Defined-benefit Pension Plan Survivorship Election Life Insurance You Choose at Retirement

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Defined-benefit pension plans pay a monthly income for life regardless of stock market fluctuations or how long you live.  Sweet.  However, participants must make a life insurance decision at retirement. It may not look like life insurance, but that’s what it boils down to.  They don’t pay a premium as one does with life insurance; instead they take a reduced income. Beneficiaries don’t receive a lump sum at the pensioner’s death as with 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 perhaps $2500/month for life with a portion to continue to one’s 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 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: the 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 and a higher risk.  This means that for a non-smoker in good health, with good parental longevity, it’s probably a poor value.
  • You could take the extra income from not having a survivorship benefit and buy your own policy. Agents see this as a sales opportunity, but be careful. Just because you get $500/month extra by forgoing a survivorship benefit doesn’t mean it’s best to put that amount in a policy.

Suppose when you reach retirement things still aren’t quite where you want them.  You might get 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 still 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 with its lower income for decades, and then your spouse predeceases you.

In summary, look at your assets and liabilities and carefully evaluate your life expectancy.  Pray for wisdom from Him who, according to Psalm 139:16, knows the day we will die. Keep in mind survivorship benefits may not be a good value for the healthiest.  Finally, it’s usually best to make the high probability decision, if the lower probability scenario is addressed other ways.

This may be the most important life insurance decision you ever make.  It will govern your and your spouse’s income for the rest of your lives, and because it involves two lives, its impact often lasts three decades.

Should I Drop My Whole Life Policy? Case Study #11

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This is a common question from clients unsure about what they have and a common recommendation from agents seeking to earn a new commission. Yesterday I talked to a Virginia client considering dropping a Lafayette whole life policy which he had purchased eight years ago when an agent recommended he replace a 20 year old Northwestern policy. Earlier this month a local client’s Edward Jones advisor recommended he replace a 30 year old Northwestern whole life policy with a new John Hancock policy. All of these were bad ideas.

At least three things drive these costly mistakes:

  1. it’s difficult for the consumer to understand the value of a cash value policy, since it’s a mixture of insurance and investment.
  2. the entire industry moves on agents pursuing commissions which only happens when new policies are sold.
  3. some respected financial advisors, e.g. Dave Ramsey, make generalizations disparaging whole life insurance.

I am not a fan of whole life insurance and rarely recommend a new purchase. (Though some companies and specific policies are much better than others and there’s a small niche for these.) However there’s a dramatic difference in purchasing a new policy and continuing an old policy that’s beyond the high early year transaction costs. Just because I don’t recommend new purchases doesn’t mean that I endorse casually dropping old policies. This decision is influenced by your age, health, investing alternatives, and largely the caliber of your policy.

Yesterday’s client should keep the Lafayette policy. An in force ledger revealed cash value earning 4%, and he already had a lot of cash earning next to zero. His immediate priority is putting his low earning cash to better use. He should have never bought the Lafayette policy to replace a Northwestern Mutual whole life policy, but that’s water over the dam now, and at least this time he’s getting advice before acting.

My local client averted a mistake by asking for an unbiased opinion first. Replacing a 30-year-old Northwestern policy with a new John Hancock policy would have only profited the agent.

Consumers don’t recognize commissions on a whole life policy are one to two year’s premiums (!), a flagrant violation of John Bogle’s eternal triangle principle of minimizing cost. It’s usually impossible for improved nuances of a new whole life policy to overcome such a blow. Adding insult to injury, switching from Northwestern Mutual to Lafayette or John Hancock were steps down in quality, only underscoring the lack of discernment and/or self-interest of the agent.

There’s another valid perspective on whether to keep a whole life policy. Whereas the Lafayette cash value was earning a net 4%, and that’s very favorable compared to a savings account, it’s unfavorable compared to long-term stock market returns averaging around 10%. And make no mistake, a life policy is a long-term investment if kept until death.

However for both these clients the cash values were a minor portion of their assets much of which were already invested in equities. Also each had a lot of low-earning cash which became the most-likely-to-improve candidate. Had this not been the case, replacement was more of a possibility, but for the sake of putting proceeds in equity returns and certainly not to buy another whole life policy. Client context can swing the decision either way.

If you’re tempted to cash in an old whole life policy:

  1. Understand what rate of return is being earned on its cash value. (Not the published rate, but the real rate.) It’s usually higher than alternatives of similar risk.
  2. Agents recommending replacing old cash value policies with new ones are often the fox guarding the hen house. Rarely can improvements overcome new commissions.
  3. If a financial guru categorically suggests replacing any whole life insurance he is often throwing out the baby with the bathwater.

What’s the take-away from these cases? ASK before you ACT. The Virginia client’s mistake eight years ago was an uninformed response to an uninformed agent. This time he’s ASKING. The local client averted a similar mistake by ASKING upfront. It grieves me to see such waste so easily avoidable. Calculating the true rate of return on your current policy is child’s play for me and my charge is small potatoes compared to what’s at stake. Proverbs 20:18.

Corollary: ASK an IMPARTIAL source. Ironically the supposed authority, the licensed insurance agent, precipitated these mistakes.

Qualification: We’ve been talking about old policies. If a whole life policy is less than three or four years old (before transaction costs have been paid) it may be best to discontinue ASAP, after replacing with cheaper coverage first, dependent on several considerations.

Surrendering a Cash Value Policy? Don’t Waste the Loss

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I see many misguided initiatives to drop cash value policies, coming from a guru’s generalization that “all whole life insurance is bad”, or an agent’s effort to make a new sale.  Dropping a cash value life insurance policy warrants careful consideration: calculating the real (not nominal) rate of return, comparing alternative investing strategies, assessing the current health of the insured, one’s current need for death benefit, and the taxation upon surrender.

If the policy is a poor value, no longer needed, and without a taxable gain, the common advice is to surrender.  Not so fast.  If there is no gain there must be a loss.  How much is it?  Could it be used to offset the gain on other life policies or annuities?  Often it can by merging the losses on some contracts with the gains of others, via a 1035 tax-free exchange.

I recently had two clients who were dropping cash value policies at a loss: the surrender value was less than the cumulative lifetime premiums. Normally upon surrender no tax deduction is allowed.  However, both these clients also had annuities with gains. Annuity gains are tax-deferred until withdrawn, and then they are taxed as ordinary income.  I’m not a fan of annuities, but these were unusual. One client’s annuity was issued October, 2007 (market peak before Subprime mortgage crisis) with the guarantee it would double after 10 years. The insurer bemoaned the day it made that guarantee, but it’s an elite annuity that shouldn’t be dropped (until after it doubles), when it will have a large taxable gain. The other client had a Fidelity no-load annuity, also with a gain.

Both clients were “self-insured” through other assets, healthy, and their whole life policy cash values earned a low rate of return, so terminating them was appropriate. Standard procedure is surrender since there’s “no gain”. However, the loss can be rolled into the annuities to offset its gain which must ultimately be recognized.

If there’s a loan on the life policy it must be paid off first and this can be a problem since you don’t want to stuff more cash into the annuity, particularly if it’s a commissionable annuity.   However, one could open up a commission-free annuity (Fidelity or Vanguard), pay off the loan, and then roll over the life policy (with its loss) into the annuity.  Once the rollover is complete, the cash could be withdrawn from the annuity, at least if the annuitant is over age 59 1/2, or if the loss totally or at least mostly negates the gain.

Again, I don’t like annuities, where the tax wrapper becomes the major selling point while the investments within languish in less than optimum strategies and subject to high transaction costs for most.  I’m only suggesting using them as a temporary tax strategy, and then get back to better investing strategies.

Withdrawals from annuities, before age 59 1/2 are subject to the 10% early withdrawal penalty, to the extent of the taxable gain, and it’s gain out first.  However, the loss of the life policy would reduce and sometimes eliminate that gain, so this penalty may become moot.

It’s important to only use commission-free annuities such as with Fidelity or Vanguard.

In summary, here are the four ingredients to make this work:

A poor cash value policy you want to drop, with a tax loss.

  • An annuity or life policy with a gain or prospect of a gain.
  • Preferably over age 59.5.
  • A no-load annuity.

It’s a rare scenario that has all these elements, but with this happening with two clients in the same week, it may have broader application than I’d thought.

[I just did another case where “not wasting the loss” came in play, by retaining a whole life policy as a paid-up policy, since its cash value grew at 3.5%.  This client had no annuity with gains to offset, but an elite cash value policy.  This policy will be retained as an emergency fund substitute and until it’s loss becomes a gain (four of five years) the 3.5% return is essentially income tax free.  See, “Is Whole Life Viable for Anybody?” for the full story.]

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.

Is Employer-sponsored Voluntary Term Life Insurance a Good Buy? – Case Study #6

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I just finished a case with an officer of a large company who had most of his life insurance through his employer. They paid for an amount equal to 2X salary; he paid for another 5X. Like a convenience store, employer sponsored life insurance makes it easy to buy: proximity, no full blown physical, check the box, and payroll deduction. However just like a convenience store, it’s not cheap.

Often 2X or 3X salary are offered “guarantee issue”, meaning there is no health screening at all. This invites higher risks. Those who sign up first often have an insurability problem – diabetes, DUI’s, obesity, smoker, etc. Insurers call this adverse selection and to provide for the inevitable higher claims they must charge more.

Even higher levels of coverage require only an abbreviated health questionnaire, far less rigorous than for an individual policy with its paramedical exam, blood testing, requesting medical records, etc.

Therefore rates charged under voluntary plans at work are always higher than favorable rates for an individual policy. I don’t just mean higher than the best risks, but also higher than the mild-hypertensive, slightly-elevated-lipids, or two-speeding-ticket risks.

If you have a major health issue, employer-sponsored life insurance may be a good buy, but if you don’t you can probably do better.

Here are some other advantages of individual policies. Most employer sponsored term plans have five-year rate bands with rates increasing at age 35, 40, 45, 50, and so on; most individual term policies have level premiums for 10, 15 or 20 years. Term insurance through work usually ends at retirement or termination of service; an individual policy goes with you regardless of employment.

One touted advantage of group life insurance is that $50k or less can be paid with pretax dollars. This small tax advantage is usually more than offset by the higher premium rate.

The popularity of employer sponsored plans is understandable. A new employee dealing with an avalanche of paperwork finds it easiest to check the box without fully understanding alternatives. Because it’s then automatically deducted from their paycheck before even seeing it, this out-of-sight-out-of-mind but ill-conceived financial tool can roll on for decades.

Remember the step that precedes all this is choosing the appropriate amount. Though buying in multiples of salary is a reasonable way for an insurer to administer a group life plan, it’s not the way a consumer should choose an appropriate amount of life insurance.

Also remember the new policy should be approved and in force before discontinuing voluntary insurance at work. Many people think discontinuing group term can only be done once per year during open enrollment period, however this time restriction does not apply to group life insurance over 50k .

After an amount is determined, then the most competitive individual term policy should be chosen, considering the nuances of your health. A duration needs to be chosen. If you need help in the process, that’s what we do