When you transition from the military, after 20+ years of service (there are a few exceptions which I will ignore for the sake of brevity), you are entitled to a pension. I have previously blogged about the value of military pensions, here, here and here.
In my previous posts, I ignored the Survivor Benefit Plan (SBP), but now I am going to take a closer look at it.
The basic mechanics of the SBP are simple. You pay a monthly premium (almost always) equal to 6.5% of your pre-tax pension amount. In return, an annuity of 55% of your pension amount will be provided to your surviving spouse and/or dependent children, in the event that you pass away. So, for example if my retirement pension was $1,000 per month and I participated in the SBP, I would pay $65.00 per month (6.5% * $1,000 = $65.00). In return for these premiums, my spouse would receive $550 per month (55% * $1,000 = $550) for as long as she lives (except for a few different circumstances, which we will ignore for the sake of brevity). Here is the official website discussing the SBP if you want to look at anything other than the plain-vanilla situation I will be discussing.
So, is this a good deal?
Most people seem to think so. According to the 2012 Statistical Report on the Military Retirement System (page 223), 65% of all military retirees participated in the SBP. I want to build a model and compare this to something. This is actually complicated to model because there is nothing worthwhile and readily-available that compares directly with the SBP. USAA practitioner, JJ Montanaro, CFP™, thinks the SBP is great, should not be compared to term life insurance and should instead be measured against whole or universal life. I have watched enough episodes of the Suze Orman Show to know that whole and universal life insurance are bad ideas. So, I am going to ignore JJ Montanaro, CFP™ , and attempt to compare the SBP as directly as possible to term life insurance.
The first thing I notice when comparing the SBP premiums to term life premiums, is that the SBP appears expensive. Not quite as bad as a whole-life policy, but expensive nonetheless.The SBP premium is $65 per month for a $550 monthly benefit, whereas a 20-year-term-life insurance policy costs roughly $0.20 per $1,000 in lump sum benefit. Term-life-insurance-premium costs depend on so many factors (age, sex, tobacco use, group affiliation, years of the term, amount of coverage, etc.), that it is impossible to select a one-size-fits-all cost. I am going to use $0.20 per $1,000 in lump sum benefit for my calculations here. This is approximately what I would currently have to pay for term-life coverage from JJ Montanaro, CFP™‘s employer USAA (BTW, I Love USAA!). Just eyeballing the two options, the SBP seems expensive, but it does have a few advantages over a 20-year-term-life insurance policy.
- It is indexed to inflation (except so are pension payments and therefore by extension SBP premium payments are also indexed to inflation, so I am not entirely sold on this advantage).
- It is paid out pre-tax, meaning you do not have to pay income taxes on your premium payments.
- It does not need to be renewed after 20 years.
Before I determine if any of the above advantages are enough to close the perceived (maybe I need glasses!) value gap between the SBP’s $65 per $550 per month in perpetuity, and the 20-year-term life’s $0.20 per $1,000 lump sum, I need to change things around a bit so I can compare apples to apples. How much of a lump sum would be needed to generate $550 per month in income?
Currently the 10-year Treasury Bond is yielding 2.16% (according to Yahoo! Finance). This rate is historically low, but I am going to use it as a discount rate because interest rates will probably be higher in the future and they are unlikely to be (much) lower. This will have the effect of undervaluing the term-life-insurance option compared to the SBP. I will assume the surviving spouse lives for 30 years and invests in a risk-free bond portfolio returning 2.16% per year. Using my trusty HP 12C calculator (Inputs: N=360, I=2.16/12, PMT=550, FV=0), the present value(PV) is $145,629.09. Next to turn the term-life cost into something comparable to the SBP, I would divide $145,629.09 by $1,000 and multiply by $0.20 to get $29.13. In other words, I would need $145,629.09 worth of term-life insurance, costing $29.13 in a monthly premium, which could be used to purchase US Treasury Bonds to generate $550 per month in revenue. Now I can better compare the two options.
So, the term-life option costs $29.13 per month and the SBP option costs $65.00 per month. This is still not quite apples to apples, because of the SBP advantages I pointed out. I will examine the three advantages I already pointed out and see if the SBP can close the $35.87 value gap between the two options. There are some term-life-insurance advantages too, and I will get to those in a bit.
The SBP is indexed to inflation while the term-life option is not. Military pensions rise with the Consumer Price Index (CPI) and this carries over seamlessly to your SBP premiums and the SBP payments. Term-life insurance on-the-other-hand is set for a period of years and is paid out in a lump sum. I see zero value created by this “advantage” while premiums are being paid. The CPI increases from a military pension could be used to purchase additional term insurance to keep pace with inflation – Voilà! No advantage for the SBP here.
There is however, a definite benefit for surviving spouses who receive an inflation protected annuity. This could possibly be countered by investing the term-life lump sum in Treasury Inflation Protected Securities (TIPS). Overall I think this is a non-issue and offers little to zero value. I will get back to why I think this is a non-issue when I discuss the advantages of a term-life option.
You do not have to pay taxes on your SBP premiums. SBP premiums are deducted from your pension before taxes are paid, whereas you would pay term-life premiums with your after-tax pension. Taxes currently range from 10% for those making $9,075 and less to 39.6% for high earners. It is difficult to know what tax rates will be in the future. The IRS claims that the 2012 marginal income tax rate for all returns was 13.1% based on adjusted gross income (link to an IRS Excel spreadsheet: IRS Tax Data 2012). Using this rate the benefit would be $8.52 ($65 * 13.1% = $8.515). If you are (or you will become) a high earner, this can actually be a significant benefit because the tax rates are progressive. Depending on tax rates and individual circumstances this benefit could help close the value gap. On average however, this advantage is currently only worth $8.52 per month for the SBP. The cost of the term-life option is still $29.13 while the tax-adjusted-SBP cost has dropped to $56.48.
The SBP never runs out, while a 20-year-term-life policy is for, well, 20 years. It is also true that you can buy more term-life insurance, albeit term-life policies get pricier with increases in age. For me, rates jump to the $0.50 per $1,000 range once I enter my late-fifties. This does put a significant crimp on the term-life option. For comparison, let’s compare two versions of myself – me and my evil twin. Assume I opt for term-life insurance over the SBP and pay $29.13 per month for years 1 through 20, and then $72.81 per month ($145,629.09 divided by $1,000, multiplied by $0.50) for years 21 through 40, for the term-life option. Meanwhile my evil twin goes the SBP route and pays the tax-adjusted $56.48 per month the entire time.
Who comes out ahead?
I beat out my evil twin with $24,465.60 in term-life premium payments versus his $27,110.40 in SBP premium payments ( [ $29.13 * 240 ] + [ $72.81 * 240 ] = $24,465.60 versus [ $56.48 * 480 = $27,110.40] ). Except that SBP payments are capped at 30 years of paying premiums (another advantage of the SBP!). So the SBP requires a maximum 30 years of payments to secure the benefit. The evil twin seemingly has the advantage for now with only $20,332.80 ($56.48 * 360 = $20,332.80) in premium payments versus my term-life’s $24,465.60.
The SBP has some other advantages. The SBP is provided by the US Government and term-life policies are provided by private-sector companies (perhaps term-life appears less expensive to compensate for risk?). The SBP also provides a study stream of income compared to a lump sum. Personally, I would prefer a lump sum because it offers flexibility. However, if my spouse’s notion of fiscal responsibility consisted of bathing in Wild Turkey, and throwing dice in Las Vegas every weekend, then the SBP would probably be a better choice for me. Assuming a fiscally responsible spouse, let’s examine the advantages of the term-life option before I say yes to the SBP.
Term-life is cheaper and your premium payments do not increase with inflation. Even with the tax-adjusted SBP premiums, the term-life option is almost 50% less than the SBP and they will never increase. I know what you are thinking. At the end of 20-years, you will need a new term-life policy and the premiums will most certainly be higher at that point. However, if the difference between the two options (SBP $56.48 and term-life $29.13) is invested during the 20 years of premium payments and earns 5% per annum (HP 12C inputs: N = 240, I = 5/12, PV=$0, PMT = $56.48 – $29.13) the future value (FV) is $11,241.77. Reinvesting the difference in premiums can be a good hedge against the SBP’s surviving-spouses-inflation advantage. In fact, if you take the $11,241.77 future value, invest it earning 5% per annum and amortize the balance towards another 20-year-term-life policy premiums, it would cover payments (PMT) of $74.19 per month (PMT = $74.19; HP 12C inputs: N = 240, I = 5/12, PV = $11,241.77, FV = $0). This would cover the $72.81 payments calculated above which makes the SBP’s third advantage above null and void (Ha! Take that evil twin!). Of course 20 years from now, term-life premiums will be higher, but remember that the non-SBP-pension amount is also growing along with the CPI so keep reinvesting the difference in premiums (this difference will increase over time) and keeping up with the SBP should not be an issue.
Term-life is flexible. The SBP is for spouses and dependent children. Term-life insurance can be for almost anyone or anything: spouse, dependent children, independent children, your favorite charity or cause, etc. What if the SBP beneficiary does not outlive the pensioner? If you have no dependent children and your spouse dies, the SBP premiums which have been paid are rendered completely worthless (but at least you are alive, right?), whereas, with a term-life policy it may still be worthwhile to continue making premium payments. The world of finance would call these already paid premiums “sunk costs” and they should not be considered when looking ahead. Another way to say this is do not throw good money after bad. However, the bottom line is that there is zero reason to continue paying the SBP premiums, while the term-life option may still be viable.
Additionally, the SBP offers a maximum benefit of 55% of the original pension amount. It is extremely likely that this would not be enough income to sustain whatever lifestyle surviving spouses and children have become accustomed to. Oddly enough, those who choose to utilize the SBP will often supplement with life insurance policies. Term-life on-the-other-hand can be obtained in nearly any amount, and will not need to be supplemented by the SBP.
A lump sum payment from term-life insurance is generally tax-free. Guess what is not tax-free? The monthly SBP payments to a surviving spouse. Ouch! The SBP payments just became $477.95 ( $550 * [100% – 13.1%] = $477.95 ). To be fair, income generated from Treasuries may also be subject to taxation. However, with a tax-free-lump-sum payment you have a better chance of constructing a tax advantaged and/or deferred portfolio (Hello municipal bonds?). This point seems to make the SBP’s 2nd point much less poignant. I would even venture to suggest that the term-life option is a huge winner in the tax round. Once again term-life is flexible.
When the surviving-spouse passes on, the SBP stops but the term-life option can still be passed on to children, grandchildren or whoever (Did I mention that the term-life option is flexible?). I also used a really low 2.16% discount rate. I don’t know where interest rates will be in 5, 10 or 20 years, but interest rates tend to be mean reverting which means they are likely going higher in the future. This will tilt the value even further towards the term-life option.
These last points are the final-knock-out blow to the SBP for me. The term-life option can practically exist indefinitely if managed properly, whereas the SBP dies with its beneficiaries. Ironically, USAA listed the fact that the SBP is permanent as an advantage. No, the SBP is not permanent; it dies with the beneficiaries. The term-life lump sum can be permanent. Even with the inflation protection of the SBP mentioned above, term-life from a reputable company like USAA appears to be a better option for me.
Disclaimer. The information presented above is modeled to meet my personal circumstances. Your circumstances are likely different and may require different inputs into the model and the results may vary. The information presented above is not designed to be advice for readers to act upon, but rather is provided to offer concerns about many of the purported advantages of the Survivor Benefit Plan. Discuss your options with your financial advisor.
Edited. This post was edited and adjusted on 16 October 2015 after a critical error was brought to my attention by an astute reader.