A common practice of married federal employees is to take a survivor annuity when they retire. The goal of the survivor annuity is to guarantee a benefit for a surviving spouse, which sounds a lot like life insurance.
The most common voices heard touting life insurance instead of the survivor annuity (SA) are people selling life insurance, who obviously have something to gain. I would like to offer my perspective on this subject as a fee only advisor that does not sell life insurance or any insurance products. We will also look at a practical example with real numbers.
The survivor annuity (SA) provides a benefit at the retiree’s death, therefore it can be considered insurance, similar to an actual life insurance policy. However, there are many differences between the SA and a life insurance policy. It is important that retiring federal employees understand the differences before electing to forego the survivor annuity or even take a reduced one.
Survivor annuity options
All married FERS employees have three options at retirement.
- Full survivor – retiree takes a 10% reduction in the FERS annuity to guarantee a survivor benefit of 50%
- Partial survivor – retiree takes a 5% reduction in FERS annuity to guarantee a 25% survivor annuity
- No survivor - no reduction in FERS annuity
The survivor annuity and life insurance are similar in the fact that they are both designed to provide a benefit at the federal employee’s death. I say, “designed” because they both have the potential to pay a death benefit, but it may depend on who dies first. That is where the similarities end.
The most important thing to know about choosing life insurance instead of a survivor annuity is how your Federal Employee Health Benefits (FEHB) work. Most federal employee’s spouses rely on the federal employee’s health benefits; FEHB is a great perk of the job.
If a retiring federal employee does not elect a survivor annuity, then the fed’s spouse will lose access to FEHB if the federal employee dies first. Please read that sentence again! If your spouse relies on your FEHB, then you must take some form of SA, but you can elect a reduced annuity.
The survivor annuity is paid out to a surviving spouse in the form of a monthly benefit where life insurance is typically paid out in a lump sum. The monthly benefit for the SA lasts until the surviving spouse dies.
The survivor annuity recipient will also receive COLAs on the monthly benefit.
The method that they’re paid
A survivor annuity deduction is automatically taken out of your annuity. If you choose the full survivor and your annuity is $3,000, you will receive a monthly annuity of $2,700. There are no premiums to be paid on the SA.
Life insurance is typically paid for in the form of monthly or annual premiums. There are steps that can be taken to make sure that premiums are paid, such as automatic deductions from a bank account or automatically charging a credit card.
The guarantee is a big difference between the two. The SA is guaranteed to pay out in the event that the spouse survives the federal employee. If the federal employee’s spouse passes first, then there is no SA benefit for non-spouse beneficiaries. The SA is guaranteed to last for the spouse’s lifetime.
Life insurance is a guaranteed payout as long as premiums are paid. One thing to be clear on is that there are different types of life insurance and I am referring to a guaranteed permanent contract. Life insurance is normally owned by the insured and guaranteed to pay out at death of the insured. If the spouse predeceases the insured, then the insurance proceeds can still be paid to a contingent beneficiary.
There is no guarantee that the life insurance proceeds will last for the beneficiary’s lifetime. That will depend on a number of factors such as how much the proceeds were, how the proceeds get invested, how much is withdrawn, and how long the beneficiary’s lifetime is.
Another aspect of a life insurance guarantee is that the company needs to stay in business to be able to pay the death benefit. I am not aware of an insurance company ever failing to pay a death benefit, but that doesn’t mean that it couldn’t happen.
There are two different forms of taxation to consider.
- Taxes on premiums, or dollars used to pay premiums
- Taxes on the benefit (the survivor annuity and insurance proceeds)
The cost for the survivor annuity is deducted from cost of the FERS annuity. If the FERS annuity is $3,000 then the cost of the SA is $300 for a net annuity of $2,700.
Insurance premiums are paid with after tax dollars, so it is unfair to equate a $300 cost for the survivor annuity to a $300 life insurance premium. For a person in the 22% tax bracket, it would take approximately $384 to net $300 after taxes.
The SA is taxable as ordinary income at both the state and federal levels (with a very small exclusion for employee contributions).
Death benefits from life insurance proceeds are income tax free.
Cost of Living Adjustments
The SA has automatic Cost of Living Adjustments (COLA) annually. The FERS COLA is based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). FERS retirees will get an annual COLA based on the CPI-W increase. Details of the calculation can be found in this article.
With life insurance there is no guarantee of an annual increase in the benefit. Low cost permanent policies usually have a flat death benefit. At the insured’s death, the benefit will be paid to the beneficiary, at which point it is up to the beneficiary to invest the proceeds. Any cost of living adjustments at that point will be based on how the proceeds are invested.
The cost of the SA increases as the FERS retiree receives COLAs. If a retiree’s FERS annuity has increased from $3,000 to $3,500, the cost of the survivor annuity has increased from $300 to $350. The full survivor annuity deduction is 10% and remains at 10% for the retiree’s lifetime.
A guaranteed life insurance policy will have the same premiums for the life of the contract. Please don’t confuse a guaranteed contract with a universal life policy or variable life policy that is not guaranteed. Not all universal life policies provide a guaranteed death benefit, but instead may depend on interest rates or market index performance.
What does this mean to me?
Everyone is different so there is no perfect answer for everyone. Take your time to digest the information above and figure out what is best for your spouse (this is really about your spouse, not you) and your family. Here are a few characteristics that fit into each category.
A good fit for the survivor annuity
- Want the assurance of a guaranteed income stream paid to a spouse
- Spouse is younger
- Have a spouse that is in good health
- Spouse has no retirement plan
A good fit for life insurance
- Spouse is older
- Spouse’s health is poor
- Want a guaranteed payout at death regardless of who dies first
- Have substantial investments
Please keep in mind that a surviving spouse cannot continue FEHB if you elect not to take a survivor annuity.
The default answer is and should be to go with the survivor annuity because of the safety. There are definitely situations where life insurance can be a good fit, but that requires doing some analysis and making sure certain precautions are in place. Survivor Annuity evaluation versus life insurance is one of many issues that we educate our clients about. If you would like retirement planning help from a fiduciary that doesn’t sell life insurance you can schedule an introductory call with Brad.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.