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.

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

An Important (often overlooked) Feature of Term Life Insurance – Case Study #5

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I’m currently doing a Life Insurance Checkup for a couple in Tennessee that underscores an important cost aspect of level term life insurance…but it’s not the premium rate.

The first step in a Checkup is rightsizing the size policy. This couple, like many, used a rule of thumb (a multiple of income plus debt) promoted by Dave Ramsey, whom I highly respect. However rules of thumb are a crude way of giving wholesale advice. I prefer fine-tune efficiency which comes best through customization. The difference can be dramatic, as it was in this case.

He is a veteran construction manager who had already retired from one employer and had a pension with a significant monthly survivorship benefit for his wife. (This is tantamount to a lot of life insurance.) There are no kids in the picture, they have a reasonable 401(k) and a $750K life insurance policy on him with Allianz. Their emphasis is on debt repayment and they don’t want to spend unnecessarily on anything, including life insurance. After reviewing her income needs and their assets and debts, they think the appropriate insurance need is $350K rather than $750K. How do we best make this adjustment?

The easiest way would be to reduce the current policy. Allianz is a strong company, ranked AA with Standard & Poor’s. He bought this 20 year level term policy four years ago when younger, so a comparable policy would cost more today at his older age. Also, if he had had a health decline it would put him in a higher rate category.

The problem is, though many companies allow a policy reduction during its lifetime, Allianz does not. Some allow it only once during the policy’s life and some allow multiple times. Since Allianz doesn’t at all, it forces him to consider a new (appropriate amount) policy, at an older age, subject to insurability, losing the reserves of the old policy, new contestability period, new commissions, etc.

Let me take a moment to emphasize an important aspect of insurance planning: the amount of insurance you need is rarely static. For most people it reduces as assets grow (401(k), savings, etc.) and liabilities diminish (mortgage is repaid, young children mature, etc.) So the thought that you’re going to need the same amount of insurance for 20 years is probably unrealistic. Yet many people buy such policies and keep them at the original amount for decades. This accounts for the invisible waste of much premium, as people imperceptibly become over-insured. Few people reassess (even if it’s only every 5 to 10 years) their insurance needs…though it’s usually profitable to do so.

Reducing term policies (almost a relic of the past) recognized this dynamic: the amount of insurance needed declines over time. Today’s most competitive policies (level term policies) do not. Thus it’s incumbent on the consumer to make his own adjustments. To do so your policy must permit it.

So when you’re buying a term policy, be sure to find out if the policy owner can reduce its amount at least once during its life. Another possibility is buying multiple policies for different durations: for example a 20 policy for $350K, and 10 policy for $400K. This automatically schedules a decline in insurance as your needs likely decline. The problem with this is that you don’t know the rate at which your needs will decline. Another problem is poorer pricing on multiple/smaller policies.

We tend to think that buying a good term life policy is simply a matter of buying a strong company with low premiums. However there are other important features. The ability to reduce the policy at least once during its life is one of them.

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.