# Rates Up Lumps Down

Richard Connor

WE HAVE ALL BEEN affected by rising interest rates in 2022, from skyrocketing mortgage rates to plunging bond prices. A less-publicized casualty: Higher interest rates are having a big effect on those approaching retirement who are eligible for a pension.

How so? Many pension plans offer a choice between a lifetime stream of monthly income and a onetime lump sum payment. Rising rates could reduce the lump sum payment that many employees would receive next year by 25% or 30%.

My former employer’s pension plan offers a good example. It’s a final average pay plan that provides a lifetime monthly annuity payment at retirement, typically defined as age 65. The monthly income amount is based on three factors: an employee’s years of service, an accrual factor usually expressed as a percentage of annual pay and the employee’s average salary over his or her final three years of employment.

In 2014, my company added a lump sum option to the pension plan. An employee could elect to get a large, onetime payment instead of a monthly annuity. We were told the plan would follow the IRS section 417e method and use the minimum interest rates.

It turns out the calculation uses the time value of money. Specifically, the lump sum can be thought of as the amount you’d need to invest today, at a specified interest rate, to generate a stream of payments equal to or greater than the monthly annuity. The calculation uses an employee’s age to model his or her expected longevity.

The critical factor, however, is the chosen interest rate. The higher the interest rate, the smaller the lump sum. This makes intuitive sense. If you can earn a higher rate of return on your money, you need less of an investment to generate a stream of payments equal to the monthly annuity you could otherwise have chosen.

Because retirement can last for many years, the IRS breaks the interest rates used into three time segments—the first five years of retirement, years five through 20, and any time after that. IRS Section 417e provides interest rates for each segment.

The IRS’s interest rates have risen sharply this year. The interest rates prescribed by the IRS for October 2022 are 5.1%, 5.83%, and 5.68% for the first, second and third segments, respectively. By comparison, the equivalent rates in October 2021 were 0.87%, 2.74%, and 3.16%.

The IRS also allows pension plans to define a stability period when interest rates don’t change. Many plans use the calendar year as their stability period. That means that plans, which are currently using last year’s low rates, will likely switch to using higher interest rates starting Jan. 1, 2023.

The upshot is the lump sum retirees will be offered will soon be significantly less than what they might get today. Many employees are just learning of this change to their pension options, and have precious little time to make a critical decision.

In September, Ford Motor sent an email to some pension-eligible employees that explained that their lump sum option in 2023 would decrease by some 20% to 25%. To receive the higher lump sum, they would have to retire by Dec. 1, 2022.

I first heard about this issue a few weeks ago when a former colleague contacted me in a mild panic. She’d left our former employer a few years ago. She’s almost 58 and eligible to start a reduced pension.

Employees could take their pension as early as age 55, but the monthly payment would be reduced by about 8% per year, so it’s actuarially equivalent to the benefit at the plan’s full retirement age of 65. She was most likely going to wait until 60 to take her pension, but now the change in interest rates would reduce her lump sum payment by about 30%. She’s in a quandary about what to do.

I spoke with another colleague still employed by the company that will pay his pension. He’s 60 and was planning to work for a few more years, so he could continue to enjoy the salary and health benefits. His lump sum will be reduced by about 30% next year.

To collect his higher lump sum payment this year, he’d have to put in for retirement now, and then find another job or possibly return as a consultant. We discussed his options. He said he’ll likely continue working and let the decision ride.

The change in lump sum payments doesn’t affect the size of the monthly annuity payments, by the way. That payment option is still available to my former colleagues.

It’ll be interesting to see what people decide. A well-planned retirement, with time to consider all your choices, is difficult enough to achieve. The stress of a tough decision, with scant time to consider it, is proving to be a real challenge for those approaching retirement.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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1 year ago

Great article, Richard. This same exact thing happened to me this year – I retired in August, fully expecting to take the company pension annuity. Just for kicks, I put the pension lump sum amount into the Schwab annuity calculator to see how much I could get monthly as a SPIA, and was shocked to find out I could get a monthly amount 26% higher from an external insurer! Digging into it, the reason was exactly as you said – the interest rate used for the company pension was set last year when rates were low, so of course by taking the lump sum, I was able to get an annuity for a higher amount this year. The timing worked out really well for me, retiring during this “sweet spot”. My only complaint was that I had to forego about 3 months of payments – the company pension would have started right away, but it took me about 2 weeks to make the decision to take the lump sum, then 6 weeks for the company to process the lump sum request and send me the check, then 4 weeks for the annuity insurer to set up the account. But at a 26% higher rate, I’ll make up the 3 missing payments within a year! The marketplace annuity also has the benefit of offering a 10 year period certain, so if I die early, my beneficiary will get the remaining payments up to the 10 year mark.

1 year ago

Very timely article Richard. My LS is set to be deposited into my IRA account in the very near future. I am lucky enough to still be employed after being outsourced and plan to retire in 2 years. I was originally ready to take the Pension Annuity until I looked into the current LS value and what fixed annuity I could buy on the open market. The lump sum would have dropped by 30% next year and I can buy a 2-year deferred income annuity with a 30% higher monthly payout. Both annuities have the 100% spousal benefit. The market annuity has the added benefit of a cash payout of the balance to our children if we don’t receive the one-time premium back in benefits. I believe the highly rated insurance companies are of equal or less risk than my previous employer when it comes to paying out. I have an amount approx equal to my lump sum in my 401K, so I just need to decide how much of the LS to lock up in the fixed annuity.

1 year ago

As a follow-up, my friend chose the LS. Her advisor suggested they could purchase an immediate lifetime annuity. I did some research and it appears she could get a lifetime annuity with a cash refund and receive about 25% more per month than the original plan’s monthly annuity. As stealea suggests below this is truly a unique opportunity.

1 year ago

Very good article Richard. My only (tangential) comment is that a person who’s considering taking the LS rather than the pension option should understand other potential consequences besides just the monetary payout considerations. Specifically, if a person intends to take the LS and then purchase an annuity they really need to understand the non-monetary differences between the two. I’m referring to the considerable ERISA protections afforded a monthly pension from a qualified pension plan, as well as the Pension Benefit Guaranty Corp backing. Depending on the state, individually purchased annuities may have significant less protections from creditors, lawsuits, and default by the issuing insurance company. Taking the LS might still be the best choice, but a person needs to understand what protections they might be giving up if they do so.

1 year ago

A cash value pension is just the opposite. You have a definite sum of cash in your account, and your can either move it as a lump sum to an IRA, or turn it into an annuity at some point in time. If rates are high at that time, then you will get a higher monthly payment.

Last edited 1 year ago by Ormode
1 year ago

A Cash balance plan is technically a defined benefit plan and the amounts people see are actually just notational amounts . The funding the same as a traditional defined benefit plan.

1 year ago

When the megacorp I worked for started fooling around with the pension plan (which went away altogether in a few years) they ofered a lump sum option. When I looked at the annuity the LS would buy and compared it to my pension I thought they must be joking. I took the pension – one of several reasons I retired early was because my pension would not increase after 30 years.

1 year ago

There is the other side to issue as well. It is common for retirement sites to suggest that if one does not have a pension one should take a portion of one’s assets and purchase an immediate annuity to assure a guaranteed monthly income. Once in a while I would do this and after looking at the paltry payout due to the then low interest rates, laugh and say to myself that I wasn’t doing that. I’d be better off to leave the funds invested and live without a guaranteed income stream beyond SS. Anyway, I just checked one of the immediate annuity sites, and the monthly amounts have increased dramatically. Very dramatically! So, perhaps for some readers this might be a time to consider getting that guaranteed monthly income stream.

1 year ago

I think that is and was true. The value is not only a stream of income, but no downside risk. I think the key word is PORTION of retirement assets.

1 year ago

The hectic nature of one’s work world is indeed a deterrent to well-considered financial decisions. During my working years, I often relied on intuition and instinct, backed up by lifelong learning and saving. That luckily worked out well for me. The immediate goal was always the satisfaction of making the best choices given the circumstances. If I felt I was doing the best I could, that was sufficient for me even during periods of financial turbulence.

Being newly retired, I am purposely waiting until next year to annuitize my 403b. The decision (many withdrawal options exist) still has to sit right, both intellectually and intuitively. Although I could take lump sum distributions, the thought of a lifetime “paycheck” is winning out, even given inflation considerations.

1 year ago

Indeed, expect to see plenty of lump sum eligible folks across the country electing to retire to capture the bigger lump sum payouts. Nothing beats the market-timing certainty of receiving a much larger lump sum payout based on near zero interest rates of the past, and then being able to invest at significantly higher interest rates going forward.
Retirees at my company (myself included) regularly took advantage of this game, but normally the lump sum impact was maybe 10% or so. As you point out, today’s unprecedented interest rate increases can impact the lump sum by a whopping 20-30%.

1 year ago

Re this

Nothing beats the market-timing certainty of receiving a much larger lump sum payout based on near zero interest rates of the past, and then being able to invest at significantly higher interest rates going forward.”

As well as being able to invest the lump in a down market.

1 year ago

Touché Michael. Or investing that larger lump-sum at whatever stock\fixed-income ratio that makes you feel comfortable.

1 year ago

There is an easy answer to this Richard, there should not be a lump sum option in a defined benefit pension. The entire concept is a life and perhaps joint life annuity.

When I negotiated pension plans the unions were opposed to LS payouts because they knew what could happen when some workers got their hands on a few hundred thousand dollars.

Eventually, we agreed on LS payouts for terminated vested employees not eligible for early retirement. That meant that neither the company nor unions had anything to do with those folks once they left the company unlike they did with a “retired” worker.

It’s not hard to find articles these days claiming 401k plans have been a failure because they don’t accumulate a guaranteed income like a pension and at the same time we find people wanting a LS in lieu of their pension thus shifting all their income risk to themselves.

The argument goes, if I die the day after I retire, nobody gets the cash, but if I take a LS there is always money – maybe. Seems like there are better ways to provide for survivors and if survivors are not the issue, does it really matter?

1 year ago

A normal person cannot make this decision on their own. They must have a CPA, CFA or RIA (hourly basis) analyze the situation and provide the pros and cons of each position. Then, one can decide; and if you take the lump sum, you better know how to invest the money or hire Fidelity, TD Ameritrade or Vanguard to manage that money for you at a reasonable fee below 0.5%/annum. EOS

1 year ago

Dick, our plan never had a LS option until they froze the traditional plan and replaced it with a Cash Balance plan. At that time the LS was added, but it did not consider the early retirement subsidy that many of us were eligible for. My company used a pension consultant to recommend the CB plan. We heard that that company told our leadership that adding the LS option would spur many folks to retire early and take the LS, even though it was a significant reduction in the actuarial value to the employee. This did not happen, and they had to freeze the CB plan after about 20 months. The “what if I die early” sentiment is very strong and hard to combat.

1 year ago