For those fortunate enough to be a participant in a defined benefit pension plan, a significant decision is required at retirement time, and that is what pension option to take. The Retirement Equity Act of 1984 (REA) requires that pension plans make the 50% joint and survivor (J&S) benefit the default option.
First, a little background. Even prior to REA, pension plans offered different retirement/survivor options. But because the plan was funded based solely on the employee (participant), any option other than the one that paid the employee for as long as he/she lived and then terminated (the sole survivor option), was funded by a reduction in benefits.
Rather than describe the various permutations, I’ll present a hypothetical example. John, our fictitious participant, is presented with the following options by his HR department: His pension will equal $5,000/month for as long as he lives. When he dies, his fictitious spouse Mary, if still living, would receive nothing. Except REA doesn’t allow John to elect that option without Mary’s written (and notarized) consent. Do you think Mary would consent to that? (Well, since she is fictitious, I suppose any answer is true. But you get my point.)
He also has other options, including a joint and 50% survivor annuity, which is the default option. In that hypothetical scenario, John would receive a reduced pension, $4,500/month as long as he lived, and if he predeceases Mary, she would receive $2,250/month (50% of John’s $4,500) for as long as she lives.
Quiz time. What does the $500 difference between the sole survivor option of $5,000/month and the $4,500/month 50% J&S option represent? Answer: It is the premium on a life insurance policy that will pay $2,250/month to Mary for as long as she lives, provided John predeceases her. Should she predecease John, he would continue to receive the $4,500/month for the duration of his life. That is, he would continue to pay a $500/month premium for a policy that will never pay a benefit.*
What if, over the course of his lifetime, John had procured a total $500,000 of permanent life insurance (with Mary as the beneficiary)? Could he convince Mary to sign off on the sole survivor option, knowing she could produce $2,250/month by earning 5.4% on the life insurance proceeds? Maybe, maybe not, but his odds would be significantly better than had he no life insurance.
My point isn’t which option is better or which option John should take, it is that having life insurance gives him options that he otherwise wouldn’t have. And that’s a good thing.
So if you are a participant in a defined benefit pension plan, you now have another reason to implement a permanent life insurance program.
*Some plans offer a “pop-up” provision, where for an extra premium (in our example, the extra premium might be $20-30/month, so the pension would be $4,470 - $4,480 instead of $4,500), the participant’s pension payment would revert to the sole survivor pension should the spouse die first.