It Pays to Know Your Pension Options

Q: My husband just retired, and now we need to make a decision on which pension option we should take. He can take a higher monthly check, which will stop upon his death. Or if we want to go the “survivor’s benefit” route, he can take a reduced amount now (about $500 less per month) so I can continue to receive payments should my husband die first.

Also, I think I should add that we have enough other savings and investments, and our home is paid for, so I could probably live without his pension. At this point we’re thinking of having him take the single life option (as he’s in great health), but we’re worried we are overlooking something. Do you think this is a mistake?

A: The decision regarding which pension option your husband takes may be the largest financial decision the two of you will ever make. A lifetime pension could be worth hundreds of thousands of dollars in benefits.

For those fortunate enough to retire with a pension these days, there are typically several options that a retiree can choose from. A single life pension, which will cease upon the retiree’s death; a reduced pension, which will continue payments after death (either for a spouse’s lifetime or for a specific period of time); or a lump-sum pension, which is offered by about half of all companies.

Here are some factors that should be considered when faced with these options:

Health: What’s the life expectancy of the spouse moving into retirement? Pension plans don’t check out the health of each retiree in the same way a life insurance company would. Instead, they base their calculations on averages. If a retiree is in fabulous health, has longevity in the family and believes his or her life expectancy is excellent, that would tip the scales in favor of the single life pension. On the other hand, if his or her health is poor, the option that provides the maximum benefit to the survivor would be more attractive.

If the pension is quite large, it may be worthwhile to have a physical to see if there are any unknown health issues prior to opting out of the survivor’s benefit.

Income need: Will the survivor be in need of income if and when the retiree dies? Obviously, if a spouse is dependent upon the continuation of that monthly income (should the pensioner pass away first), electing options that will provide income to the survivor is vitally important.

In many households, a spouse would be devastated financially if a partner’s pension ceased upon death. But this isn’t the case for all households, and it sounds like it’s not the case in your situation. If there is no “need” for the continuation of a pension, deciding which option is best is a little more difficult.

Other considerations: Sometimes there are situations where a spouse has the need for only a short period of time, but not for the remainder of his or her life. For example, if there is a mortgage that will be paid off in, say, six years, then maybe it’s not necessary to pay for a full survivor’s benefit, yet it still could be important to have the pension paid out for a specified number of years (if this option is provided by the company).

When a person takes a reduced pension (in order to provide financial benefits after death), it is really a form of life insurance. For example, if a retiree has the option of receiving $1,000 per month without any survivor’s benefits, or receiving $900 per month with a survivor’s pension, that $100 monthly cost is really an insurance payment.

Sometimes life insurance agents will encourage retirees to take the maximum, single life pension, and then purchase life insurance from an insurance company. But this financial maneuver, sometimes called "pension max," rarely works out very well. For one thing, forgone pension benefits (when one opts for a survivor’s pension) aren’t taxable.

As stated in my earlier example, the $100 monthly “cost” is not subject to income tax. But if a retiree chooses to receive the higher, single life pension, and chooses to take the higher monthly payout, that extra $100 would be taxable, which actually leaves less money to pay for that life insurance policy.

Secondly, from my experience, most people do not have enough insurance coverage to adequately replace the pension. The cost of life insurance is often cheap when a retiree is young, but the cost can be downright prohibitive in later years.

Given your situation, at this point, it’s really a personal decision. Because you won’t be reliant upon your husband’s pension (if he were to die young), you don’t “need” to choose a lesser benefit in order to provide a survivor’s pension.

Obviously, it would be terrible thing if your husband were to die prematurely, but the sting of losing his pension might be bad, as well. For you, in this particular instance, there is no absolute “right answer.” The only time we will know precisely which approach would have been best is after you have both passed away.

Scott Hanson, CFP, answers your questions on a variety of topics and also co-hosts a weekly call-in radio program. Visit MoneyMatters.com to ask a question or to hear his show. Follow him on Twitter at @scotthansoncfp.