The Pension Election Dilemma

A Better Option for Pension Elections

Selecting the spousal continuation pension election may protect the spouse LESS than some other choices that are often not even considered. However, as most people approach retirement, they simply select between one or two options their HR department provides without talking with a professional retirement planner. This could be a big mistake.

Many companies, unions, state and county governments, and other organizations provide pensions as an inducement toward employee loyalty and recruitment. The trend over the past few decades has been to reduce this employer cost by pushing employees to rely on 401(k), 403(b), and 457 type programs that are funded by the workers themselves. This is a backhanded way to shed the employer the cost of employee retirement. Besides pushing employees toward employee funded tax-deferred plans, corporations are trying to reduce their pension obligations in other ways, such as reducing pension payouts with misleading incentives. The most deceptive incentive is spousal continuation pension elections.

Many organizations hire big financial firms to administer their pensions with a cost savings mandate in mind. These firms use convoluted election plans that can fool employees. Most pensions require you to make an important decision just before receiving that first pension check. That option determines how your retirement funds will be disbursed, should your spouse outlive you. Some plans do not allow a early spousal election thus exposing your spouse to no pension continuation payments should you die early, and long before retirement pensions payments have started.

Some pensions only pay for the duration of the employee’s life. Nothing will go to your spouse after you die, unless you elect to reduce your monthly pension payments. This reduced payment option is often called a life-plus-spouse option. If this election is made, pension payments for the employee will be reduced, but payments will continue to the surviving spouse after the employee dies. Depending on the pension plan, these continuing spousal payments are typically at a lower rate, sometimes at 50% or 60% of the rate paid before the employee’s death. Here is an example: 

Unmodified Plan

Plan with life-plus-spouse Election

• Payment during employee’s life: $9,400
• Spousal continuance payments: $4,700

Other pension plans have a built in 50 or 60% spousal (widow’s or widower’s) continuance. However, these continuance payments are too small to sufficiently provide for the surviving spouse. Another reduced pension payment election, often called a “Buy-up” option provides a better spousal pension as shown in the below example:

Unmodified Plan

• Monthly payment during employee’s life: $10,000
• Monthly spousal continuance payments: $ 5,000

Plan with a Buy-up Election

• Monthly payment during employee’s life: $9,400
• Monthly spousal continuance payments: $9,400

It is interesting to note that some plans call this a “Buy-up” instead of a reduced pension option. Could it be that employers are encouraging you to make this election by giving it a name with a more positive spin?

I believe these pensions end up costing the sponsoring organization less money if the spousal election is taken and so the spousal election is encouraged. This is clearly a savings for corporate sponsored plans. But did you realize that many governmental retirement plans are administered through the International Association of City Managers Retirement Corporation, which is a privately owned investment advisor that has over 12.6 billion in assets under management? Also note that the owners of this private corporation is largely a consortium of city managers. Hmmmm.

Note that in the above examples, a $600 reduced payment is just an estimate. Your actual reduction will depend on your pension plan contract. Regardless, taking the $600 per month reduced option may be a misguided attempt to better provide for your spouse. Who truly benefits from this option? Do you believe organizations offer this option as a benefit for the employee or to lower cost? Does your employer suggest you visit a financial advisor or retirement planner regarding this option? Or do you just get advice from the human resources people, encouraging you to take the reduced pension payment option? In some circumstances this can be a mistake.

Examples Of Disastrous Pension Elections

Using the numbers provided in the above example case, here are just 3 situations where electing the life-plus-spouse or Buy-up options would not benefit the retiring couple :

First, if husband and wife live a long life together, they may suffer due to the monthly pension payout reduced by $600 for the rest of their lives. Without the early death of the employee, the reduced payout needlessly limits retirement cash flow. If the employee lives in retirement for 30 years, this reduction equates to a total of $216,000. Here, the employer benefits, not the employee who loses nearly a quarter of a million dollars.

Second, if the spouse dies shortly after the pension starts, then the employee is stuck with the reduced pension payout for the rest of their life without any benefit. Here again, the employer is the big winner at the expense of the employee—an expense of nearly a quarter of a million dollars, assuming a 30-year retirement.

Third, if either the husband or wife fall ill and have large medical or other emergency expenses, the $600 per month reduced retirement cash flow limits savings for an emergency fund.

On the other hand, if the non-reduced pension is elected, the early death of the employee results in greatly reduced pension payments to the spouse…not a happy outcome for the spouse!

Pension Elections Ignore Inheritance Legacy

Pensions can be a huge financial asset, maybe your larges retirement asset. However, the design of pension ignore the huge issue of inheritance legacy of this asset. Non of the above options allow any path for pension funds to flow to the next generation and provide for children like your other assets, your home, your savings, and your tax-deferred accounts, IRAs, 401(K)s etc.

Alternatives to Typical Pension Elections

But there is an alternative. Elect to take the full, non-reduced, employee-only option. Then use some of the $600 (as shown in the example) additional monthly pension income to buy life insurance. The simplest strategy would be to buy a 20-year Term Life insurance on the retiring employee’s life. If the now retired employee dies during this term period, a considerable sum of death benefit would be paid to the spouse that could completely replace the pension income. The insurance payout might end up being more money than a spousal continuance pension would have been. Plus, the death benefit is tax-free unlike the fully taxable pension.

Another advantage of the life insurance is that it could provides a benefit if both spouses die to children or others. The the next generation could benefit from the higher pension payments being used to buy life insurance that contingently benefits them with a tax-free payment.

Term policy costs are often so low that the coverage may only minimally reduce pension income available for other more enjoyable purposes. However, this is not a lasting solution as term insurance is only good for the term period, typically 10, 20 or 25 years, after which you have no remaining life insurance. Assuming the recent retiree is not hoping to hurry up and die, there may be a better solution.

Buying permanent Guaranteed Universal Life, GUL, or Whole Life insurance is an obvious solution. A GUL would provide lower cost lifetime coverage. While the more expensive Whole Life policies could also provide accumulating cash value and funds to supplement long-term care benefits. Both plans will reduce retirement cash available due to the cost of the premiums.

However, both permanent life insurance solutions have advantages. First, if both spouses die shortly after retirement, the life insurance death benefit would be available for their heirs. In contrast, none of the pension options provides income for heirs. Second, if the spouse should die shortly after retirement, the retiree could elect to stop making payments on the life insurance, cancel the life policy, and return to having a full pension available for the rest of their life. This would not be the case if the life-plus-spouse or Buy-up option had been elected.

Alternatively, a good life insurance agent can design a hybrid solution which would provide better benefits at a lower cost. In this solution, a 20-year low-cost Term Life insurance policy can be coupled with a low cost, cash value, growing permanent IUL policy. The IUL policy would provide minimum life insurance coverage at the beginning but the death benefit and cash value would grow considerably over the next twenty years. When the term insurance expires in 20 years, the IUL policy, with its now larger death benefit would continue to provide coverage for the spouse. 

This solution solves the pension election dilemma fully. Other benefits include the growing cash value of the IUL policy that can also be used to provide retirement cash flow, funds for emergencies, and funds to supplement a long-term care policy. Other living benefits with an IUL are more fully described in Chapter 8.

The point is to sit down with a financial planning advisor who understands your retirement pension and explore options that are mathematically better than electing to reduce your pension with a Buy-up or life-plus-spouse election.

Better still, start this process long before retirement. If you wait until retirement age, your health conditions could prevent you from buying affordable life insurance. If you buy permanent life insurance when you are younger and healthier, you eliminate the significant risk of not qualifying for life insurance due to your health at retirement age. The cash value of your IUL could have been growing substantially for years. This IUL could have grown to the point that taking a monthly cash flow from the IUL could be larger than your pension income and have tax advantages compared to your fully taxable pension income.

The bottom line is to become less dependent on the pension and more financially self-reliant. 

It is Best to Be Less Dependent on Pensions

Many couples are far too dependent on pensions to fund their retirement. They don’t realize that if the employee dies before starting the pension, many plans provide nothing since the plan is only for the employee’s life span. As a result, many couples are at risk, counting on a pension the spouse may not get due to the employee’s death before retirement age. Often, the chance to make the spouse continuation pension election is only available just before the pension starts paying. What if you die before reaching retirement age?

And here’s another thing to consider: what if your employer became insolvent? Major corporations and even government pension plans can go bankrupt and fail to meet their pension obligations. Some pensions are protected by the Pension Benefit Guaranty Corporation (PBGC), a U.S. government agency. Most city and state plans are not covered by PBGC. Is yours? What if you live in California and the major 8.9 earthquake happens? If your pension contributions are funded by a city or county instead of a state, will your small local government still be able to fund the pension plan?

Consider the famous case of the 2005 United Airlines bankruptcy, where United was relieved from responsibility from their pension obligation of over one billion dollars. Although now profitable, United is not required to payback their pension obligations and the underfunded PBGC is slowly paying these pension obligations. Google “United Airlines pension scandal” for more information. 

As a side note, when congress first passed legislation protecting pensions in 1974, they called the new entity the Pension Benefit Insurance Corporation (PBIC). As critics pronounced this agency’s acronym in the most unfavorable way, congress realized their mistake and changed the name to Pension Benefit Guarantee Corporation (PBGC). You think Congress would have seen this issue coming.

Excerpted from Curtis’s book, The Financial Blind Side.

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