Editor’s note: Last month, this column began exploring the decision of how to best receive money from a defined-benefit retirement plan: Should you take all of it in one lump sum and invest it yourself, or should you annuitize the balance? This month, we take a closer look at the annuity option with the help of Mike Cave, a fee-based insurance and annuity expert.

If you participate in a defined-benefit plan, you will have to make an important life-insurance decision upon retirement. It may not look like life insurance, but that’s what it boils down to. And it may be the most important life-insurance decision you ever make.

A little context

Defined-benefit retirement plans are being replaced at a rapid clip by defined-contribution plans, such as 401(k)s. However, defined-benefit plans, which pay a monthly retirement income based on a formula that factors in years of service and last salary, are still common for many government employees, members of the military, educators, utility workers, and more.

If that includes you, upon retirement you will probably have your choice of receiving a lump-sum benefit or a monthly distribution. If you opt for the latter, you’ll have one more very important choice: to base benefits on your life expectancy only, or yours and your spouse’s (a survivor’s benefit).

The formula often goes like this: your number of years of service (say 30), multiplied by a factor (say 2%), multiplied by your salary at retirement (say $5,000/month). In this example, you could receive $3,000 per month if you choose to base your benefit on your life only, or a reduced amount if you choose to have a portion of your monthly benefit (typically 50-100%) continue to be paid to your spouse after you die. The higher the survivor’s benefit, the lower your monthly benefit right now.

Again, this may not look like life insurance, but that’s what it amounts to. You don’t pay a premium as you do with life insurance—but that “premium” is paid via you receiving a reduced income. And your beneficiary doesn’t receive a lump sum at your death but receives a continued lifetime income. Framing the issue this way can help you make the best possible decision, which will impact your income and your spouse’s income for the rest of your lives.

Four questions to consider

Most married people who participate in a defined-benefit pension plan opt for a lower benefit now so that after death a portion of it will continue to be paid to the surviving spouse. It seems like the right thing to do, but is it?

Before making a choice, consider the following questions.

  1. Might a survivor’s benefit cost too much?
    Take a minute to consider a defined-benefit survivor’s benefit as a form of life insurance. From an issuer’s standpoint, selling policies this way would be risky. After all, this form of life insurance requires no insurance exam or blood work, and no questions about the beneficiary’s health history or driving record. In insurance-speak, this is known as adverse selection. An insurance company would have to charge a lot for a policy like that, which helps explain why the monthly benefit is so much lower when you choose the survivor option.

    If you are in good health and can qualify for favorable rates, you may be better off basing your pension benefit on your life only, then using the additional income to buy a life-insurance policy on yourself. It could be that such a policy would provide more money to your spouse than your pension’s survivor’s benefit.

    To find out, consider how large a policy you would need, assuming the death benefit were conservatively invested, to generate the same monthly income as your survivor’s benefit. Could you buy such a policy for less than the amount you would lose by electing a survivorship benefit, which is essentially a life-insurance premium?
     
  2. Will your spouse need the extra income?
    What other sources of income will your spouse have if you die first? If he or she would have sufficient income, you may be better off taking the higher benefit amount now and using it to pay off a mortgage or to allow you to reduce withdrawals from your other retirement accounts.
     
  3. How long are you both likely to live?
    What is your spouse’s life expectancy relative to yours? If your spouse predeceases you, having chosen a survivor’s benefit will lock you into a lower monthly benefit, perhaps for decades. So, as unpleasant as it may be, honestly assess your spouse’s life expectancy. If yours is longer, that suggests not choosing a survivor’s benefit; the opposite leads toward it.
     
  4. How might this decision impact long-term care?
    If you or your spouse have a family history of Alzheimer’s disease, you may be better off choosing to receive a higher monthly benefit by forgoing or opting for a low survivor’s benefit and using the added monthly income to buy a long-term care policy.

Wrapping up

This article isn’t meant to convey that choosing a survivor’s benefit is necessarily the wrong decision. It’s only meant to suggest that choosing a survivor’s benefit—especially at the highest possible monthly amount—isn’t always the right decision.