Defined-benefit Pension Plan In-Service Death Benefits: Life Insurance You Didn’t Know About

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, Johnson and Johnson, UPS, Lockheed Martin, Exon, 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 superintendent, under the Teachers Retirement System of Georgia, make some decisions upon 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 like the amount he would’ve received had he retired at that point. 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 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 he died, 30% of his salary (2 X number of years of service) or $1,000/month would go to his 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 tantamount to 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 have accelerated the mortgage or funded 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 your benefits manager or human resources director 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 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.

[See, Is Employer-sponsored Voluntary Term Life Insurance a Good Buy?]

Defined-benefit Pension Plan Survivorship Elections; Disguised Life Insurance at Retirement

All participants of defined-benefit pension plans, the type that at retirement pays a monthly income for life regardless of stock market fluctuations or how long you live, will have to make a life insurance decision upon retirement. It may not look like life insurance but that’s what it boils down to. You don’t pay a premium as you do with life insurance; instead you take a reduced income. Your beneficiary doesn’t receive a lump sum at your death as if you purchased a policy, rather they receive a continued lifetime income. It’s life insurance in disguise.

The retirement income formula from a defined benefit pension often goes like this: your number of years of service (say 30 years), times a factor (say 2%), times salary at retirement (say $5000/month). This yields $3000/month lifetime income ending at death; or a reduced pension of say $2500/month for your life for a portion to continue to your spouse until their death. The proportion continuing can vary (say 100% or 50%) and the higher it is, the lower your pension.

There are at least four aspects of this decision which warrant careful consideration.

  • Don’t get tunnel vision. Predeceasing your spouse isn’t the only contingency to address. What if you took the lower income in order to provide a survivorship benefit but then one of you needed long-term care? Having an extra $500/month would come in handy.

In considering which survivorship benefit, carefully evaluate the needs of your mate and assets to meet those needs apart from a survivorship benefit: higher of the two Social Security checks, earnings from an IRA, spouse’s income capacity, and other life insurance. You may be self-insured and the cheapest form of insurance is self-insurance. While few married retirees take no survivorship benefit, most should take less than 100% to the survivor, since it takes less for one person to live than two: one less person eating, clothing, one less car, etc.

  • Remember the defined benefit pension survivorship benefit is “life insurance” not subject to insurability: no insurance exam, bloodwork, questions about health history, driving record etc. For insurance companies this means adverse selection, i.e. those who elect it are often in poorer health, have DUI’s, etc. For a non-smoker in good health, with good parental longevity, it may be a poor value.
  • You could take the extra income from not having a survivorship benefit and buy your own policy. Suppose when you reach retirement things still aren’t quite where you want them. You might buy a 10-year level term policy, buying a bit more time to finish the mortgage, get closer to Social Security age, etc. However just because you could do it (and it may be the better value), doesn’t mean you should do it. There still may be better uses of that money. The likelihood of a healthy 65-year-old dying before the end of a 10-year level term policy is very small.

Your mate’s sentiments are key. Start by looking at what their income would be at your death without survivorship benefits. Then compare it with the lifestyle you want to ensure and their comfort level.

  • Since the future is unknowable, an advisor can’t definitively tell you what to do. There are risks each way. You could forgo the survivorship benefit and die early, or you could elect a survivorship benefit and forgo the higher income for decades and your spouse predecease you. So look at your assets and liabilities and carefully evaluate your life expectancy. Pray for wisdom from Him who, as per Psalm 139, knows the day we will die. Keep in mind survivorship benefits may not be a good value for the most healthy. Finally, it’s usually best to make the high probability decision, as long as the lower probability possibility is addressed through other means.

This may be the most important life insurance decision you ever make. It’ll govern your and your spouse’s income for the rest of your earthly days. Because it’s predicated on two lives, and “a cord of two strands is not easily broken”, it can last for three decades.

Defined-benefit Pension Plan In-Service Death Benefits; The Life Insurance You Didn’t Know About

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

One often overlooked aspect of these plans that smacked me in the face, when asked to help a school superintendent at retirement time, was how it should have influenced how much life insurance he carried before retirement. He had carried voluntary payroll deduction term life insurance most of his career, which ended at retirement. and wanted to know what to do about it. Premiums were over $200/month. A danger of payroll deduction is out of sight out of mind. He’d elected five times salary, and as his salary and age crept up, his premiums followed.

What he’d been oblivious to was a significant lifetime income for his wife had he died, once he had become vested after 10 years. That line of demarcation varies among plans, yet had he had an “in-service death” (died during employment but before retirement) his beneficiary would have received a lifetime income similar to what the employee would receive if they had retired at that point. The formula is 2%, times number of years of service, times current salary.

His salary was the highest in the system, so let’s consider a teacher making $40,000/year working for 15 years. If they died, 30% of their salary (two times 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 similar to owning a $250,000 life insurance policy.

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 have accelerated the mortgage or funded a Roth, for a definite future benefit, instead of renting term insurance expiring at retirement.

If you are under such a plan, call human resources and find out if you have an in-service death benefit, if not when you will and for how much. Then calculate how much life insurance it takes to yield this income.

One ancillary point: employer sponsored voluntary term is usually not a good buy for a healthy person. 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. Also rates for term through work usually increase every five years, versus 10, 15, or 20 for a personal policy.

So when you call HR to find out about the in-service death benefit, if you’re in a voluntary term plan, find out the rate schedule for future years so you can later compare it to a level premium term policy.

However, don’t bog down in comparing rates until you first fine tune the amount of coverage in light of the in-service death benefits and other assets. As Peter Drucker said, “There’s nothing more wasteful than doing efficiently that which shouldn’t be done at all.” Buying life insurance to duplicate an in-service death benefit you didn’t know you had usually shouldn’t be done at all.