Federal employees nearing retirement have an option to forego a portion of their pension annuity in exchange for an annuity benefit that would go to that employee’s surviving spouse if he or she dies. Most federal employees take this survivor benefit option.

However, many life insurance companies are pitching what they say is a better deal to federal employees. They are encouraging employees to take the portion of their annuity that they would lose under the survivor benefit option and instead apply it toward a life insurance premium that would pay out a bigger benefit to a surviving spouse.

Substituting life insurance for the pension survivor benefit — often referred to as “pension max” for short — is an option that generates a lot of interest and confusion.

It is important that people approach this pension max option with much caution. There is not a one-size-fits-all answer to the question of whether the pension max option is right for you. And one should approach any pitches from life insurance agents with a wary eye — they have a sizeable self-interest in selling pension max options. Some pension max plans from life insurance agents could cost your survivors dearly down the road.

The decision to forego survivor benefits is a critical one because the decision generally cannot be reversed once it is made, and its outcome will affect the annuitant, the survivor and their dependents for the rest of their lives. Moreover, the financial analysis required to understand the real pros and cons of these complex pension max options is beyond the abilities of most people.

As an annuitant, electing survivor benefits lets you guarantee your surviving spouse or other qualified dependent, a continuing stream of income for the rest of their lives, guaranteed to increase annually with a cost-of-living adjustment. The price of this survivor benefit is a lower annuity income from the point of retirement until the annuitant dies.

When a person opts for the pension max, a surviving spouse forgoes the survivor benefit in order to increase the amount of pension income while the annuitant is alive. The survivor or annuitant then purchases a life insurance policy on the life of the annuitant, using the additional pension income to pay the premium on the life insurance policy. When the annuitant dies, the life insurance benefit is used to provide an income stream to the survivor, in lieu of a pension benefit.

The primary advantage, say pension max proponents, is a recovery of the “lost” cost of the annuity survivor benefit in the event that the intended survivor dies before the annuitant, since the proposed income stream is usually lower for pension max than for the inflation-adjusted survivor annuity. The primary disadvantage of pension max is increased risk that it will fail to provide benefits that are at least equal to the survivor annuity option when all is said and done.

The importance of analysis

Problems occur when incompetent or incomplete analysis is used to convince an annuitant to elect the pension max strategy. Remember, the person advocating pension max is very likely to be an insurance agent seeking a lucrative commission on the sale of the life insurance policy that will eventually fund the survivor’s income stream.

Unfortunately, I have yet to see a fair and complete analysis presented by an insurance agent as part of a pension max proposal. So, I thought I’d present an example of the results of some probability analysis I recently conducted, using data from an actual insurance company proposal presented to an employee preparing to retire who is covered under the Civil Service Retirement System.

I analyzed three different scenarios: electing the CSRS full survivor annuity; pension max with the life insurance proceeds invested; and pension max with the life insurance proceeds used to buy a private annuity for the benefit of the survivor.

In each scenario, I assumed that inflation would occur, taxes would be paid and any available sums would be invested in a very conservative portfolio consisting of 30 percent stocks, 60 percent bonds and 10 percent cash, with total investment expenses of 1 percent per year.

I also accounted for the “pop-up” feature of the survivor benefit, which allows the CSRS annuitant to receive unreduced annuity payments in the event that their beneficiary dies before they do, obviating the need for survivor benefits. I then allowed the ages at death and annual investment returns to vary randomly during thousands of simulations of combined lifetimes for the couple and tabulated the results, which are presented in the graphic. The first section summarizes the results for four different variations in age differential between the annuitant and the spouse. The percentages listed in the table represent the probability of the couple successfully meeting their lifetime income needs — $55,000 per year, after tax and indexed for inflation — until both are dead.

As you can see, the survivor annuity produced the greatest probability of success in all but two instances, both of them when the spouse was considerably older than the annuitant and the pension max life insurance proceeds were invested rather than used to buy a private annuity contract. From this we can conclude that pension max may be more attractive to consider when the prospective survivor is considerably older than the annuitant, but is likely a poor choice otherwise.

The second section summarizes the results with different expected income streams during retirement. You can see from the results that, when all other factors are held constant, increasing the income demanded from the system tends to increase the attractiveness of pension max if the life insurance proceeds are invested conservatively rather than used to purchase a life annuity, although the viability of all of the options decreases at the same time. This is because investing a large life insurance benefit brings with it the possibility for greater upside performance effects compared to the survivor annuity, where the only investment component is the accumulation of any unspent income.

From these results, we can see that the more of your retirement benefits you plan to consume, the more interesting pension max becomes, although considerable caution is warranted in making any decisions, since the point at which the results cross over in favor of pension max lies in fairly risky territory. I consider probabilities of success below about 80 percent to be unacceptable in situations like this. You should also note that probabilities above 90 percent may be excessive and allow for additional consumption by the annuitant.

What is most interesting to me about these results is not that they favor the survivor annuity election, but that they differ markedly from the conclusions presented in the proposal on which the analysis was based — which argued that the pension max solution was clearly superior to the survivor annuity.

This example is not intended to make your decision for you if you are considering pension max, but to alert you to the fact that careful, competent and unbiased analysis is required to inform such an important decision, and to illustrate an analytic approach that will help you to clearly understand your options.

Written by Mike Miles
For the Federal Times
Publication May 30, 2005