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One major decision facing near-retirees who are due a pension can be whether to take those benefits as an upfront lump sum rather than over time as an annuity.
If you’re among those leaning toward a one-time payment and are edging close to retirement, it may be worth considering how interest rates have risen — a current state of affairs — affect that amount.
In simple terms, the higher the rate used to calculate a lump sum — to make it actuarially equivalent to the annuity — the smaller your payout.
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“The calculation works the opposite of what you’d think,” said Wayne Titus, a CPA and managing director at Savant Wealth Management in Plymouth, Michigan.
Roughly 15% of all private-sector workers have access to a traditional pension, which is generally funded by the company and sometimes employees, and provides monthly payments for the rest of the retiree’s life. Most workers (65%) are at employers that offer 401(k) plans — which are largely funded by the employees.
In contrast to the role that interest rates play in lump-sum calculations, pension annuities are not directly impacted by rate changes, said Linda Stone, senior pension fellow at the American Academy of Actuaries.
Those payments are generally determined by a formula — based on factors such as age and years of service — and are a fixed amount per year.
However, pension annuities are subject to inflation risk over time, because company plans typically don’t include an annual cost-of-living adjustment, although state and local government pensions may include one.
To illustrate inflationary erosion: A 1% annual rate of inflation would reduce the value of a $25,000 yearly pension benefit to $20,488 after 20 years, according to the National Association of State Retirement Administrators. And a 2% rate would translate into a benefit of $16,690.
Right now, inflation is running at a rate of 8.3% year over year — the highest in nearly 40 years and far above the Federal Reserve’s target rate of 2%.
At the same time, to combat inflation, the Fed recently boosted a key interest rate by a half percentage point, marking the second increase this year and the biggest hike in more than 20 years. And additional upward adjustments are expected in the coming months.
That’s where the connection to pension lump sums comes in. The specific set of IRS-published interest rates — generally based on a corporate bond yield curve — that companies must use in their lump sum calculation has been rising alongside inflation.
“Higher rates mean a lower lump sum,” Stone said. “You are discounting [the value] of a stream of future payments.”
While the IRS updates the rates monthly, many companies use one month’s numbers — say, from August or November — to those one-time payouts calculate for the following year, Stone said.
In other words, a lump sum paid out this year and based on a lower rate set in 2021 would be more than a 2023 payout determined by a higher rate this year.
A simplified illustration: If the rate used is 4%, a pension benefit of $5,000 monthly ($60,000 a year) over 20 years would yield a lump sum of about $815,419, Titus calculated. At 6%, the one-time payout would be about $688,195 — a difference of $127,224 and about 16% lower.
So, if the upward trajectory continues and you’re planning to retire with a lump sum in 2023, you could get more if you were to retire this year.
Of course, interest rates aren’t the only factor you should consider when it comes to a one-time payout.
“A lump sum isn’t best for everyone,” Stone said. “People have to manage that lump sum and make it last their lifetime … some people have the financial wherewithal to do that, and others don’t.”
And, moving up a retirement date may be easier said than done. It also could mean missing out on income you would have earned in the interim or additional benefit credits you may have earned toward your pension.
Stone’s group offers a free program that provides actuary experts to help answer people’s questions about their pension plans. However, she said, there may be a raft of other things to consider that go beyond their expertise, ie, taxes, estate planning, etc.
“There are so many factors that come into play, and people should really talk to a financial advisor before they make a decision, especially if it’s a large sum,” Stone said.