Pension Maximization

The fourth article from Ed about Life Insurance Options for feds – make sure you get all the details about “pension-max”

Edward A. Zurndorfer

This is the fourth of four FEDZONE columns during the month of September in conjunction with September being designated as “Life Insurance Awareness” month. This column will present the strategy of “pension maximization” in which a retiring employee chooses to maximize his or her pension by not giving a survivor pension to his or her spouse. In place of giving a survivor pension to his or her spouse, the retiring employee applies for and approved for a life insurance policy on himself or herself in which the spouse is the sole beneficiary. As discussed in this column, “pension maximization” is not without some financial risk, requiring a thorough analysis before making this irreversible decision to do it.

The Advantages of Pension Maximization

The pension maximization strategy can offer a married couple several advantages. First, while both spouses are living, the couple will receive the maximum amount of pension which the two of them can enjoy together. On the other hand, in order for the retiree spouse eligible to receive a lifetime pension to give a survivor pension to his or her spouse, the retiree spouse must take a permanent reduction in his or her pension. The following example illustrates:

Example. Robert, age 63, retired from federal service on Dec. 31,2021 after 30 years of FERS service. He elected not to give a FERS survivor annuity to his wife Emily. Robert’s starting and current FERS gross annuity is $40,000 per year. Had he elected to give Emily the maximum survivor annuity of 50 percent, Robert’s FERS gross annuity would have been permanently reduced by 10 percent of $40,000 (his starting FERS gross annuity) or $4,000. The $4,000 will be subtracted from Robert’s FERS gross annuity every year while Emily is alive. If Robert were to predecease Emily, Emily would receive a FERS survivor annuity equal to 50 percent of Robert’s gross annuity at the time of his death. However, since Robert elected (with Emily’s written and notarized consent) not to give Emily a survivor annuity, if Robert were to predecease Emily, then the annuity stops, and Emily receives no survivor annuity.

With no reduction to his or her pension in order to give a survivor annuity, the pensioner (Robert in this example), takes out a life insurance policy on himself and names his or her spouse (Emily in this example) as the sole beneficiary of his life insurance policy. When Robert dies, his FERS annuity stops and Emily (assuming that a sufficient amount of life insurance was purchased and paid to Emily) will hopefully continue to live at the same economic level as she has prior to Robert’s passing.

With the purchase of a permanent (cash value) life insurance policy, a married couple is eligible for the following benefits: (1) They can take out loans against the cash value of the life insurance policy; (2) The cash value of the policy will accumulate at least tax-deferred and maybe tax-free; and (3) They will also have the added income from the annual dividends, assuming they are paid.

When the pensioner dies. the surviving spouse has immediate tax-free funds paid to him or her from the life insurance proceeds that is a source of income to pay expenses and debts. If the spouse were to instead receive a survivor pension benefit, the surviving spouse would have to pay tax (federal and state) on the survivor pension and use the after-taxed pension dollars to pay expenses and debts.

Criteria to Make “Pension Maximization” Workable

In order to get the most out of pension maximization, the retiree needs to receive a pension which will pay a fixed and guaranteed income amount each month. For a federal employee who is eligible to receive an inflation-adjusted and guaranteed lifetime pension in the form of a CSRS or FERS annuity, pension maximization may work. But as discussed below, there are some risks associated with pension maximization for a married federal employee that need consideration.

A retiree will need to apply for – and be approved – for a permanent (cash value) life insurance plan in which the death benefit would be adequate enough to provide a future income stream to the surviving spouse for as long as he or she lives. This amount ideally will be equal to or greater than what he or she may have received from a survivor annuity. It will also be beneficial if the surviving spouse has retirement-source income in his or her name, such as qualified retirement plans and IRAs.

For the pension maximization strategy to work, the importance of life insurance cannot be overemphasized. The retiree needs to purchase a sufficient amount of life insurance necessary to cover the surviving spouse’s future income needs.

There are requirements related to the purchase of life insurance in order for the pension maximization strategy to work, including: (1) The retiree must be in good enough health in order to be insurable; and (2) The couple must be able to afford to pay the life insurance premiums every year. The retiree spouse is therefore encouraged to apply well in advance of his or her anticipated retirement date (ideally, at least 10 to 20 years before) while he or she is more likely to qualify for the life insurance and the premiums should be more affordable.

Risks Associated with Pension Maximization

Pension maximization carries risk if the retiree fails to do the necessary pre-planning. The strategy makes sense and will work only if it does indeed maximize the income of both the retiree and the surviving spouse. Likewise, the amount of life insurance coverage on the retiree must be adequate to meet the future financial needs of the surviving spouse.

There is another issue with respect to pension maximization that applies to married federal employees. That issue involves the Federal Employee Health Benefits (FEHB) program. A surviving annuity must be given to the surviving spouse if the surviving spouse (who is included as a family member on the federal annuitant’s FEHB program health plan) wants to retain FEHB program coverage in the event that the federal annuitant predeceases the surviving spouse. In other words, when a federal employee (covered by CSRS or FERS) retires, he or she is eligible to keep their FEHB program coverage in retirement and keep all eligible family members (spouses and children younger than age 26) on their FEHB health insurance plan. But if the employee at retirement elects to not give a survivor annuity to the spouse (with the spouse’s written and notarized consent) the surviving spouse will lose their FEHB health insurance coverage when their retiree spouse dies.

It needs to be emphasized that the premium cost of the life insurance should not exceed the amount the married couple would be paying without a pension maximization plan (in particular, for the annual cost to provide a full survivor annuity). If so, then a pension maximization plan should not be implemented.

It is also important that the life insurance policy stay adequately funded. The retiree may consider adding a guaranteed insurability rider to his or her life insurance policy. In so doing, it will allow the retiree to increase the amount of life insurance coverage without the need for additional underwriting to secure it. This will allow the pension maximization benefit to remain flexible in case the family’s financial circumstances change.

Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

Pension Maximization

Pension Maximization