Survivor Benefit confusion: part two

If you think about it, the survivor benefit election under the “Annuity Election” section of the FERS (or CSRS) retirement application is a form of insurance. You are “paying a premium” that is equal to 10% of your retirement while you need this coverage to protect your spouse against the loss of your FERS (or CSRS) retirement benefit if you die first.  If your spouse predeceases you, then the premium can be canceled, and your retirement can be restored to unreduced value. The benefits of the spousal survivor benefit election include the following features that should not be underestimated:

1. A survivor benefit election is a permanent election and cannot be changed if more than 18 months have passed from the beginning date of your annuity.  This provides protection to your spouse that no matter what happens, if you die first, they are entitled to a portion of your retirement for the rest of their life in addition to continuation of FEHB insurance. The only exception is if your marriage ends through divorce.  At the time the divorce is final, the election made at retirement is void. To continue this benefit for a former spouse, it must be included in a court order.  
2. Your spouse cannot outlive or outspend this benefit. They will receive a monthly benefit for the rest of their life if you die first. With life insurance proceeds, your spouse will need to manage a large lump sum in a way that will produce income to support them for the rest of their life, regardless of whether they outlive you by two months, two years, or 22 years.
3. A survivor benefit receives cost-of-living adjustments before and after your death.  
4. For a surviving spouse to maintain FEHB insurance coverage, a full or partial survivor annuity must be payable unless the surviving spouse has entitlement to FEHB through their own Federal employment or retirement.  

Here’s a recent email that I received:

I will be retiring in the next 6-12 months as a federal law enforcement officer and have been trying to determine whether to opt for the full survivor annuity or a reduced annuity with an increased FEGLI (Federal Employees Group Life Insurance) benefit component. Below are some generalized numbers that are a pretty fair representation of my circumstances and a brief explanation of what I see as some benefits of the higher FEGLI component. 

• Age at retirement 50
• Salary at retirement $175,000
• Calculated retirement annuity $70,000
• FERS Special Retirement Supplement $20,000
• Current FEGLI- Basic, Option B 5x

I understand there are several other factors that go into retirement planning, but I am just trying to compare these to one another. My thoughts are that my wife would be better served by a tax-free life insurance payout in the high six-figures than an additional $17,500 in taxable annuity payments. If I elect the 75% reduction (at age 65) to my basic insurance and keep 5 multiples until 65 and then have 3 multiples fully reduced, I will have significant life insurance until age 65, my coverage will remain substantial until reductions are complete around age 70 and then still have around $400,000 in coverage afterward. If I live past 80, the cost of the insurance would become significant, but I still think this could be a better plan than paying the extra $3,500 for a full survivor annuity. I have searched for an article or resource that compares the options but haven't found it. 

Let’s put some numbers on the FEGLI elections that are mentioned in the email:

Basic FEGLI is valued on your basic pay rounded up to the next $1,000 plus $2,000. In this example, the basic pay at retirement is $175,000, so the Basic FEGLI would be worth $177,000. At retirement, to continue Basic FEGLI, you can elect from the following three options:

• 75% reduction at a cost of $.3467/ $1,000/month until the later of retirement or age 65, then no further premium. One month after age 65 (or retirement, if later), coverage begins reducing by 2% per month until coverage reduces by 75%.  
  • $177,000 would cost $61.40/month to age 65, then no further premium.  Coverage remaining would be $44,250.  
• 50% reduction at a cost of $1.0967/$1,000/month until the later of retirement or age 65, then $.75/$1,000 based on original coverage, with coverage reducing by 1%/month until coverage reduces by 50%.
  • $177,000 would cost $194.10/month until age 65 and then $132.80/month with coverage reduced by one%/month to $88,500 starting at age 65.
• No Reduction at a cost of $2.5967/$1,000/month until the later of retirement or age 65, then $2.25 / $1,000 / month with coverage not reducing. 
  • $177,000 would cost $459.60/month until age 65 and then $398.30/month thereafter. 

Option B premiums in retirement:

• 50 – 54:  $.2167/$1,000/month
  • Each multiple of $175,000 would cost $37.92/month
  • Five multiples would cost $189.60/month
• 55 – 59:  $.3900/$1,000 / month
  • Each multiple of $175,000 would cost $68.25/month
  • Five multiples would cost $341.30/month
• 60 – 64:  $.8670/$1,000/month
  • Each multiple of $175,000 would cost $151.72/month
  • Five multiples would cost $758.60/month
• 65 – 69:  $1.040/$1,000/month
  • Each multiple of $175,000 would cost $182.00/month
  • Continuing only two multiples would cost $364.00/month
• 70 – 74:  $1.8630/$1,000/month
  • Each multiple of $175,000 would cost $326.00/month
  • Continuing only two multiples would cost $652.10/month
• 75 – 79:  $3.9000/$1,000/month
  • Each multiple of $175,000 would cost $682.50/month
  • Continuing only two multiples would cost $1,365.00/month
• 80+:  $6.2400/$1,000/month
  • Each multiple of $175,000 would cost $1,092.00/month
  • Continuing only two multiples would cost $2,184.00/month

The value of FEGLI using the 75% reduction election for Basic FEGLI and continuing only two multiples of Option B after age 65 once all the reductions have completed would be $394,250. Prior to age 65, the original coverage has a value of $1,052,000 based on Basic FEGLI ($177,000) plus five multiples of Option B each worth $175,000 ($875,000). Based on the planned election at retirement, at age 65, 

• Basic FEGLI will begin to reduce by two% $1,000/month starting at age 65 until it reduces by 75% ($177,000 reduces to $44,250) and 
• Three multiples of option B ($525,000) start to reduce by two%/month until they reach $0 value and 
• Two multiples of Option B ($350,000) would continue at the above rates that would begin at $364/month at 65; $652.05/month at 70; $1,365/month at 75 and continue at a rate of $2,184/month at 80).

In addition, the FERS annuity benefit of $70,000/year or $5,833.30/month would be reduced by five% ($3,500 / year or $291.70/month) to provide a survivor benefit equal to 25% of his unreduced FERS retirement benefit to his surviving spouse. This would reduce his retirement to $66,500/year or $5,541.70/month.  

In 25 years, assuming an annual cost-of-living adjustment of three%/year, the unreduced value of his FERS retirement could increase to $144,200. The 25% survivor benefit would provide his surviving spouse $36,050/year or $3,004/month income for life with continued COLAs. Presumably, she would also receive a Social Security widow’s benefit if it were higher than her own earned Social Security benefit as well as the proceeds of her husband’s TSP account.   

Important: The survivor benefit reduction reduces taxable income in retirement, but the premiums for FEGLI are paid with after tax dollars. In the above example, the $291.70/month reduction to provide a partial FERS survivor annuity could save $64/month in federal taxes if it were taxed at the 22% tax rate in addition to saving state income tax on this reduction, if applicable.

If he elects the maximum FERS survivor benefit, then his $70,000/year or $5,833.30/month FERS retirement would be reduced by $7,000/year or $583.30/month (also reducing his taxable retirement income by this amount) leaving him a reduced benefit of $63,000/year or $5,250/month.  

Once he reaches age 65, if he elected the full reduction of his Option B coverage for all five multiples and the 75% reduction for Basic FEGLI, he would have $44,250 remaining FEGLI after the reduction is completed. However, in 25 years with a three percent COLA, the FERS survivor benefit would be 50% of $144,200 or $72,100/year or $6,008/month.  

If this retiree dies prior to age 65, in either case, she will receive the full value of FEGLI (the reduction for Basic and Option B doesn’t begin until age 65) and the FERS survivor annuity elected at retirement. However, if he lives to age 75 or beyond:

• Option 1 (partial FERS survivor election with 75% reduction for Basic FEGLI and only two multiples of FEGLI Option B continue with no reduction)
  • Final value of $394,250 Basic and Option B FEGLI coverage with continued escalating premiums for Option B, plus
  • Estimated reduced FERS survivor annuity of $36,500/year. 
• Option 2 (maximum FERS survivor election with 75% reduction for Basic FEGLI and Full Reduction of all multiples of Option B)
  • Final value of $44,250 Basic FEGLI remaining, plus
  • Estimated maximum FERS survivor annuity of $72,100/year.  

I am not a financial advisor, and we don’t know the “rest of the story” as far as their monthly living expenses, other assets, additional income from investments, inheritance, or other sources of income, so it is not possible in this column to come to any accurate conclusion other than based on both the retiree and the spouse’s view, it appears that the maximum survivor election provides a more generous and protected outcome for less overall cost than the reduced survivor benefit election with the option to maintain more life insurance.

From the retiree’s perspective:  

• Would you rather have a 10% reduction to your FERS retirement so that around age 75, the reduction may be approximately $1,201.70/month (also reducing your taxable income by the same amount resulting in a net cost more like $900/month), or
• Would you rather have a five% reduction to your FERS retirement so that around age 75, the reduction may be approximately $600/month (resulting in a net cost of around $450/month) plus a monthly “after-tax” premium of $1,365 for the two remaining multiples of FEGLI Option B for a total cost of $1,815/month?

From the spouse’s perspective:

• Would you rather lose $144,200 in FERS retirement when your spouse dies which will be replaced by a one-time tax-free payment of $394,250, plus a lifetime annuity of $36,500/year, or
• Would you rather receive a one-time tax-free payment of $44,250 plus a lifetime annuity of $72,000/year.  
  • Consider that to create $36,500 annual income from $394,250 would require withdrawals of around nine% of the principal.  
  • Consider what happens at age 85 (or sooner) if you have run out of money.  
  • If times get tough while you are both living, the cost of maintaining the $394,250 could be reduced to $0 by canceling the coverage.  
  • Spousal consent is not required to cancel FEGLI – or to change the beneficiary.  
  • The survivor benefit election cannot be reduced or canceled unless the marriage ends through death or divorce.

Final thoughts:

• Longevity is a financial risk if one spouse outlives the other by decades instead of months or years.
  • Although age differences and health conditions are factors, they are not guarantees that the older spouse in poor health will die first.
• The long-term cost and value of the spousal survivor annuity should be considered prior to choosing an alternative option such as life insurance.  
  • Inflation can be offset by cost-of-living adjustments that are applied to benefits such as CSRS/FERS retirement and Social Security.  Can the same be said for the alternative options?
  • Lifetime streams of income can provide protection against the risk of longevity.
• Consider the income you have from all sources (FERS/CSRS retirement benefit, Social Security, Thrift Savings Plan, etc.)  while you are both living and then try to compute the value of the income payable to the surviving spouse when one spouse predeceases the other.