Deciding on annuitized payments versus a lump sum takes some tricky math.
With the SECURE Act 2.0, required minimum distributions (RMDs) are getting a lot of media attention. Pundits discuss strategies for what to do at certain ages, and how market volatility and rising interest rates may affect distribution strategies from your individual retirement accounts.
But there’s another retirement income source that is affected by both rising rates and inflation – namely pension payouts. While pensions seem to be rarer and rarer these days, if you have one, you may have some opportunities and challenges to think through as inflation and interest rates are on the rise.
Consider this
It’s no secret that interest rates have risen significantly since the beginning of 2022. High-quality corporate bond yields – the interest rates used to value lump-sum payments from a pension plan under Employee Retirement Income Security Act – reached elevated levels not seen in quite some time.
While higher rates impact pensions in a few ways, retirees planning to rely on that income should know that higher rates produce lower lump-sum payouts. That means a lower amount is required for the pension fund to completely “cash out” what it owes you as the participant.
About 15% of private-sector workers have access to a traditional pension
The rate debate
Many defined benefit (DB) plans offer lump-sum payouts based on a uniform interest rate table from the IRS, known as 417(e) rates, which are issued monthly. The calculation is complex; there are actually three different rates or “segments,” based on a number of factors, including one’s life expectancy. What you really need to understand is that there’s an inverse relationship between those rates and lump-sum pension payouts. When the rates rise, the payout decreases and vice versa.
If you’re nearing retirement, you’ll have a decision to make: Do you want monthly payments or a lump sum? In the not-too-distant past, interest rates were low enough to make the lump-sum option more attractive. A rising interest rate environment is bound to have a negative effect on lump-sum payouts. As will inflation.
Just how big that effect is may rely on the answers to these two questions, which you’ll want to know before navigating the numbers.
1. What’s the timeline?
Some defined benefits plans offer lump sums as an ongoing option. Others only do so for a limited time. Find out how yours operates.
2. What rates are used for the lump-sum calculation?
There are several methodologies for the interest-rate calculation, and the calculations can be made monthly, quarterly or annually. Some pension funds even take an average to figure out their lump-sum payments. The key is to figure out your fund’s approach and review the summary plan description with the plan administrator, so you know what you’re dealing with.
On the other hand, pension annuities are not directly impacted by rate changes; they’re determined by a formula based on factors such as age, years of service and salary. You can generally expect a fixed amount per year. However, those monthly payments typically do not come with any cost-of-living adjustments either, which make them susceptible to inflation risk. You’ll want to factor all these things into your decision.
The higher the interest rate used to calculate a lump sum, the smaller the amount.
Timing is everything
Because of the complex math involved, you can see that current interest rates have an outsized effect on your lump-sum calculation, particularly in a rising rate environment. Of course, interest rates have increased in the last 12 months, along with inflation. Both of which would chip away at a lump-sum value.
But there may still be opportunity. Because pension plans typically change their lump-sum calculations once a year, many base their computations on previous months’ rates, as mentioned above. So, some eligible retirees may be able to use older, lower rates when calculating their current lump-sum value.
Know yourself
Of course, interest rates aren’t the only factor to consider when it comes to a one-time payout. Do you have the discipline to properly manage that lump sum so that it’ll benefit you over your lifetime? Are you ready to retire sooner rather than later? Doing so could mean missing out on earned income. There are many factors that come into play, and your human resources department, plan administrator and professional advisors can help you parse the details.
Sources: Worker Participation in Employer-Sponsored Pensions: Data in Brief, Congressional Research Service, as of November 2021; segalco.com; mainstaycapital.com; forbes.com; cnbc.com
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