Retire soon? How interest affects your benefits

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A key decision for retirees who are eligible for an annuity can be whether to receive those benefits as an upfront payment rather than as an annuity over time.

If you’re one of those inclined to make a one-time payment and are about to retire, it may be worth considering how rising interest rates — a current state of affairs — are affecting that amount.

Simply put, the higher the rate used to calculate a lump sum – to be actuarially equal to the pension – the lower your payout.

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“The calculation is the opposite of what you think,” said Wayne Titus, a chartered accountant and chief executive at Savant Wealth Management in Plymouth, Michigan.

About 15% of all private sector workers have access to a traditional pension, which is generally funded by the company and sometimes by the employees and provides monthly payments for the remainder of the retiree’s life. Most employees (65%) work for employers that offer 401(k) plans — which are largely employee-funded.

Contrary to the role that interest rates play in lump sum calculations, annuity pensions aren’t directly affected by changes in interest rates, said Linda Stone, a senior pension fellow at the American Academy of Actuaries.

These 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, retirement benefits are subject to a risk of inflation over time because business plans typically do not include an annual cost-of-living adjustment, although state and local pensions may include one.

To illustrate the inflationary erosion, a 1% annual inflation rate would reduce the value of a $25,000 annual pension benefit to $20,488 after 20 years, according to the National Association of State Retirement Administrators. And a rate of 2% would result in an advantage of $16,690.

The calculation works the other way around than expected.

Wayne Titus

Managing Director at Savant Wealth Management

Right now, inflation is at a year-on-year rate of 8.3% — the highest in nearly 40 years and well above the Federal Reserve’s target rate of 2%.

At the same time, to combat inflation, the Fed recently raised a key interest rate by half a percentage point, the second hike this year and the largest in more than 20 years. And more upward adjustments are expected in the coming months.

This is where the connection to flat-rate pensions comes into play. The specific set of IRS-published interest rates – generally based on a corporate bond yield curve – that companies must use in their calculation of lump sums has risen in tandem with inflation.

“Higher rates mean a lower flat rate,” Stone said. “You discount [the value] a stream of future payments.”

While the IRS updates rates monthly, many companies use a month’s numbers — say, August or November — to calculate those one-time payouts for the following year, Stone said.

In other words, a lump sum paid this year based on a lower rate in 2021 would be more than a payout in 2023 determined by a higher rate that year.

To put it simply, if the rate used is 4%, a pension benefit of $5,000 per month ($60,000 per year) over 20 years would result in 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% less.

So if the uptrend continues and you plan to retire on a lump sum in 2023, you could get more if you retired that year.

Of course, interest rates aren’t the only factor to consider when considering a one-time payout.

“One lump sum isn’t best for everyone,” Stone said. “People need to manage that lump sum and make it last a lifetime…some people have the financial means to do it, some don’t.”

And moving a retirement date might be easier said than done. It could also mean losing any income you might have earned in the meantime, or any additional benefit credits you may have earned towards your pension.

The Stone Group offers a free program that provides actuaries to answer people’s questions about their retirement plans. However, she said there may be a number of other things to consider that are beyond her expertise i.e. taxes, estate planning etc.

“There are so many factors at play and people really should talk to a financial advisor before making a decision, especially if it’s a large sum,” Stone said. Retire soon? How interest affects your benefits

Gary B. Graves

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