Retirement signals the time for making several critical decisions. One of these decisions will involve determining the most beneficial pension option for individuals eligible for pension benefits. The choices may include a lump sum benefit and some annuity. Two main types of annuity options available through a pension plan have a single life-only annuity (which pays a benefit over the life of the retiree but stops when the retiree dies) and a joint and survivor (J&S) annuity (which pays a benefit over the combined lives of the retiree and spouse).
The monthly benefit in a J&S annuity is less than it would be under a single-life option because the benefit potentially will be paid over two lifetimes instead of just one. For example, a retiree receiving a monthly pension benefit of $1,700 under a single life annuity might receive $1,300 under a J&S option. Some think of a J&S annuity as a type of “insurance,” with the “premium” for the continued benefit to the spouse being the reduction in the monthly benefit amount (in this case, $400 each month).
A retired couple may find deciding between a single life only and a J&S annuity difficult. Suppose a J&S option is selected, and the spouse dies before the retiree. In that case, the surviving retiree will continue to receive the reduced benefit amount, even though no benefits will ever be paid to the spouse. Conversely, when a retiree covered under a single life annuity dies, the pension stops providing continuing benefits to the surviving spouse.
A financial planning tool called pension maximization may provide some retirees with a way to enjoy the higher monthly benefit of the single life annuity, yet with financial protection for the spouse in the event of the retiree’s death. The basic concept of pension maximization is this: Choose the single life annuity and use some portion of this more considerable monthly benefit to purchase a life insurance policy that could be used to generate income for the spouse after the retiree’s death. If the spouse dies first, the retiree can change the beneficiary or cancel the policy and pocket the money formerly used for premiums. Furthermore, if the policy had any cash value, this money could be used for another purpose.
Is pension maximization the right strategy for you? Several factors should be considered in answering this question-
• Insurability. The retiree must be able to get a life insurance policy. For those in poor health, this may not be an option. It is critical that the retiree secure sufficient life insurance before making their pension choices.
• Financial means and discipline. The retired couple must be conscientious about making premium payments on the life insurance policy to ensure it does not lapse. Thus, the income generated by the single life annuity (and other income sources) must be adequate to cover your living expenses plus the cost of the life insurance premiums.
• Other income sources. What assets and investments does the retired couple have outside the pension plan? Does the spouse have a separate pension plan or retirement account?
• Pension plan COLA. Pension plans with a cost-of-living adjustment (COLA) increase the benefit amount over time for inflation. This valuable feature can make the J&S option more attractive.
• Ancillary pension benefits. Sometimes, any additional benefits for a spouse-such as medical coverage-are forfeited if a single life annuity option is chosen.
The retiree considering pension maximization should consult a qualified financial and tax advisor to obtain a detailed analysis of tax consequences and inflation. Only through such an analysis can one get a good picture of the “cost” of the J&S option and the amount of insurance needed to replace the survivor benefit if the single-life option is chosen. That said, pension maximization offers the advantage of a higher monthly pension benefit for the retiree’s lifetime, coupled with insurance protection for the spouse. For many, it represents a smart financial planning strategy.