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

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.

Insurance Should Be Third Tier

I just finished a case that showcased how smart people are tricked by the insurance industry. As I reflected on it I thought of a simple exercise that can keep others from falling into the same trap. I’d like to share the story and solution with you.

This client is a surgeon– a pretty smart guy. Yet he did something so inappropriate I could cry. He bought a cash value policy from Northwestern costing $3000/year. What’s wrong with that?

Sometimes (rarely) cash value life insurance is OK, so don’t automatically cash in your old policies. It depends. But this client had much debt and was eligible for a Roth he couldn’t afford to fund each year. These are two key points. They shout of the inappropriateness of cash value insurance, and the simple paradigm I’m about to share puts it in clear focus.

Here’s the paradigm. Most financial planning decisions fall in one of three broad categories: repaying debt, saving/investing, or insuring. Yet financial planning decisions being made every day are more detailed: buy this stock or that mutual fund, accelerate the mortgage or fund a 529 plan, a Roth or more in the 401k, etc. It’s easy to lose sight of the forest for the trees.

So here’s the plan. It’s worth its weight in gold. Clip it and save it and use it for the rest of your life. It will help you avoid many costly mistakes.

When confronted with a decision of where to send your precious few discretionary financial planning dollars, first step back and view the decision from a higher altitude. First put the decision at hand in one of these three broad categories:
1. Repay debt
2. Save/Invest
3. Insure

Initially don’t sweat the small stuff, don’t swallow the camel while straining at the gnats, and don’t be pound foolish while trying to be penny wise. The abundance of similar maxims testifies of this strong human tendency that trips people up. For now, simply put the decision in its general category; one of three; simple.

The agent directed his focus to preparing for death with a $75,000 whole life policy. Knock out that issue with a policy that pays after your term ends. Sound good? But it’s out of context. For this client, buying the policy is obviously insurance, category 3. He could quickly realize that’s the lowest priority and until the top two are satisfied, he shouldn’t spend extra insuring. He still had unpaid consumer debt (1) and an unfunded Roth (2), so expensive cash-value insurance should’ve stayed relegated to the back seat until 1 and 2 were satisfied.

Why are these ranked in that order? It’s as simple as asking which advances your net worth in the most surefooted manner:
1) By saving interest, debt-repayment dollars are guaranteed to increase your net worth, from day one; 1) investment dollars may do the same, depending on transaction costs and how invested (it could go down);
2) insurance dollars (for most people), decrease your net worth because transactions costs are the highest of the three and for most the insured peril does not occur.

For this client, these dynamics were extreme. His most expensive debt was at 11% interest and the cash value policy he bought, after three years’ premiums totaling almost $10k, had a surrender value of only $2000. In defense of the insurance sale, the doctor did not have this high interest debt when he bought the policy. Incriminating the sale however is that the company sells other policies building cash values much quicker. This was clearly commission driven.

No sense in cursing the darkness (caveat emptor), so how could this client have avoided this mistake? By stopping to put the decision at hand in its broad category. Insurance should be third tier in the scheme of financial priorities.

An agent will try to make it first tier… so expect it. Your emotions will also lure you to give it a higher priority than appropriate. Seldom do emotions lead well in finances.

If you relegate insurance to the back seat, you’ll make better decisions. There will be some exceptions, and that they are …exceptions, not the rule. Postpone them or deal with them a cheaper way (term insurance), but hold fast that pecking order.

What might that look like? Higher deductibles, not insuring old cars for collision, skipping dental insurance for most people, term life insurance often at smaller amounts, tinier long-term care policies or none at all, recognizing that self-insurance is the cheapest form of insurance and not insuring that which you can pay for yourself.

It’s not just that insurance is so bad, but that other options are so priority. You can’t do it all. Tenaciously keep right priorities: honor God with the tithe, be at least somewhat generous to others as you’d want done to you, avoid debt like the plague (and aggressively work to get out of it), keep a reasonable emergency fund, fund your matched 401k and maybe a Roth.  This will likely moderate your use of insurance and help you come out ahead.

The Most Important “Credential” an Insurance Advisor Can Have

Consumers naively believe that professional designations are the most important credentials an insurance advisor can have: Chartered Life Underwriter (CLU), Chartered Financial Consultant (ChFC), or Certified Financial Planner (CFP). Granted, credentials mean the advisor has a reasonable head on his shoulders and has completed a disciplined educational path.

I would submit to you that the salutary restriction of receiving no commission may be the most valuable “credential” an advisor can have.  It alters the advisor’s heart which then liberates the head from the tunnel vision of seeing only those solutions that pay him a commission. It thus opens up a whole new (often commission-less) world. These solutions are typically unfamiliar to insurance reps who know only one way to get paid– to sell a policy.

By receiving no commissions, the heart is unfettered from the undertow of self-interest, placing the advisor in the most objective posture possible. It expands his capacity to give the best advice. After all it matters little how much an advisor knows if he does not use it for the customer’s advancement.

Warren Buffet said it this way:

In looking for people to hire, you look for three qualities: integrity, intelligence and energy. And if they don’t have the first, the other two will kill you.

Consumers naturally long for someone to strive exclusively for their welfare without regard to commissions. But it’s a two way street and any healthy relationship must have mutual respect. Consumers should be willing to pay for keen insurance market insight (where to find the best insurance bargains), the ability to evaluate proposed and current policies in a way few agents can, familiarity with alternative uses of premiums dollars for investing, and the seasoned ability to put it all together the best way that comes through years of experience.

Here’s a major challenge: commissions are hidden while fees from an unbiased advisor are fully disclosed. While fees are dramatically less than commissions, some consumers choke on them primarily because they can see them. It’s the old “strain at a gnat while swallowing a camel” human tendency.

Remember, the fee-only advisor has already forsaken the most profitable path in the insurance industry: selling policies for commissions. He’s probably doing it to genuinely serve others. So as a consumer, demand a good track record, a long list of satisfied clients, and then be willing to pay a fair wage, remembering that you should get it back (multiple times) through the on-going savings he will help you achieve.  The fee is one time; the savings is ongoing.

The Advantage of Using a Multi-company Insurance Brokerage Firm; of Backdating; of Paying Premiums Annually. Case Study # 13

I just finished a case that illustrates the advantage of an insurance brokerage firm representing many companies versus a single company, even a good one such as Northwestern Mutual, State Farm, or USAA.

The best offer my normal go-to company would provide this client was Preferred rather than Preferred Best, because she uses anti-anxiety medication. However the insurance brokerage firm which I suggest for many clients (but from which I receive no commissions, in case you’re wondering) uses a generic application, so without her having to sign additional paperwork automatically switched her to Metropolitan who issued her Preferred Elite. Met had no problem with her mild medication and the premium difference was 21% less for 15 years. This brokerage firm routinely uses over 30 companies and shuffles risks around based on health conditions, medications, avocations, and occupational hazards, for optimum offers. Insurance underwriting departments have personalities too, and some are more tolerant of certain risks.

We also backdated the policy to be issued at a younger age for a lower premium. Backdating is a common practice allowing the policy to be issued up to six months earlier to gain a younger issue age, for lower lifetime premiums. The downside is you pay premiums for a period when you had no coverage, so you have to weigh the savings against the waste. After careful calculations, even if this insured backdated the maximum allowable time of six months the future savings represented a 16% after-tax return on the “wasted” premium. However she only needed to backdate for three months meaning the future savings represented a 36% tax-free return. It makes me wonder why it’s not automatically done, however agent commissions are a percentage of premium and an older issue age means higher premium, so there is a disincentive to do so.

The final piece of advice which I’ve devoted an entire blog to in the past is the advantage of paying annually versus quarterly or monthly. Sometimes this is a budget issue (can’t afford to pay annually) but the financing charge inherent in a monthly payment is typically 10%. If you take the money out a savings to pay annually, you save a lot more interest than you would earn leaving your savings account intact.

All of these improvements are small nuances compared to the big picture (right-sizing the policy, a competitive company, the right type, etc.) but collectively they are weighty. Once a policy is launched it’s usually carried for decades if not a lifetime, so trimming the premium down upfront is certainly worth the effort

Which Insurer Will Treat You Best?

I finished two cases in December that each took over half a year to wrap up. Very unusual. They had other similarities too: minor health issues, over insured by major insurers, with young children yet oblivious to Social Security survivorship benefits, and best of all, their improvements were outstanding. These type of improvements motivate me.

The first client was a pharmacist with a State Farm $750,000 20 year term, issued nine years ago, costing 140/month, and rated table 2. His health condition had improved so we asked State Farm if they might reduce the rating, but they would not. I have my auto and homeowners insurance with State Farm, but they are no leader in life insurance. We first right sized his policy since he had young children with substantial Social Security survivorship benefits he did not know about. His assets had increased and debt reduced since he purchased the policy and he and his wife felt comfortable reducing it to $500,000. The new 15 year level premium policy (four years longer than the current one) was issued at Standard Plus for $505/year. He’ll save nearly $1200/year.

The second client was a young engineer whose pharmacist wife had a Northwestern whole life policy with a large loan. A Lincoln life agent was encouraging her to roll this into an annuity. The agent had sold each of them a $1.5 million term policy, and after carefully evaluating their survivorship goals and how they were already self-insured through current assets we reduced her coverage to $500,000 and his to $750,000. We also reduced the Northwestern to shrink the policy loan. Its cash value was earning an attractive dividend interest rate, and putting it through the commission ringer for the annuity unnecessarily whittled down its value.

Lincoln would not permit her to reduce her current policy which was excessive as per their goals. The engineer’s weight was a tad above the guidelines for the best risk category, so over several months he dieted to get below the threshold and ended up getting Preferred Best rates. I directed him to an insurance brokerage company representing many companies. The best risk category with a super competitive term specialist, along with rightsizing the policy, saves them $1440/year on term premiums, while reducing loan interest to Northwestern, and avoiding annuity commissions.

Periodically ask yourself– how did you came up with the amount of your policy? do you understand Social Security survivorship benefit? and have things changed? One last similarity: they will each save my fee back 1.4 times per year for many years, likely totaling 18K for one and 30K for the other. That’s a 140% annual after-tax return on their fee.

Neither the “Good Neighbor” company nor the one named after America’s favorite president served these clients as well as a specialist whose name you wouldn’t recognize. Knowing which insurer will treat your risk factors best and how to put your best foot forward is why there’s no such thing as a “good” company for all insureds. The risk category you are assigned can make a “good” company not so good after all.