3 Reasons for Federal Employees NOT to Do a "Pension Max"
Wednesday, February 2, 2011
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I was doing a retirement check up for a federal employee and a spouse a while ago. When I asked about their plans for survivor benefits, they said they didn’t want to leave a survivor annuity from their federal pension. I asked why... they said they were doing "Pension Max."What is Pension Max?
Most people aren’t familiar with Pension Maximization, aka "Pension Max." To understand it, you first need to understand how your survivor benefits work.
When you elect a survivor annuity, your federal pension is reduced. In general, if you choose the ‘full survivor’ benefit..which means they’ll get ‘half’ of your pension when you die...it costs you 10% of your initial pension amount.
So if you were going to get $1,000 from your FERS retirement, you elect a ‘full’ survivor benefit... your spouse will get $500 a month when you pass away. But while you’re alive, instead of $1,000 a month, you’ll now get $900 a month. That $100 reduction is the ‘cost’ to provide a survivor benefit.
The idea behind Pension Max is that you can replace that survivor benefit with life insurance. The goal is to increase your retirement take home pay while you’re alive -- and when you pass away, that life insurance provides the income your spouse should need. Another way to look at it is that $100 a month is the ‘cost’ of providing an annuity to your spouse...Pension Max presumes that you can provide the same benefit -- but at a lower cost -- by using life insurance products.
In Concept vs. In Practice...
I like the concept of Pension Max...the problem is that most people set it up wrong. And when Pension Max goes wrong...it doesn’t really affect you...it affects your spouse after you die.
Most people don’t hear about Pension Max unless they’ve been pitched the idea by their insurance person. But most insurance agents don’t understand your federal benefits. This can lead to serious, even disastrous consequences for your spouse when you pass away.
What’s Your Biggest Benefit?
Of all of your federal retirement benefits, I believe that being able to keep your health insurance (FEHB) in retirement is your biggest benefit.
If you want your spouse to continue to have FEHB after you pass away, you MUST leave a survivor annuity from your federal pension. It can be the reduced survivor annuity, but you must leave something. Otherwise, when you die, your spouse loses FEHB.
Even if your spouse is on your FEHB plan during retirement -- once you die -- if your spouse is not receiving a survivor annuity your spouse will lose the federal employee health insurance.
Most insurance salesmen don’t know this. So they highlight all of the benefits of Pension Max, without understanding what consequences it has for your federal retirement benefits.
My 3 Biggest Problems with Pension Max...
Problem #1) Your Spouse Loses FEHB in Retirement
If you don’t leave a survivor annuity for your spouse (full or reduced... but something), your spouse will LOSE FEHB after you pass away.
Now not only is your spouse dealing with your passing, but now just lost your federal employee health insurance. If they want to get health insurance now, they’ll have to pay astronomical prices for private insurance. (Recently, I was helping a client in good health look for private health insurance... the premiums were in excess of $2,400 a MONTH) But even if they can afford high prices... they may no longer be insurable. Depending on their age and health, they may not be able to get private health insurance at all.
So if you want your spouse to be able to keep FEHB after you pass away, you must leave some amount of survivor annuity from your federal pension. Otherwise they lose it.
Problem #2) When Times Get Tough...
With Pension Max, you buy a fairly large insurance policy to provide income for your spouse when you pass away. But you start paying the premiums for that insurance while you’re alive.
When times get tough, people look for expenses they can cut. Too often, people decide to cut life insurance.
This is the second biggest problem I see with Pension Max in real life... the person chose to pay for a big life insurance policy instead of leaving a survivor annuity. But later, they stop paying the premiums on that life insurance policy when they were tight on cash flow.
So now their spouse has no survivor annuity... and no life insurance.
As long as you live forever, this isn’t a problem. But what happens to your spouse when you die?
Problem #3) Underfunded Policies
In theory, Pension Max can work if you provide enough life insurance. When federal employees do Pension Max, they buy ‘permanent’ life insurance policies. These policies accumulate cash value, which typically grows based on a certain interest rate.
When I see people who’ve done Pension Max, 9 times out of 10, their insurance policy is underfunded. This means that when they die, their spouse may not have enough money.
Two reasons policies are ‘underfunded’... either the person didn’t buy enough life insurance in the first place, or the cash value of the policy didn’t grow as well as they had expected.
Either way, your surviving spouse pays the price. And I’ve worked with too many widows who paid the price for someone else’s poor planning.
Does Pension Max Ever Make Sense?
Most of the time when I see people doing Pension Max...it’s fouled up.
The problem is that people don’t understand how their benefit choices impact other areas of their financial life. People get into trouble when they only look at one ‘slice of the pie’. They don’t fully see how changes in once area can have a big impact on other areas.
Can Pension Max ever work? Sure. And I’ve seen it work very well for a few people. Pension Max can make very good sense for some people.
It can work particularly well when you have two federal employees who each have their own retirement pension and are able to keep FEHB in retirement. Or a federal employee married to a state government worker. If your spouse has a way to ‘pick up’ health insurance benefits after you die, there’s a great chance Pension Max could work for you.
Understanding Your Benefits
Pension Max is just one example of something that is ‘great in theory’ -- but can have serious consequences for your federal benefits if it’s done wrong.
This is why I think it’s so important to understand your federal benefits from a financial planning perspective. You need to know how benefits choices impact other areas of your financial life.
This is what I help my clients with. I help make sure all of their benefit choices are working together. And this is why I teach federal retirement classes and publish articles. I want to help federal employees understand their benefits from a financial planning perspective.
You can learn more about how your Survivor Benefits work at my pages for FERS Survivor Benefits and CSRS Survivor Benefits.
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