If you've been around the insurance industry long enough, you've probably heard of the "pension maximization" or "pension max" concept.
Many pensioners with significant others are faced with a dilemma when they retire: take the higher single life annuity payout (which will end when the pensioner dies) or opt for a lower joint life payout that will continue as long as one of the couple survives.
The insurance industry rarely misses an opportunity to sell more life insurance policies, so it should not surprise you that a cottage industry sprang up to help address this dilemma. Pension max advocates direct pensioners to opt for the single life annuity payout and then use the "excess" payment above the joint life payout to fund a life insurance policy on the pensioner, with the pensioner's significant other designated as the life insurance beneficiary.
After reviewing many of these proposals over the years, we developed a healthy skepticism toward the pension max concept due to flawed assumptions (such as ignoring taxes on the excess payments) and overly optimistic life insurance illustrations. Furthermore, these proposals almost always involved life insurance policies that had the richest amount of agent compensation possible, which in our experience significantly eroded the financial appeal of the technique.
However, a recent engagement with a retired professional athlete made us reconsider. We were originally hired to help determine if the former athlete should select the higher single life annuity or if he should choose from among various joint and survivor options (for simplicity the presentation here is limited to the joint and 100% annuity, which assumes that the payment to the surviving spouse does not change upon the death of the pensioner).
We quickly discovered that with this particular set of circumstances, including the favorable health of the pensioner and the larger-than-normal spread between the single life and joint and 100% annuity payouts, the pension max concept not only made sense - it was an absolute no-brainer.
Of course, because of the involvement of a fee-only insurance advisor, this pension max solution bares little resemblance to the typical pension max proposal. We did everything possible to benefit our client, from the use of a no-commission life insurance product to a death benefit pattern that created maximum efficiency.
The pensioner and his wife are relatively close in age, and his pension begins at age 55. The chart below shows the present value of the after-tax benefits under the single life and joint and 100% annuity options, assuming the female dies at age 80. (The higher the present value, the more desirable a particular option is.)
This chart illustrates the typical trade-off: An early death for the pensioner tips the scales in favor of the joint life annuity, but a late death for the pensioner tips the scales heavily in favor of the single life annuity (especially when the female is assumed to die at a young age like 80).
Now let's look at the same comparison if we assume a long life for the female (death at age 100).
Because we are assuming the female lives until age 100, there is absolutely no variation in the present value of benefits for the joint and 100% annuity option. Once again the chart shows that if the male lives long enough, there will eventually be an advantage to the single life annuity.
The couple in this situation had a significant portion of their overall net worth tied up in this pension. Therefore, they had great concern about the financial well-being of the wife should the husband die prematurely.
If these are the only two options available, then the charts above suggest that the only logical alternative is to take the joint and 100% annuity option. There is simply too much risk with the single life annuity if the husband dies prematurely.
But what if we elected the single life annuity and used the excess over the joint and 100% annuity (adjusted to reflect taxes) to purchase a no-commission variable universal life policy (assumed to be invested in a diversified and balanced basket of low-cost index funds with an assumed gross return of 5%)? We designed a policy such that the face amount would be decreased periodically to reflect that the wife's financial exposure associated with the pensioner's premature death decreased over time. The chart below shows the results for the scenario where the female dies at age 80.
Clearly, the pension max scenario (red line) absolutely dominates the joint and 100% annuity. This is true in any scenario where the female dies relative young (not just at age 80).
And what if the female lives a long life? The chart below assumes that the female dies at age 100.
The chart above shows that the pension max approach is largely a push with the joint and 100% annuity, which was our goal when designing the death benefit pattern for the life insurance policy.
If the female dies earlier than age 100, then the advantage goes to the pension max approach, with the advantage getting wider and wider the earlier the female dies.
In this particular situation, it's a no-brainer that the client is going to opt for the single life annuity and purchase a life insurance policy with the "excess" income. This approach will not only add peace of mind, but is also likely to add substantial value.
Based on applicable actuarial tables, the male's life expectancy is age 87, while the female's life expectancy is age 91. At those "expected" ages of death, the pension max appraoch has a present value advantage of roughly $80,000 over the joint and 100% annuity approach, which represents a boost of more than 10% of the overall value.
Some ongoing monitoring and policy adjustments will be required, but that is a small price to pay for the superior solution identified here.
CAUTION: Pension max is not right for everyone, and don't assume that just because it worked here that it will work for you or your clients.