Some employers offer a variation of the joint benefit options known as the pop up provision, which, if taken with one of the joint benefit options, allows the pension benefit to “pop up” to the maximum payout if the pensioner’s beneficiary is the first to die. With the provision, however, comes a further reduction in the initial benefit.

Buying Life Insurance

The joint benefit options are alternatives to taking the maximum payout and buying life insurance. The accompanying reduction in income can be attributed to the cost of insuring that the income stream will be extended to the pensioner’s surviving beneficiary. This raises two key questions: First, should the pensioner accept the maximum payout and privately buy life insurance? Second, is privately purchased life insurance more expensive than the insurance offered by the pension benefit? To determine the answers, many factors must be considered and every situation must be analyzed individually.

Points to Consider

Health. A principal factor is the pensioner’s health. If the pensioner is in poor health and considered a high-risk candidate for premature death, buying private insurance will likely be costly and disadvantageous. Instead, the pensioner should opt for a payout plan that includes the life expectancy of the beneficiary because the traditional pension has no underwriting process and calculates pension income based on life expectancy tables, not individual health. On the other hand, if a healthy retiree is willing to go through the underwriting process and is considered a low-risk candidate, the cost of life insurance may be lower than the reduction in pension benefits.

In anticipation of maximizing the pension benefits, some employees purchase life insurance prior to retirement. Before a payout option is selected, however, existing life insurance policies should be evaluated to determine whether the initial assumptions are in line with the current needs, insurance costs, and dividend rates. The ability to safely meet policy projections should also be examined.

Amount. The amount of insurance needed to replace the pension income can be determined by conducting a present value analysis on the potential income extended to the beneficiary at different future points. Assumptions about the beneficiary’s life expectancy, income taxes, rates of return, and inflation determine the analytical outcome. Interest rate assumptions on the life insurance contract and the earnings on the death benefit will vary based on the pensioner’s risk tolerance and experience, possibly influencing the choice of options.

Taxes. Normally, a pension is 100% taxable at the federal level, but many states exempt pension income for retirees that remain in their home state. Additionally, some states, such as New York, offer an exclusionary amount from income tax. While life insurance proceeds are exempt from income taxes, the earnings on the life insurance death benefit are taxable at both the federal and state level, which should concern retirees living in high state and local tax regions such as New York City. Therefore, after-tax income should determine pension replacement values.

Personal property. The pensioner’s personal financial situation is another factor. Non-pension assets or income may be all that is needed to support the beneficiary.

Other qualitative factors also shape the decision to obtain life insurance privately, for example, the health and life expectancy of both parties. Clearly, if the health and life expectancy of the pensioner are good and the outlook for the beneficiary is poor, insuring the pension may be ill-advised. Additionally, the ability to leave a legacy is significantly diminished by the traditional pension because it ends when the beneficiary dies. If life insurance is purchased privately to insure the joint life expectancy of the pensioner and beneficiary and either dies before their life expectancy is attained, the insurance proceeds will be available to create an estate for the next generation. Policy ownership, and possibly the use of a trust, should be considered to reduce the chances of unplanned estate taxes. In addition, when either the pensioner or the beneficiary live longer than their life expectancy, the cash value accumulated within the life insurance policy becomes a source of extra income.

Because term insurance cannot be held beyond a certain age in most states, a permanent insurance policy such as whole, universal, or variable universal life insurance is necessary. If the pensioner is young enough, a hybrid of term and permanent insurance may be an option, allowing for reduced insurance and related costs. Such a strategy depends on the growth or accumulation of other assets to replace the retirement income expected from the insurance.

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA/PFS, CFP

Contributing Editors:
Theodore J. Sarenski, CPA/PFS, CFP
Dermody Burke & Brown

Mitchell J. Smilowitz, CPA
GBS Retirement Services Inc.

©2009 The New York State Society of CPAs. Legal Notices