My column this week addresses an important issue for married federal employees who have yet to retire from federal service: the idea of using life insurance as a substitute for survivor benefits on a Civil Service Retirement System or Federal Employees Retirement System annuity.

Life insurance companies and agents continue to aggressively promote this strategy, in spite of its shortcomings. Usually referred to as pension maximization, or pension max, the basic concept is to decline all but the minimum survivor benefit on your annuity at retirement and buy a life insurance policy that will provide funds for your surviving spouse when you die.

Since your annuity election at retirement is an irreversible decision that will affect you and your spouse for the rest of your lives, it is critical that you avoid serious mistakes when the time comes.

The first step in considering pension max as an alternative to the survivor annuity is to prioritize your retirement goals. The survivor benefit decision directly affects three basic areas of retirement planning — your cash flow before you die, your surviving spouse’s cash flow after you die and the estate you and your spouse ultimately leave for your beneficiaries. Figuring out which of these areas are most and least important to you is prerequisite to analyzing your options.

For federal employees, a pension max proposal will usually focus on two potential benefits — increased spendable income between the time you retire and the time you die; and an increased estate after you and your spouse are gone. What is not usually well supported is the spendable income available to your surviving spouse. This is the area that the federal annuity’s survivor benefit is specifically designed to support.

The two main reasons that pension max often fails as a suitable solution for federal employees are its lack of guaranteed cost-of-living adjustments and the increased risk associated with substituting an insurance company for the federal government as a guarantor. In fact, in every case I’ve ever analyzed, pension max reduces the survivor’s expected after-tax, inflation-adjusted income while significantly increasing overall plan risk.

Choosing a survivor benefit on a federal annuity guarantees that the survivor will receive inflation-adjusted income for life in exchange for a modest premium. That survivor benefit is expected to provide about the same purchasing power in 20 or 30 years as it does today.

On the other hand, the life insurance benefits typically used in pension max proposals remain constant through time. The policy guarantees to pay the same benefit in 30 years that it pays today in exchange for annual premium. In my experience, pension max proposals usually include a life insurance death benefit that is just sufficient to replace the initial survivor benefit without future adjustments for inflation.

So, if the survivor benefit would be $25,000 per year today, the pension max solution is designed to support that payment in the future. If inflation averages 3 percent per year, the buying power of that $25,000 payment will be cut in half about once every 24 years.

The survivor has the choice of investing the pension max life insurance proceeds and drawing needed income while retaining control of the principal, or using the proceeds to buy a private annuity.

The investment option produces significant risk in that returns are uncertain and withdrawals must be limited to prevent poor investment performance from causing the fund to fail prematurely.

Buying a private annuity will usually provide an income stream that is guaranteed to last for life, and that is slightly higher than that provided by an investment fund. This additional income comes at the expense of the principal, however, which is paid as an insurance premium. Another problem with the private annuity option is that it won’t guarantee that the payments will keep pace with inflation. There are currently no private annuities available to  the public with unlimited inflation adjustment guarantees.

There is only one reliable rule of thumb for making the pension max decision, and that is to proceed with caution. The outcome depends on a combination of factors unique to each situation, and the analysis required to fully understand the options is complex. Remember that a pension max proposal is only one point of view. The stakes are high for you, for your survivor, for your beneficiaries, and, with life insurance sales commissions often equal to one year’s premium, or more, for your insurance agent.

Written by Mike Miles
For the Federal Times
Publication May 29, 2006