Clients on the brink of retirement face a crucial decision on the income they’ll receive for the rest of their lives, if they’re lucky enough to have a pension. Most pensions offer different income-level options, some that provide income till your client dies, and others that continue at a reduced amount if the client dies before his or her spouse. Making that choice – selecting one over another – requires expert advice.
When it’s time to decide on a pension option, it’s vital to start with a retirement plan. What do clients need out of their pensions in order to meet their goals? Sometimes, the choice is based on whether the spouse has sufficient sources of income to survive on his or her own. Other times, the decision is based entirely on the need for higher income at retirement, although this choice can leave a spouse without income later on.
The best of both worlds
Whenever possible, I like to offer clients the best of both worlds – the dual-planet option, or pension maximization (also known as “P-max,” and not to be confused with the Manulife Performax Gold product.)
This strategy is something I developed, but it has been tried and tested over decades (I have some old, yellowed newspaper articles to prove it). So, if it’s not new, why write about it? The only way clients learn the best way to manage their pension income is from advisors – they’re just not getting the information from other sources.
Here’s why. Pension administrators – being administrators and not financial planners – are not familiar with the best ways to optimize pension income. They provide your client with the traditional options – up to five – and simply ask them to make a choice.
Too often, I meet people who are retiring within a month and only seek help in selecting the right pension option at the last minute. By then, it’s too late. And, if they’ve already retired, they can’t un-ring the bell – the deed is done and the finish line is behind them.
Imagine that your client, Martha, has received the following pension options to choose from:
The difference between the highest possible income option and the lowest possible income option is $350 per month. Per month! Your client is essentially giving that $350 per month to the pension plan. What do you think the plan is doing with the money? It is their “insurance” cost, the cost of possibly providing income to a spouse who may outlive the pensioner. Ergo, if your client’s spouse is younger than your client, your client will pay more to protect them.
If your client gives up $350 per month at retirement and continues to live for thirty years past that point, they’ve given up $126,000 over their lifetime. That’s before factoring in lost increases to income if the pension is indexed, or the cost of the opportunity lost in not investing those funds.
Now let’s roll up our sleeves and consider a typical scenario.
If Martha chooses pension options one, two or three, she receives pension income for the rest of her life. If she dies within the guarantee period, her spouse or estate will receive a benefit, either continued payments for the guarantee period, or the commuted value of those payments. So if she chooses number one, with a five-year guarantee period, and passes away three years after her pension income begins, what does her spouse receive? Two years’ worth of pension payments (or their commuted value) and then . . . nothing. If Martha passes away after that guarantee period has ended, the pension income stops with her.
What if Martha chooses pension option four or five? Martha receives income for life. It continues on to her spouse if she is the first to pass on. When both Martha and her spouse have died, the income stops. There is no further benefit for their children.
But what happens if Martha’s spouse dies first? If she chooses a pension with a survivor option, she’s lost the bet. Martha can’t go back to her pension administrator and ask to start receiving that $350 per month difference. She will continue to pay the pension plan to insure income for a spouse she no longer has. Martha is stuck with a lower lifetime income from her pension. She has lost, and the pension plan has won.
The alternative: optimizing income
If Martha chooses to optimize her pension income, maintaining control and receiving the highest level of income offered through a pension maximization strategy, she would come out on top.
Let’s figure out what it would cost to insure her spouse for that 100% guarantee income of $2,050. Assuming an average tax rate of 20%, average earnings of 5% and a 36-year horizon (to Martha’s age 90), the present value of that pension is $325,642.04. Remember, this is the after-tax present value. Insurance proceeds are received tax-free, and we are protecting the income that Martha’s spouse would actually receive, not what he would receive and pay out to the government.
Now, we’ll assume Martha is 55 years old, a healthy non-smoker, and any insurance company would consider her a standard risk. Buying $325,000 of Term-to-100 insurance coverage would cost $3,576.36 per year.
As Martha’s pension income increases over the years at an assumed inflation rate of 1.5%, her pension maximization plan gains speed. In the first five years of her pension, she’s out-of-pocket each year. But starting in year six, her pension income increases to the point that the cost of insurance is less than the after-tax monthly gain she has received by choosing the single life pension. By the end of year 10, Martha has more than broken even – she’s now ahead of the game.
If Martha lives to be 90 years old, she’s managed to provide herself with a lifetime after-tax income gain of over $30,000!
Additionally, Martha owns an insurance policy. She can cancel it and keep the difference, if she finds she doesn’t need it in future. She can choose to keep some or all of it for the benefit of her children or grandchildren – an option not available through her pension plan. Doors remain open for Martha and her family, now that she’s not locked in to an irreversible pension option.
Cindy D. David, CFP, CLU is president, estate planning advisor, Cindy David Financial Group Ltd.