Pension maximization is a strategy to maximize a person’s pension through the use of life insurance. Instead of decreasing your monthly payment to include spousal benefits, you would take the higher single life payout and use a portion or all of the difference to fund a life insurance policy. That policy would be used to fund your spouse’s benefit when you pass away.
Jim is 65 and could receive a pension of $5,000/month for his life only or $4,000/month for the joint lives of his wife Debbi and him (100% survivor benefit). He’s giving up $1,000/month ($12,000/year) in order to ensure his wife gets $4,000/month for the rest of her life if he passes away. But if Debbi passes away, Jim still gets $4,000/month and is essentially still paying for the benefit that’s no longer needed.
Jim could get a $750,000 20-year term life insurance policy for $875/month. $750,000 could provide $4,000/month for just over 19 years with a 3% return. With this strategy, he receives his $5,000/month pension and pays $875/month for life insurance, therefore savings him $125/month ($1,500year). If Debbi passes away, Jim would still receive $5,000/month, but he could cancel the life insurance (or use it to provide for another family member).
Jim has a life expectancy of 84.3 years, so it’s very likely that he would pass away within 20 years (the length of the insurance policy). Life expectancy, however, is a 50-50 proposition. 50% of people live less, but 50% live longer. Jim has a 20%-25% chance that he’d live past age 90 and a 9%-10% chance he’d live past 95.
A good scenario would be that Jim lives 15-20 years before he passes away. Jim’s pension would stop, but Debbi would receive $750,000 which could last her another 19 years. Jim would get to enjoy the extra income but also know that his wife is protected as well. However, there are two bad scenarios:
- Jim dies early. If Jim passes away too early, Debbi will have to make the $750,000 last. She risks outliving the money.
- Jim dies much later. If Jim lives past the end date of his life insurance (and doesn’t renew because premiums would be extraordinarily high at that point), there would be no protection for his wife. Debbi would lose the $4,000 pension and not have new assets to replace it. This could really affect her lifestyle.
Term insurance was used in the example because it is the cheapest. Permanent insurance could be used too, as it would eliminate the ending date associated with term insurance. Permanent insurance is much more expensive though.
Pension maximization does not have to be an either or proposition either. A retiree could protect a 50% spousal benefit through his pension and use life insurance to cover the rest. Pension maximization is a flexible strategy. It can be a great option for some people, but not so good for others. When looking at whether or not this strategy makes sense, there are many factors that come into play:
- Is the retiree healthy and insurable?
- What are the ages and projected life expectancy of the retiree and spouse?
- What is the difference between the single pension payout and the joint life payout?
- What is the rest of the couple’s financial situation like?
- Are medical benefits tied to the retiree’s pension benefits?
- How comfortable is the couple with the strategy?
Each of these factors can have a significant impact on whether pension maximization should be considered or not.