Life Insurance You May Not Know About Defined-benefit Pension Plan In-Service Death Benefits

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If you participate in a defined benefit pension plan it can dramatically reduce the amount of life insurance you need.

Few employers sponsor this type of pension plans these days, however they are still typical for government employees, military, school systems, utilities, and some large employers like IBM, UPS, Lockheed Martin, et al.  DB plans remove classic retirement challenges like stock market volatility or living too long. but they require decisions of their own, such as which survivorship option to elect or should I buy back years if eligible?

I once helped a school administrator, under the Teachers Retirement System of Georgia, make some decisions at his retirement: which survivorship election to make and what to do with his voluntary term life insurance.  He had worked for the school system over 30 years, and the formula for his pension was number of years of service, times 2%, times highest salary in the last two years which is typically the final salary. Most DB pensions have a similar formula.  He didn’t elect a survivorship benefit, because he was in good health, had significant assets, and most importantly his wife was a schoolteacher with over 30 years of service and entitled to her own pension.  This gave him the highest lifetime income.

He had carried voluntary term life insurance by payroll deduction most of his career, which ended at retirement. and wanted to know what to do about it.  Premiums were no small amount, about $200/month.  It started out cheap and convenient: just check the box and its payroll deducted.  The danger of payroll deduction is out of sight out of mind. He’d elected five times salary, and as his salary and age crept us, his premiums followed.

As we probed into the details of his pension, it became clear that had he died since the time he had been vested (after 10 years of service or for the last 20 years!) his named beneficiary would have received a lifetime income.  This is an “in-service death benefit”– the benefit paid to the employee’s beneficiary if the employee dies during their working career, after they are vested but before they retire.

This man had a high salary and great number of years of service, so his survivorship benefit was equivalent to a substantial amount of essentially hidden life insurance, well over $1 million. In other words, it would take $1 million invested at 5% to generate the lifetime monthly income his beneficiary had been entitled to.

Let’s consider a teacher making $40,000/year working for 15 years.  If they died, 30% of their salary (2 X number of years of service) or $1,000/month would go to their beneficiary for life.  How much life insurance does it take to generate this much income?  $250,000 of life insurance, invested at 5%, yields about $1000/month. In other words, this in-service death benefit is like owning a $250,000 life insurance policy.

It stands to reason that such a benefit would exist, for the employer pre-funds the DB pension over many years which creates a value which doesn’t disappear in event of the participant’s early death. The more popular 401(k) pension plan balance simply goes to the named beneficiary in a lump sum, while the in-service death benefit goes to the DB beneficiary.

Most participants in defined-benefit pension plans are unaware of this. Adding insult to injury, many sign up for voluntary term insurance which ends at retirement, and it only duplicates the in-service death benefit under the pension.  That premium could be accelerating the mortgage or funding a Roth for a definite future benefit, instead of renting term insurance expiring at retirement.

The point is simply that if you participate in such a plan, call human resources and see what income your beneficiary is entitled to should you die before retirement. Translate this into the amount of life insurance it takes to generate this income and it should reduce the amount of life insurance you carry.

When you call HR also find out the rate schedule for your voluntary term policy’s future years so you can compare it to a level premium term policy.  Employer sponsored voluntary term is usually not a good buy for a healthy person.  It’s often offered on a guaranteed issue basis with no or minimum underwriting required.  An individually underwritten policy requires a physical, blood work, etc., while the group term does not (guarantee issue; “just check the box”), so its rates are higher.

Lastly, rates for term through work usually increase every five years, versus 10, 15, or 20 for a personal policy.

Don’t bog down in comparing rates until you first fine tune the amount of coverage considering the hidden life insurance from in-service death benefits and other assets.  “There’s nothing more wasteful than doing efficiently that which shouldn’t be done at all”, says Peter Drucker.

 

Comparing Northwestern Mutual’s Term Insurance Case Study # 7

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I just finished an insurance review for a Michigan business owner. The results were straightforward and with a company I deal with regularly- Northwestern Mutual. NML is an excellent company, as their agents will tell you, but like all companies they have their strengths and weaknesses. An eclectic strategy can use them for some needs but not all. Even in their strong areas (cash value life insurance) there’s a vast disparity among cash value policies within their portfolio. We addressed that with the Dr. Ryan Wetzel who is featured on our Testimonials page with an accompanying blog.

Here I’d like to compare NML’s term life insurance rates to alternatives. The first step is to ascertain the appropriate amount of insurance. This client had $1.2 million of term life insurance with NML. He is well-managed with a strong income, emergency fund, debt-free, and retirement assets. Because of his large young family, should he die, Social Security Survivorship benefits would be over $4,000/month until the children were age 18. This is something he did not fully comprehend. In light of his assets, and after careful review with his wife, they felt comfortable reducing his life insurance to $1 million.

From there it was simply a matter of shopping for a term policy with more favorable rates.
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NML’s term insurance was convertible to a more favorable whole life policy, but the client and I discussed this and he was not inclined is to use whole life anyway. The new company’s financial strength was slightly less than NML’s, however this is not as important for term insurance as for cash-value insurance.

He paid me a fee of $675, higher than most reviews. However it took over seven hours of time, carefully and objectively considering his assets, goals, and sentiments. (I also reviewed his Northwestern disability policy which was left intact, and his wife’s life insurance which they changed for additional savings not reflected above.) He adjusted down to a more appropriate amount after having it brought to his attention the survivorship benefits that commissioned agents rarely explain. There were over 50 emails over several months. I walked him through the underwriting process, though I did not sell the replacing term policy.

We got the best of the best; found a strong company with very favorable rates and he got the superlative risk category. It was worth the effort, he will recover his fee the first 14 months and earn (by saving) a substantial tax-free return on his investment, far better than any other way he could “invest” $675.

Most who think they are with a “great” company have little idea of how much they can save. That’s what objective experienced guidance provides and why Scripture so frequently commends it- Proverbs 1:5, 11:14, 15:22, 20:18, 24:6.

The fine art of choosing an amount of life insurance: Case Study #4

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Johann S. Bach once said, “All one has to do is to hit the right keys at the right time and the instrument plays itself.” It’s mechanical, right? I had a CPA friend make the same observation when I first told him about my idea of a life insurance planning service: just devise a computer program to do it. Many insurance companies have done just that… and the recommendations they spit out compared to mine are as different as night and day. Why?

While there is an underlying element of mathematically measurable data, we are also dealing with people with a variety of human emotions and experience, all of which color their thinking. Blending these two components together is done better with experienced judgment, just as the piano is best played by the experienced.

Yesterday I finished a case with a South Carolina engineer. It started like this:

My present plan is to get a term policy that will bridge the gap until Beth would qualify for Medicare and Social Security. My thoughts are that I would get a 15 year fixed rate term policy for $500,000. I would like to get assistance in evaluating if this is the right type of coverage to get and if this is adequate in duration and amount and where is the best place to purchase it.

It ended like this:

I looked over the Life Insurance Needs assessment you prepared and I have a real peace about buying the $250k life insurance. For me, the $5800/month [income goal] looks good. This gives Beth about 15% more than I had calculated her needs would be.

What he initially wanted costs $1500 per year; what he ended up with costs $700 per year. What transpired in between? It was a combination of financial analysis (clarifying survivorship benefits from his pension, and the way assets were growing and liabilities were being quickly discharged, and the low probability of death within the next 15 years) along with addressing what was emotionally driving him.

Let me make a couple of observations:

  • He would not get this advice from an agent. They promote more, not less.
  • The consequence of this upfront decision has 10 times the effect of getting a good rate.

On the other hand I got a recent inquiry from another person wanting a quote on term insurance. Apparently he misunderstood the service I provide and when I ask him to complete the questionnaire for the needs assessment, he balked; he “just wanted a quote”. The presumption is he knew how much and what type he needed, so could not benefit from my input in this respect. This is getting the cart before the horse and overlooking the greatest opportunity for price savings, not over-buying to begin with.

Shopping rates is important, but it’s not the starting point. If that’s where this engineer had started he might have felt shrewd while straining at gnats, but would have been unwittingly swallowing a camel. Instead he started with experienced counsel, as Proverbs 20:18 commends. While the second guy saved a consultant fee, the engineer most likely came out way ahead.

Notice that I don’t tell people what to buy. Rather he said, “I have a real peace about buying the $250k life insurance.” I just raise their awareness of facts and considerations that are overlooked in most insurance sales settings. I try to calm their fears, as per Luke 10:41 and 12:25, so they aren’t emotionally off balance as they decide. Then they make their decision. It’s a combination of financial analysis and emotional counseling- it’s an art.

Debt-free Is Stronger than Well-Insured Case Study #2

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Clients typically have two or three primary goals, each of which is in tension with the others: they may want to be debt-free and save for retirement, or they may want to have adequate insurance while investing adequately too.

The nature of economics is the distribution of limited resources, and every dollar spent on insurance means one less dollar available for debt repayment.  Each of these goals may strengthen you financially and many can be done simultaneously, but the resources that go to one cannot go to the other.  The real question is often which should be emphasized, and which should be deemphasized.  From this tension, we get the title of this blog.

Being well-insured has a possible advantage:

  • if the precise event insured occurs, proceeds will be paid.

However, being well-insured also has risks:

  • most term policies expire before the insured does, so much premium is wasted.
  • This means that every $1 spent on insurance tends to yield less than $1. Most people pay more into insurance than they get out of it.

Being debt-free has a guaranteed advantage:

  • saving interest.
  • Regardless of which contingency arises (death, disability, or losing a job), it helps to not have debt payments.

Being debt-free does not have the risks of carrying insurance cited above:

  • you always save money, regardless of what contingencies materialize in the future.
  • every dollar spent on debt tends to save a $1.20, after accounting for interest saved.

For example, many people buy insurance and then lose their jobs… to discover insurance doesn’t help at all.  Insurance is often like France’s Maginot Line, not only ineffective but also so expensive to maintain that it results in underfunding other priorities.  On the other hand, those who are debt free can better weather a variety of financial storms: disability, death, layoff, shrinking real estate values, etc.

How does this translate in the real world?  I’m working with a couple both about 50 years old with two independent children.  Husband and wife each earn about $70,000 and their chief concern is a $200,000 mortgage.

Currently they have term life insurance of $450K on him and $400K on her.  Their goals are to pay off debt, save for retirement, and optimize their insurance.

How much LI should they carry?  What about $250K each, just enough to pay off the mortgage and bolster the emergency fund?  The survivor is debt-free, gets a $50,000 emergency fund, and has a reasonable ongoing salary.  The wife (often more security conscious) may want $350K on her husband.  We can always justify more, but that means less for debt repayment.  A major tape running in the back on my mind is that 95%+ of term policies end up in the trash can anyway.

You don’t get this emphasis from a sales agent and this couple’s decision will largely hinge on their emotional comfort with an amount reduction.  Some don’t feel comfortable reducing coverage and I respect that.  However at least they get the nudge toward what’s likely provide the best long-term return.  Being debt-free is some of the best insurance you can have.

 

The Paradox of Insurance

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Moderating or even skipping life insurance can strengthen the widowhood most wives will experience, if those premiums are invested well.  Doesn’t seem right?  It’s a paradox.

There are many economic paradoxes: using a home equity loan to get that new car or vacation “you deserve” ends up reducing long-term life style, raising tax rates decreases total government tax revenue; sponsoring welfare kills personal initiative and fosters generational poverty; lowering lending standards to encourage home ownership creates a housing crisis.

Wouldn’t it be nice if we could trust our instincts to do the right thing?  We can’t.  Since most people pay more into insurance than they receive from it, astute consumers use it sparingly not liberally; and as soon as they can responsibly afford to, they’ll not use it at all.  That’s why Larry Burkett said, “Don’t insure that you can afford to pay for yourself”.

Recently a well-intentioned 61-year old husband called about buying a $250k 15-year level premium term life policy for $1250/year.  The actuarial tables say the chance (after screening with an exam and blood work) he will die within 15 years (by age 76) is highly unlikely.

Normal life expectancy is young 80’s for men, comfortably (for the insurer) beyond the reach of the 15-year level period. Think about it: how many $250,000 claims can they pay collecting $18,750 (15yrs x $1250/yr)?  After 15 years, at age 76, the premiums explode as he approaches normal life expectancy, forcing most policyholders to discontinue.

Many people play this game, speculating on a premature death for a segment of time ending well before normal life expectancy, (age 61-76 in this example).  Somewhat like the lottery, it’s a loser’s game.

Our imagination is often our enemy.  In this case they just had a close family member die from an accident.  With this fresh in their mind, their most easily recallable fear lures them to a plan unlikely to deliver.  She is likely to become a widow, but not in the next 15 years.

Here are some things to get firmly in mind:

  • How well are you self-insured? Get a handle on Social Security widow’s benefit, 401k assets, support from children, etc. “The cheapest form of insurance is self-insurance.”
  • Know what normal life expectancy is, considering your health, etc.
  • Know what future term policy premiums are after the level period.
  • Know the opportunity cost. Figure what premiums would accrue to if invested for the same duration.  Consider a Roth IRA.  Investing that cash flow at 8% grows it to over $50k by his age 81 normal life expectancy.  This is what the policy will likely cost her, i.e. the opportunity cost.

Many people bought level term policies 10,15, and 20 years ago who have exhausted that period and now must decide to let it go or re-up.  Often what made them buy that duration has been accomplished: the kids are independent, the mortgage has been paid, the 401k has grown…but they feel they need a little more time.  What to do?

Re-upping appeals because it creates an illusion of addressing the problem…for a low monthly outlay.  But it’s more illusory than real and for most it’s just kicking the can down the road and at 76 (in this example) they’ll be facing the same decision, but at much higher premiums.

Rather than taking the easy way out, it may be time to do some serious soul searching:

  • Do you have any inheritance coming?
  • At your death where will your widow live? If she moves to be near kids, what will housing cost there?  Will downsizing release equity for income?
  • Seriously consider not taking Social Security until your age 70, which will make her lifetime pension larger.
  • Have a heart to heart talk with your kids. What kind of support might mom expect from them?  I know you “don’t want to be a burden”, and you won’t unnecessarily, but the family unit is the oldest form of insurance, so don’t ignore it.  (This answer impacts the Long-term Care insurance decision too.)
  • Take a pulse on your wife’s fear and contentment level. The more content she is, the less you may have to dissipate on insurance today, the more you can invest, and the better off she’ll like be. If anxiety compels you, try to think like an actuary, and see if you can achieve unity in this delicate decision.

Most advice is given by commissioned agents who are happy to sell a policy.  They will not point out these weaknesses, nor advantages of alternative uses of premiums.  The commission is $900 if you buy, and nothing if you don’t.

Don’t insist on a perfect contingency plan for an unlikely segment of time.  It’s a contingency plan, not a probable plan.  Insisting it be perfect (“comfortable”) today, robs resources and usually leads to less financial margin in later years when health care and other unknowable’s may need it most.