By Allen Giese, ChFC®, CLU®
Here’s a concept that if you’re an FRS special risk employee approaching retirement, I’ll bet you’ve heard. The idea is, if you’re married, you choose Option 1 for your pension. That’s the option where if you die before your spouse, then your spouse gets no continuation of benefits—they get nothing. But Option 1 also has the highest monthly payout. So to make up for that, you also buy a large amount of life insurance that would be paid to your spouse, and then your spouse goes and buys an annuity or invests the money and draws an income to make up for the pension they lost.
Sounds like a great idea, right? Not so fast.
I’m Allen Giese, and our firm, Northstar Financial Planners in Plantation, helps special risk FRS employees make better decisions with their finances. With this pension maximization idea, the FRS retiree is obviously trying to increase his or her pension payout. The trick is to get the cost of the life insurance policy to be less than the difference between the payout of Option 1 and Option 3 or 4.
So let’s say a life insurance agent you are talking to shows you a plan where, indeed, the cost of the policy is less than the difference between the two pension payouts. Now you have to ask yourself: “Is it really enough life insurance to replace my pension?” I mean, how do you know how much you need? Have you factored in inflation and a reasonable return on the money and a conservative assumption for your spouse’s life expectancy?
The problem is, I often see plans like this where the retiree has far too little life insurance in place to accomplish the goal. That, of course, makes the premium lower, which makes the idea appear to work—until it doesn’t. But at that point it’s too late. And here’s typically the culprit, more often than not: You have to understand that the life insurance agent gets a commission for placing the policy, right? And that commission is no small amount. It can be as high as 100% (or even more) of the first year’s premium for the policy! So the agent has this big incentive to get the insurance in place. In fact, his or her number-one concern is to get a policy in place. The number-two concern is, is it enough?
We believe that you should always have somebody besides the life insurance agent (who stands to make a big commission and therefore has a conflict of interest) figure out how much insurance you really need in this situation.
Now I’m going to point out something that may not be obvious. Let me ask you, how does the state determine the difference between the Option 1 payout and the Option 3 payout, where Option 1 payments end at the retiree’s death and Option 3 payments end at the second of the two married persons’ deaths? They determine the difference using mortality tables. Well, guess what? They use the same mortality assumptions that life insurance companies use—except there is one big difference. Insurance companies are in business to make a profit, so they are going to mark up above the mortality to make that profit. The state doesn’t do that. The truth is, the average age a healthy 50-year-old lives to doesn’t change because he or she has a life insurance policy versus FRS pension Option 3.
So, in essence, Option 3 has already factored in the mortality at most likely a more favorable rate than the insurance company. So if the insurance is coming in at a better rate, then logic dictates that something is amiss. Again, it would probably make sense to have somebody, who doesn’t have a vested interest in you buying the life insurance policy, take a look at it and give you an unbiased opinion. Remember, once you make this decision and retire, there’s no going back and changing it.
Now one other problem I have with this pension maximization idea. This one is a little more philosophical than mathematical, but hear me out. Why do most people who pick the pension plan monthly benefit over the investment plan lump sum do so? Everybody I’ve asked says it’s because they feel safer and more secure not having to invest the money themselves and making perhaps a big investment mistake. They like the security of knowing that every month they are getting a check no matter what.
So let’s say an FRS retiree and his or her spouse do take Option 1 and buy a couple million dollars of life insurance. What happens when the retiree dies? Well, of course the monthly pension check stops coming, but what does the spouse get? A couple million dollars.
Now what are they supposed to do with it? Think about it: They are distraught. Is this a good time to be making major financial decisions? Is this a good time to be shopping for an advisor they can trust to do the right thing for them? Are they really going to take any investment risk with that money, even though you probably built the assumption they are when you determined the life insurance amount?
Aren’t they basically just a huge target for every unscrupulous commissioned salesperson with the “greatest investment you ever saw” in their briefcase? And isn’t having all this investment risk exactly what you were originally trying to avoid, which is why you took the pension in the first place? Logically, we think it’s just a bad idea.
All that security the FRS retiree had when they were getting a monthly check is gone and probably at one of the worst times possible as far as the surviving spouse is concerned. Believe me because I’ve been there: Surviving spouses aren’t looking for risk, and losing the security of their income that they live off of is a big deal.
I have a few other issues as well, but those are the biggest ones. My point is, there’s a lot to think about and a fair amount of homework that you have to make sure is right if you are considering taking Option 1 and buying life insurance to replace the lost income to your spouse. Every case is unique, and it would be a good idea to bounce the idea off someone who doesn’t have a vested interest in you buying the life insurance and has the ability to correctly analyze the situation.
If you find yourself in that or any other complex situation, or you just want to know if you are making good decisions in today’s economy, consider Northstar Financial Planners for a second opinion. We think you’ll be glad you did. Thanks for watching, and be sure to stay safe out there. Now, if you are an FRS employee and would like a free copy of Retired Battalion Chief Gary Gonzalez’s book explaining what you need to know about retiring from FRS, just give us a call or drop us a line.