As you’re nearing retirement and are due a pension, a tricky decision you’ll be faced with is whether to take your benefits as a lump sum, or as an annuity over time. For those leaning towards an upfront payment, the choice may be more complicated now, because of rising interest rates.
As rates rise, lump sum payouts are dropping by as much as 30%. Now, rising interest rates can be a blessing for pension plans. This is because their bonds can earn more interest, making it less expensive to fund future payments. Unfortunately for those nearing retirement, lump sum payouts fall, because they are calculated based on what future benefits cost today.
This situation has created a dilemma for employees. They could retire soon to lock in a lump sum. Or, they could remain on the job and risk reduced payouts if interest rates continue to rise. For a lot of people, this is the biggest financial decision they’ll make.
Workers in pension plans that update their lump sums annually might still be able to get 2021’s higher lump sums. But, only if they retire soon. Retiring early to take a higher lump sum may make sense for some people, who have planned to leave their job soon and are prepared emotionally and financially for such a thing.
But others may be better off remaining on the payroll to bolster their finances. For example, their 401(k) accounts that have lost ground this year. The decision to retire requires financial analysis and planning. As a result, accelerating your retirement just for this situation may not be the right move.
Pensions are Subject to Inflation Risk
In contrast to the effect that interest rates have on the lump sum option, the annuity/periodic payments option is not directly impacted by rate changes. However, this method is subject to inflation risk over time. This is because company plans don’t typically include an annual cost-of-living adjustment.
To illustrate inflationary erosion, let’s look at the facts. A 1% annual inflation rate reduces the value of a $25,000 yearly pension benefit to 20,488 after 20 years. A 2% annual rate would translate into a benefit of 16,690… And right now, inflation is running at a rate of 8.6%, the highest it’s been since 1981, and obviously far above the Fed’s target rate of 2%.
At the same time, to combat inflation, the Fed boosts interest rates. This is 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.
In short, higher interest rates means a smaller lump sum. However, higher inflation means less valuable payments. So then, which is the superior choice? Well, of course, interest rates aren’t the only factor you should consider when making this choice.
Reach out to our firm. We can discuss this, and other important financial decisions you may be struggling with.