary and Richard, a married couple in their 20s, earn a combined annual gross income of $60,000. Together, Mary and Richard save 5 percent of their combined gross income each year, or $3,000.

As another example, Christine and Tom, a married couple in their 30s, earn a combined annual gross income of $80,000. Together, Christine and Tom save 10 percent of their combined gross income each year, or $8,000.

Build an emergency cash reserve

The savings that you accumulate can serve as an emergency cash reserve. Ideally, you should have in savings an amount that is comfortable for you to fall back on in case of an emergency, such as a job loss. A common formula used for calculating a safe emergency fund amount is to multiply your total monthly expenses by 6. When determining how much cash should be in your emergency fund, a major factor is your comfort level. If you and your spouse feel secure with your jobs and are confident that if you lost your current jobs you would be able to find a new one fairly quickly, an emergency fund of three times your monthly expenses should be sufficient. However, if either of you has an unpredictable income, you may want to have an emergency fund that is equal to 12 times your monthly expenses.

Example(s): Christine and Tom, a married couple in their 30s, plan to build up an emergency cash reserve. Both Christine and Tom are attorneys and feel quite secure with their present jobs. Christine and Tom have monthly expenses of $3,000 and plan to build up an emergency cash reserve that is equal to 3 times their monthly expenses, or $9,000 ($3,000 x 3).

As another example, Mary and Richard, a married couple in their 20s, plan to build up an emergency cash reserve. Both Mary and Richard are employed as freelance writers and feel that their incomes are at times unpredictable. Mary and Richard have monthly expenses of $1,500 and plan to build up an emergency cash reserve that is equal to 12 times their monthly expenses, or $18,000 ($1,500 x 12).

Investing your money

When you have established an emergency cash reserve, you can begin to invest your money to target your financial goals. There are three fundamental types of investments: cash and cash alternatives, bonds, and equities. Cash and cash alternatives are relatively low-risk investments that can be readily converted into currency, such as money market accounts. Bonds, sometimes called debt instruments, are essentially IOUs; when you invest in a bond, you’re lending money to the bond’s issuer–usually a corporation or governmental body–which pays interest on that loan. Because bonds make regular payments of interest, they are also known as income investments. Equities, or stocks, give you a share of ownership in a company. You have the opportunity to share in the company’s profits and potential growth, which is why they’re often viewed as growth investments. However, equities involve greater risk than either cash or income investments. With equities, there is no guarantee you will receive any income or that your shares will ever increase in value, and you can lose your entire investment. In addition to these three basic types of investments–also known as asset classes–there are so-called alternative investments, such as real estate, commodities, and precious metals.

No matter what your investment goal, your overall objective is to maximize returns without taking on more risk than you can bear. You’ll need to choose investments that are consistent with your financial goals and time horizon. A financial professional can help you construct an investment portfolio that takes these factors into account.

Establishing good credit

In general

Establishing good credit is an important step in the path towards a solid financial future. A good credit history can enable you to make credit purchases for items that you might not otherwise be able to afford. Most creditors will require a good credit history before extending credit to you. If you do not have a credit history, it is important to establish one as soon as possible. If you have a poor credit history, you should take steps toward improving it right away.

Individual or joint credit

Married couples can either apply for credit individually or jointly. One of the benefits of applying for joint credit is that both you and your spouse’s income, expenses, and financial stability are considered when a creditor evaluates your overall financial picture. However, applying for separate credit has its advantages. If you and your spouse ever run into financial problems (e.g., illness or job layoff), separate credit allows one spouse to risk damaging his or her credit history while preserving the other spouse’s good credit. In addition, separate credit can also protect you and your spouse from each other. If you and your spouse cosign a loan or apply for a credit card, you are both responsible for 100 percent repayment of the debt. In other words, if your spouse does not pay his or her share, you can get stuck with paying the whole amount. On the other hand, if your spouse takes out a loan or applies for a credit card on his or her own, generally your spouse is solely responsible for the debt.

Tip: While the general rule is that spouses are not responsible for each other’s debts, there are exceptions. Many states will hold both spouses responsible for a debt incurred by one spouse if the debt constituted a family expense (e.g., child care or groceries). In addition, in some community property states, both spouses may be responsible for one spouse’s debts, since both spouses have equal rights to each other’s incomes. You may want to discuss your state’s laws with an attorney if you live in a community property state.

Forefield Inc. does not provide legal, tax, or investment advice. All content provided by Forefield is protected by copyright. Forefield is not responsible for any modifications made to its materials, or for the accuracy of information provided by other sources.