Arizona Faculty and Staff: How to Increase Retirement Income by 20-30% without disinheriting your spouse and children!

by Harold Wong PhD

 

Note: This article will be the first of a series to be published in The Advocate (published by the AZ chapter of the American Association of University Professors). The series will focus on how to increase AZ faculty/staff assets before retirement and how to increase income after retirement. Key research findings by faculty across America will be reported.

 

In Arizona, all faculty and staff, whether Kindergarten - 12th grade, community college, or the three universities ( U. of A, ASU, or NAU), must belong to the AZ State Retirement System (ASRS). In 1974, the Legislature established an Optional Retirement System for faculty & administrative officers of the three universities. However, it was not until 1986 that both the employer and employee contributions were pre-tax contributions. Therefore, this article wil concentrate on the ASRS. However, the conclusions still hold for those who elect the Optional Retirement System, the Section 403(b) Tax-Sheltered Annuity.

 

Arizona faculty & staff have been underpaid relative to national averages.1 The economic life of a faculty member is summarized as:

 

• 1. Finish college and one's doctorate with loans, family help, part-time work...
• 2. Publish madly and teach well for 6-7 years and obtain tenure.
• 3. Continue the process until retirement.
• 4. Live one's whole academic life (from 18 year-old freshman until the typical 65-70 year-old retirement date) without much income.
• 5. Hope that one's retirement income will be adequate to meet one's physical needs.
  When one retires under ASRS, the single biggest decision one has is which retirement annuity option to select. Unlike an IRA, one cannot pull out one's retirement account in a lump sum. One has 7 options, broken into 4 life annuity options (designed to provide monthly retirement benefits while the employee is alive and very limited, if any, benefits for the beneficiary (typically the spouse or kids); and 3 joint & survivor options, which provide both the employee and beneficiary with lifetime benefits. One must pick one of the 7 options and it's normally an irrevocable decision!The most popular option is the life annuity with refund option.2 This options pays the highest retirement benefit. If the member's death occurs before his employee contributions plus interest have been paid, the remainder of his contributions (but not the employer's contributions) plus interest are paid in a lump- sum benefit to the designated beneficary. All employees are eligible to choose this option.
  The most popular joint & survivor option is the joint & survivor-100% option, which pays the lowest benefit.3 At the time of the retired member's death, the designated beneficiary will receive a lifetime benefit equal to 100% of the monthly benefit that the member was receiving at the time of death. The retired member cannot choose this option if (1) he is more than 10 years older than his beneficiary, and (2) the retired member's beneficiary is someone other than his spouse. Restrictions do not apply when the beneficiary is older than the retired member.
  In a case where the employee retires at 65 (and assume the spouse is also 65), the life annuity with refund option pays 20% more than the joint & survivor-100% option. So why would anyone not choose this opton? The answer is that Congress passed the Retirement Equity Act of 1984 (REA) in the desire for fairness and equity and as a means to protect the survivors of retirees. REA requires that all retirement benefits be paid as a joint & survivor annuity, unless the worker's spouse agrees to waive the survivor's share. The survivor's share is typically 50% of the benefit paid to the employee during his retirement life.4
  A case study illustrates why Congress was concerned with the rights of spouses. Suppose a married couple chose the life annuity with refund option and it paid $64,791/year of retirement income. The employee had worked 38 eligible years under ASRS at an average $50,000 income and the average employee contribution was 3.36%5 of income to ASRS. The total employee contribution is therefore 38 years ($50,000 average salary)(3.36%) = $63,840 plus interest. If the employee died 12 months after retirement, the beneficiary would receive a lump-sum distribution of the remaining employee contribution ($63,840 - $64,791 paid in year 1 retirement benefits = nothing left) plus interest. There would not be any further monthly retirement income (except for any interest remaining). Unless there were other substantial savings, this could leave the spouse and kids almost nothing. The only financial legacy of the academic would be the house, car, and pile of old books.
  Let's examine a case study where an employee retires at age 65 (spouse is also 65) after 38 years of service, has a $48,000 income at age 35 that increases 2%/year and an average $85,252 income for the last 3 years of employment.If one chose the joint & survivor- 100% option, one's retirement income at age 65 would be $54,088/year, a reduction of $10,703. If one assumed that retirement benefits increased by an average 2%/year cost-of-living adjustment, the total amount lost by this option in the next 22 years (IRS tables indicate a median 22 years expected that at least one spouse will survive past 65) is $286,870. Demographic studies show that the over-80 and over-90 age groups are the fastest growing age segments in America. Many Americans can expect to live 20-30 plus years after retirement.
  THE BIG DILEMMA: For many faculty & staff, the choice is to either risk disinheriting their spouse and kids, or to lose an actuarially expected $286,870.
  SOLUTION One potential solution to this dilemma was proposed by an Oregon State University professor in the College of Business.6 Dr. Norma Nielson tested life insurance as a substitute for survivor's pension benefits. The concept is that families about-to-retire purchase life insurance to provide for the income needs of survivors instead of electing a joint & survivor annuity option under an employer's pension plan. The family then selects the maximum retirement annuity option (lifetime annuity).
  Using our case study, the principal advantages of the "insured approach" are:
• 1. $10,703 more retirement income at age 65, rising to $16,222 more retirement income at 87.
• 2. A total of $286,870 more income over the actuarially expected 22 years of retirement benefits.
• 3. Insurance proceeds to assure income for the surviving spouse at the retiree's death. This income would equal or exceed what the spouse would receive under the joint & survivor option.
• 4. Flexibility to change the beneficiary under the insurance policy. If the employee's spouse died, he could change the beneficiary to the children or a future spouse.
• 5. Cash value for the retiree if the spouse dies first. If he did not want to continue the life insurance policy, he could stop paying premiums and cash in the built-up value.
• 6. Insurance proceeds not needed for support of the retiree or spouse can provide an inheritance for the retiree's heirs or charities (such as his favorite schools).
• 7. Substantial income tax benefits. Typically, 100% of retirement income (whether from an IRA, tax-sheltered annuity, or pension plan) is taxable when received. If the surviving spouse was in the 30% tax bracket, there could be a 30% reduction in spendable income. In contrast, properly structured life insurance death proceeds are not taxable to the recipient. If this source of spousal funds came from life insurance death proceeds, there would be an extra 30% left. The major disadvantage of the "insured approach" is the possible sacrifice of any cost of living adjustment the survivor might have received under the pension plan, unless the insurance policy also contains automatic cost of living adjustments. However, not every pension plan grants continual increases and many depend on state legislature action. Another obvious disadvantage is if severe medical problems preclude the employee from qualifying for life insurance.
  In our case study, the annual insurance premiums at age 35 to 40 (on a permanent life policy fully paid for over 5 years) were about equal to the increased annual income by picking the life annuity with refund option instead of the joint & survivor-100% option. In addition, the cash value by year 12 (if the policy earned a conservative 6.0%) would equal the total premiums paid. In summary, our case study family would trade as little as 12 years lost interest on the 5 years of premiums (but those premiums are returned to the policyholder through the policy's cash value) for an actuarially expected $286,870 more retirement income.
  Dr. Nielson suggested that the "insured approach" works best if started two or three years before retirement because of the rapid escalation of the insurance prices for persons in their late 50s and early 60s. However, let me state that there is an even greater societal and personal reason to purchase life insurance in one's 30s and 40s. If you were to die at an early age, what will happen to your spouse and dependents (kids, parents, siblings)? You will not have built up substantial retirement or other assets, your house will not be paid off, and your kids will not have completed college. If the "insured approach" still works fine for those in their early 60s, the rate of return and family protection needs are even greater for one in the 30s, 40s, and 50s.
  For those who still think that life insurance is not a wise choice, consider the alternative. By not purchasing a commercial life insurance policy, one is effectively purchasing a life insurance policy from the AZ State Retirement System with premiums starting at $10,703 (the amount of your reduced retirement income at age 65) and ending at $16,222 at age 87. The premiums continue after you die until your spouse or other beneficiary die. Although the actuarially expected loss over 22 years totals $286,870, longer life by you or your spouse/beneficiary will increase the loss. In essence, you will buy a life insurance policy from either ASRS or some commercial alternative. Which source is dumb and which is smart will be obvious once one consults with someone who can run the numbers.
  SUMMARY A faculty or staff employee of AZ universities and colleges is not highly paid. In most cases, the biggest assets at retirement are a fully paid-for home and>