This is an updated version to my article originally posted 04 October 2017. This version includes a substantive correction. The previous version of the article failed to accurately describe all the calculations required when comparing a pension with an inflation-linked Cost of Living Adjustment (COLA) to life insurance. I noticed my omission today and reworked the affected paragraphs. I also took the opportunity to clean up some grammar. You will see substantive changes noted in red text. I believe the changes make the comparisons between life insurance and survivorship more competitive.
The incomplete calculations I described in the previous version of my article appeared weighted towards survivorship. That was not my intent. Since the intent of the article changed, and I believe in full disclosure with my readers; I felt this mistake warranted a revision with new publish date.
This is a first for me in the blogging sphere, although in the military we routinely strive for this level of transparency when an official report, memorandum, or instruction contains a major mistake. The primary purpose for issuing a correction is to prevent anyone from acting on erroneous information. It’s also important that the historical record reflect accurate information. I’ve decided to hold myself to the same standard on this blog.
As a result, I advise anyone who read and used the methods described in the previous version of this article to read this update and adjust your calculations accordingly. While I apologize for the inconvenience, and always strive for 100% accuracy in my articles; I would remind everyone I’m not a professional. Nor am I considering your case specifically. No matter how comfortable you are with your retirement numbers and plan; it’s always best to run your plan by a professional like a fee-only Certified Financial Planner who adheres to the fiduciary standard. Again my apologies.
In late Summer 2003, a member of my unit and one of its seasoned mentors was killed in the early days of the Insurgency in Iraq. We were both part of a tight-knit group of young officers that worked and played hard. While I would not have called him a close friend, many in our group did, and I often sought advice and guidance from him. His death was a blow to everyone in our group and the unit as a whole. Nothing was the same after it. Most of us were not prepared mentally and we all took it personally. Each of us dealt with his death in our own way, and I am sad to say it splintered the group in ways I never could’ve foreseen.
Thinking and talking about death is a de-motivating topic. Scratch that, it’s downright depressing. It’s one of the many reasons the majority of American’s don’t have wills. I suspect they aren’t alone. However, planning for death is essential to those of us who intend to use our pensions to achieve Financial Independence (FI) for our families. While I doubt my friend’s wife took great comfort from the money and benefits she received upon his death; I’ve no doubt that they helped her at some point along her financial path after his death. Ensuring that money would be there took advanced planning on his part. Ensuring your spouse and/or dependents have enough money if you die will take advanced planning on your part.
With that sobering thought in mind, I’d like to delve into the topic of pension survivorship. It’s not a light-hearted subject, but it is extremely important that you and your family get it right. Doing so will ensure that the thousands of dollars you either save or spend, according to your decision, is well worth it.
What is Survivorship?
As I mentioned in Part Four of this series, survivorship is something that must be offered by U.S. law to a pensioner upon his or her retirement. It is essentially an insurance policy which allows the pensioner to pass some percentage (depending on the pension plan) of a pension onto a surviving spouse or dependents. The premiums for survivorship are determined by the percentage elected by the pensioner and are typically taken straight out of the monthly pension payment. This reduces a pensioner’s monthly income accordingly. Depending on the pension plan there may be some tax-advantaged status for the premium payment. The bottom line is that this is a BIG decision since survivorship premium payments aren’t typically cheap.
That said there are some obvious reasons why a couple (per U.S. law if married, it must be both spouses’ decision) may choose to either elect or decline survivorship. Lack of family, plenty of retirement assets, major health problems, and/or a significant amount of previously purchased life insurance coverage are just some of the factors that would make a decision to take or decline survivorship relatively easy.
If that’s you then the remainder of this article will probably prove superfluous. If that is not you, and much like me, you are stuck in a gray zone with pros and cons on both sides; then your decision is much harder. Much like other retirement decisions, there is a wrong answer too. That would be if you don’t elect survivorship, but it turns out your survivors needed it. Of course, you just won’t be around to find out if you made the correct decision.
Let’s be clear here though, the consideration isn’t about if you want to leave your survivors enough to live on … or at least it shouldn’t be. If it is, you are a cold person and I am not sure I want you reading my blog. No, the consideration is whether or not there is a better, or more money-wise, way to provide for your survivors than the survivorship election. Thus, in true Grumpus Maximus form, I would say if you have not read my Planning and Resources sections, tracked your money, written a financial plan (both with and without survivorship payments), and run calculations against your proposed retirement plans using high-end retirement calculators; then you are not ready to answer the question of survivorship. Why? Because you have no idea how much money your survivors would really need to live on.
Which brings up a good point I made in Part Four of this series. Since I’m sure changing a pension agreement is hard, if not impossible; don’t walk into this decision blind. If you can’t answer whether or not your retirement budget can support spending thousands of dollars each year on a survivorship benefit (which much like insurance may never get used), then you aren’t ready for this decision. Here are some other questions you will probably want to answer prior to your decision:
- How much money do your survivors need to live comfortably?
- How does healthcare get covered? Is it linked to the pension and require survivorship?
- How long until Social Security starts? Would Social Security replace the need for the pension?
- Does the pension end when Social Security starts? Some do.
- What is your family’s history of longevity?
- How much would it cost for a comparable amount of life insurance?
- Do the terms of survivorship change if your spouse remarries?
Healthcare and Life Insurance
The way I see it there are two points worth discussing deeper in depth (healthcare and life insurance); the other questions have (in my opinion) obvious implications. Let’s discuss healthcare first. If healthcare is somehow linked to the pension and requires survivorship to continue, I’d take it, unless you are within a few years of Medicare. Even then you are running a serious risk. Self-insuring is super expensive at the moment, even through the Obamacare insurance exchanges. Some retirement experts are planning on $20K or more in today’s dollars, annually, with a 5-10% inflation rate in future years. Ouch! That is a retirement budget killer right there. Thus, if you can access cheaper health insurance for your survivors through your pension, this becomes a no-brainer. Find the money in your budget somehow, elect survivorship, and sleep better knowing your survivors will be spared that expense.
Whether or not you can find comparable life insurance coverage cheaper than your survivorship payments, is the other important question you need to answer. I say that because I can’t think of another way to cover the loss of future earned income if you, the pensioner, should die prematurely. Certainly, if you have a real estate empire that generates a lot of income, or a family business to pass on, then maybe you’ve solved that problem. However, I am going to go ahead and assume that is not the majority of us since we’ve dedicated our working lives to a pensionable career. So the real question is whether or not you can find some sort of comparable coverage on the private insurance market?
Before you go looking though, I would refer you to my previous two articles and their discussions on inflation. Most germane would be the portions that deal with whether or not your pension tracks inflation using a Cost of Living Allowance (COLA) linked to the Consumer Price Index (CPI). The reason I bring this up is if you have an inflation-linked COLA, or even partial inflation-linked COLA, you’ll be hard-pressed to find life insurance that does the same. Conversely, if you don’t have a COLA, then for once you’re in luck because it makes your comparison straight apples to apples.
Pricing Life Insurance: Inflation Linked COLA vs. Non-COLA Pensions
Let’s discuss both scenarios in further detail starting with the harder one first, inflation-linked COLA pensions. As pointed out in Part 3 of this series, inflation eats away at the future value of a pension unless its COLA adjustments are linked to inflation. That may seem like an obvious statement for anyone who read Part 3 and 4 of this series. However, that may not be the case for at least U.S. military members since I typically see exchanges like the one below when it comes to whether military retirees should elect the Survivor’s Benefit Plan (SBP):
“SBP… to take it or not? The cost of paying for the Survivor Benefit Plan is approximately $300/month and in the event the military spouse dies, the payback would be an annuity that would return approximately $2500/month for the duration of the spouse’s life. Is this a good deal or should we invest $300/month in something else?”
“I’m pretty sure there are plenty of life insurance plans that would be a better deal than that…”
That’s an actual Facebook conversation, and it is not the only time I’ve seen one like this during the few short months I’ve been on Facebook. I think many U.S. service members may believe they can simply calculate what their pension is worth for a certain length of time, and then in lieu of electing the SBP, go out and obtain a term life insurance plan to cover that amount on the cheap. However, it’s not that simple. The reason I say that is because the SBP covers a COLA linked pension, but term life insurance doesn’t do the same. According to Karl Stockton at Inflation Data:
Due to Inflation the amount of life insurance you buy today will not be worth the same amount ten years from now. Assuming a 3% inflation rate over each of the ten years, your insurance policy would be worth at least 30% less by the time you reach the tenth year and with compounding the effect is even worse.
Interestingly enough, Karl also points out in his article that it’s possible to obtain an inflation rider for life insurance, which might be one option for pricing the difference between survivorship and life insurance. However, he also states inflation riders are expensive. I haven’t priced it myself, but if you did, I would be interested in knowing which one comes out cheaper. Alternatively, Karl states that building a life insurance ladder, with different policy values obtained over time to cover inflation’s effect, might also be worth considering. However, one major drawback is that the older you get, the less eligible you become, and the more expensive it becomes.
With all that said, I developed one other method for pricing the difference in life insurance coverage and survivorship for those with an inflation-linked COLA pension. This method calls for you to calculate your pension’s Cumulative Future Dollar Value (CFDV), which includes inflation, over a set number of years corresponding to your spouse’s estimated lifespan (or for your minor children until the last one turns 18). Then, if survivorship doesn’t cover the entire CFDV, reduce it based on the percentage it does cover. Once that is done, find out how much term life insurance for that CFDV (or reduced CFDV) would cost you.
Practical Example #1
As a practical example, I once again refer you to the following chart I built for Part 4 of The Pension Series:
|Grumpus’s Calculator||Before Taxes|
|Years Out||Year||Monthly Pay||Annual Pay||Cumulative|
Let’s say I plan to retire in 2020 and for whatever reason, I calculate that Mrs. Grumpus is going to live 40 more years after my retirement. I might die on the first day of my retirement, or I might outlive her. However, should I shuffle off this mortal coil prematurely, I want to ensure she has access to the highest amount of my pension that SBP covers (55% for military).
I am contemplating survivorship, but want to price term life insurance too. I also know that inflation will eat away at the value of any term life insurance payout. Thus, I am looking for the cumulative amount of my pension including what the inflation-linked COLA would pay out over a 40 year period — the CFDV. That value is highlighted in green in the lower right-hand corner and equals approximately $3.5 million. Not too shabby!
Wait, don’t crack out the champagne just yet. As I stated above, SBP only covers 55% of that total. Assuming I die on day one of retirement (worst case) but she lives 40 more years, she would only receive 55% of $3.5 million. Mathematically it looks like this:
- .55 x $3.5 mil = $1.925 mil
Thus, for comparison’s sake, I am looking to ensure $1.925 million in future earnings upon the day of my retirement via a life insurance policy — which is a significant amount. So prior to retirement I would shop around for a $1.925 million 40-year term life insurance policy with all my favorite life insurance brokers, and on the internet. I might even look into an inflation rider just to see how much more it costs. If I cannot find a 40-year term life insurance policy for $1.925 million with monthly payments that costs less than my monthly survivorship payments; I elect survivorship. Conversely, if I can find a term life insurance policy cheaper than survivorship’s monthly payments, then I should I take the term insurance, correct?
Not so fast! Remember the calculations for my reduced CFDV included an estimate for the rate of inflation because survivorship comes with a COLA. I believe for this scenario I used 2% or 3% inflation. Who knows if that estimate proves true over the next 40 years? What if the U.S. hits another bout of 1970s style inflation? A term life insurance policy locks in a certain amount for a certain term, outside conditions be damned.
If I elect survivorship I don’t have to worry about 1970s style inflation, knowing Mrs. Grumpus’s survivor payments would track inflation no matter what. Also, I estimated Mrs. Grumpus’s mortality at 40 years. What if she lives longer? My term life insurance quote would somehow need to incorporate those scenarios, in order to get a true apples to apples scenario. At best my method represents a guess that puts me in the “neighborhood” for comparison. At worst it represents a SWAG (Shitty Wild Ass Guess), and for those of you who read the second part of FI Numbers Don’t Lie know that I dislike SWAGs when dealing with retirement planning.
Conversely, the idea of insuring my entire pension’s reduced CFDV for 40 years takes on a level of absurdity the longer I live. Think about it, whether I die in the first year of retirement, or the thirty-ninth, Mrs. Grumpus receives ~$1.925 million. While she would absolutely need that much if I died early in retirement, she wouldn’t need nearly that much if I kicked the bucket at year 30 of retirement. She’d be in her 70s at that point, with about zero likelihood she could spend it all before dying herself. Although it would be good for Grumpus Minimus #1 and #2 in terms of inheritance, that was not my main intent for the money.
However, when you look at it that way, survivorship itself takes on a level of absurdity all its own too. With survivorship, you essentially lock in a monthly payment for life, whether or not your survivors ever need, or get to use the benefits. So maybe it’s not such a bad method of comparison after all?
Practical Example #2
OK, did I beat the inflation-linked COLA pension survivorship horse to death? I think I did, so let’s move onto the last type of survivorship vs. term life insurance comparison one might need to make. Whereas when calculating Total Dollar Value (TDV) for non-COLA pensions in Part 4 of the Pension Series proved harder; if you have a non-COLA pension, life is easier for you in this scenario. Why? Well, if you took your annual Initial Dollar Value (IDV) and multiply by however many years you want, the value you get would be the exact amount that you would want to price on the term life insurance market.
Thus, for my final example let’s say again I am looking to compare survivorship costs but this time for a non-COLA pension covering 40 years of Mrs. Grumpus’s life. I want to compare it to 40 years of term life insurance. Referring to my chart above, if I took my annual IDV, the value highlighted in blue ($56,778.47) which has yet to feel inflation’s impact, and multiplied it by 40 years I would get $2,271,138. Since both a non-COLA pension and a term life insurance payout are susceptible to the same inflation effects, there is nothing more you need to do. Take your ~$2.3 million value and shop it around to see if you can beat the monthly costs of survivorship on the term life insurance market. If you can, and the terms are comparable, then take the term life insurance and sleep well knowing you got a better deal.
As I said at the beginning of this post, no one likes to talk about death. It is a depressing topic. However, if you have a family who depends on your pension, planning properly for your unexpected departure is not only the right thing to do, but the loving thing to do. Like my friend’s spouse, I’m sure your family would rather you be alive than receive a large payout. While no replacement for you, the money you leave either through survivorship or insurance, will provide them the security they need well into the future.
My intent was to provide you some of the tools you’ll need to make an informed decision when comes to electing or declining survivorship. Remember, if you are married, it’s a team decision. Both you and your spouse must sign. Take the time as your retirement approaches to exam the facts around your pension’s survivorship options, and discuss it with your significant other. If you follow the advice in this, and many of my other articles, you will undoubtedly come to the right decision for your individual situation. Good luck!