Myth – Profit By Forgoing Joint & Survivor Option for Life Annuity Option
I have been hearing this more and more about how a retiree should not sign up for the joint & survivor benefit option (if married) and go with the life annuity option. The premise is that the life annuity will give them a bigger benefit that they can invest the difference in the two benefits and have more money to pay to their spouse when they die. Unfortunately, this is an old myth created by life insurance agents to sell more life insurance policies that has continued because people do not understand the math behind the issue. They just see a bigger benefit and focus on that.
To understand this better, when a person selects a monthly annuity from a company, the factors used to adjust the life annuity to a different benefit form (e.g., joint and survivor annuity) are based on what is called actuarial equivalence factors. The factors convert a benefit in a way that the “normal” person would receive an equivalent benefit no matter what option he/she choices. For example, if a retiree has the options of choosing between a $1,000 per month life annuity versus $850 100% Joint and Survivor option (where $850 is paid to the retiree and spouse when either one is alive), the joint and survivor benefit is smaller because it is expected to be paid out over a longer period instead of a shorter life annuity paid only when the retiree is alive. Based on actuarial tables, both options would pay out the same amount benefits on a present value basis.
Second thing to understand is to get a similar benefit from the life annuity option as a from the Joint & Survivor option, the retiree will need to buy a term life insurance benefit to pay for an annuity for the spouse when retiree dies. By doing this the retiree is paying two commissions (one commission on the life insurance and another on the annuity). Thus, instead of making money, the retiree is usually paying it out any profit to pay for commissions instead, thus actually losing money. Sure, people can show examples of where a person can win by selecting a life annuity option, yet they tend not to show where people (actually their spouse) can lose if the retiree dies to soon.
For example, let us assume retire and spouse are both age 65
- Life Annuity - $1,000 per month
- 100% J&S Annuity - $850 per month
- Difference is $150 per month
If the retiree dies immediately, the spouse would need approximately $135,000 (based on calculation done at Vanguard to get an equivalent $850 annuity per month. Now, the retiree can buy term life insurance for slightly less than $150 per Insurance.com yet it is for a 10-15 year term policy being assuming the retiree is in superior health. If the retiree is not in the best of health at 65, he would be paying a lot more money for the policy than $150. In addition, he is opening his spouse up to risks if he lives past the age 75 because he still needs to buy additional term life insurance. At age 75, he would have only accumulated $12,000 in savings ($75 per month at a 6% return) which will pay his spouse for only 90 to 100 months which is not enough if she lives into her mid-80s. However, buying life insurance at age 75 to have the additional benefit needed to guarantee annuity benefit to the spouse for her life will cost more than any savings (e.g. cost will be over $200 for a 10-year term policy in the best of health) that is if the retiree can qualify for life insurance at all.
Yes, the extra $150 per month does sound enticing. However, it does open up the retiree’s spouse do large risks:
• Cost of term insurance goes up significantly with age, so any perceived savings is reduced and eliminated in future years with additional costs
• Spouse may significantly outlive the retiree and any additional savings they may have accumulated
• Any short-term savings assume the retiree is in the best of health to qualify for term life insurance
• In future years, the retiree may not even qualify for term life insurance based on his future health condition (e.g., having a heart attack, cancer, etc.)
Thus, before selecting a life annuity instead of a joint and survivor annuity, understand the risks involved to the spouse if everything does not go as perfect as in the example from the insurance agent or financial planner. There may be times when the math does work due to age, sex and health of the retiree and spouse. However, with commissions paid to the agents, any profit can quickly erode any of the profit and there may still be risks involved.
Note, an insurance agent will say that there is a benefit because life insurance is paid out tax-free. This tax-free benefit will not change my example significantly. For example at a 33% tax bracket, the $150 extra a month for a life only benefit will be reduced to $100 after taxes are paid ($1,000 life only benefit is $667 after-taxes and $850 joint & survivor annuity is $567 after-taxes). Because the retiree only need $567 annuity for his spouse after his death, he will only need 2/3rd of the $135,000 life insurance benefit. Thus, instead of paying $75 for $135,000 of life insurance, he is paying $50 or so. As you are starting to see, the initial example without taxes is similar to an example with taxes factoring in the tax-free distribution of a life insurance benefit (just all results are reduced by 1/3 for taxes). Thus, because life insurance is paid for with after-tax money, reflecting the tax-free benefit of a life insurance payout does not materially affect the initial example.
