What it means
Most defined benefit pensions (schemes that promise a set income for life) ask a married retiree to choose between two payment options at retirement. A single life option pays the highest monthly amount but ends at death, while a joint-and-survivor option pays less each month and continues, in whole or in part, to the surviving spouse.
Pension maximisation is the idea of taking the higher cheque and solving the spouse's problem a different way. The different way is life insurance.
The retiree uses some of the extra monthly income to pay premiums on a policy that would pay the spouse a lump sum on the retiree's death. If the policy is big enough, the spouse can invest that lump sum to replace the income the survivor pension would have provided.
The strategy is a bet on three things: that the insurance premium is lower than the extra pension income, that the retiree stays insurable, and that the lump sum can be invested sensibly. Health matters a great deal here, because a retiree with a serious condition may find the cover unaffordable or unavailable.
Age matters too, since premiums rise steeply for older buyers. The order of events matters as well.
If the retiree stops paying premiums, lets the policy lapse or dies before the policy was properly in force, the spouse may be left with no pension and no insurance. The choice of pension option is usually irrevocable once payments begin, so the decision has to be right the first time.
Advisers often present pension maximisation as a break-even exercise. The retiree compares the extra annual income and the cost of cover, then checks whether the policy payout could realistically fund an income as large as the survivor pension that was given up.
Independent advice is wise because some people selling the strategy earn commission on the policy.
In practice
Real-world examples.
Example
A 64-year-old engineer in good health is offered a pension of $4,000 a month on a single life basis or $3,300 on a joint basis. He buys a $500,000 term policy for his wife with part of the $700 monthly difference. His family keeps a larger income while he is alive and has a lump sum if he dies.
Example
A retired teacher takes the higher single life pension but is later diagnosed with a heart condition. She cannot renew her cover at an affordable price, and her husband would be left with no survivor income. The family realises the strategy depended on her staying insurable.
Example
A financial planner at a mid-sized firm compares a client's pension options in a spreadsheet. The extra income barely covers the premium once fees are included, so the planner recommends the joint-and-survivor option and keeps the arrangement simple.
Formula
Calculation
Extra annual income = (single life monthly pension - joint-and-survivor monthly pension) x 12
Net annual advantage = extra annual income - annual insurance premium
Suppose a retiree is offered a single life pension of $3,000 a month or a joint-and-survivor pension of $2,400 a month. The extra monthly income is 3,000 - 2,400 = $600, so the extra annual income is 600 x 12 = $7,200. A $400,000 life policy for the spouse costs $4,500 a year. The net annual advantage is 7,200 - 4,500 = $2,700 a year. The survivor pension given up would have been 2,400 x 12 = $28,800 a year, so the $400,000 payout would need to be invested well to replace it.Case study
Seen in the real world.
Harbourview Logistics is an illustrative, fictional company whose long-serving warehouse manager, Daniel, is about to retire. His pension offers $2,500 a month for his life alone or $2,000 a month with a full survivor benefit for his wife. The $500 difference looked attractive to him.
His adviser asked for a written quote on life cover before any decision. A $300,000 policy cost $3,600 a year, while the extra pension income was 500 x 12 = $6,000 a year. That left $2,400 a year in hand, but the survivor pension would have paid his wife $24,000 a year for life, and the policy payout of $300,000 would need to produce that income reliably.
Daniel and his wife decided the saving was too small for the risk that the policy might lapse. They chose the joint-and-survivor option, and the illustrative lesson is that a higher monthly figure is not a better deal until the cost of replacing the protection has been counted.
Watch out
Common mistakes.
- Choosing the higher single life pension without first getting a firm insurance quote, which leaves the spouse's protection as an assumption.
- Comparing the monthly premium with the monthly pension difference but ignoring whether the policy payout can replace decades of survivor income.
- Forgetting that cover can lapse or become unaffordable, since pension options usually cannot be changed once payments start.
Questions
People also ask.
Is pension maximisation always better than the joint-and-survivor option?
No, it only wins when the insurance is cheap, the retiree is insurable and the payout can be invested well, and many couples find the joint option simpler and safer.
What type of life insurance is used?
Term cover is cheaper but ends after a set period, while permanent cover lasts for life but costs more, so the choice depends on how long the spouse needs protection.
Does the spouse have to agree?
In many pension systems a spouse must consent in writing before a retiree gives up survivor benefits, so the decision cannot normally be made alone.
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