Interest Rates and Pension Lump Sum Payouts

Early in my career, I spent six years with a company that offered a defined benefit retirement plan. I worked there just long enough to vest in the plan.  When I turn 65, I can choose monthly payments or a lump-sum cash-out.  The monthly payments are formulaic, related to years of service and my compensation at the time.  Once a year, I log in to make sure they haven’t forgotten me, moved websites, otherwise forgotten me, or — in this age of cybercrime — allowed a fraudster to hijack my account.

This weekend, when I checked in, I noticed my lump-sum payout had declined by about 8%.  How did that happen?  The rise in interest rates (and possibly changes in the actuarial table). The company calculates the lump sum as the present value of the monthly payment over my expected life.   Those monthly payments are discounted by interest rates that track the bond market. Over the last year, those rates have increased by over 100 basis points. The present value of my monthly payments therefore drops. As rates rise, the value falls, and as rates drop, the value increases.

There is an intuitive counterargument. If I take the cash, I can invest it in bonds and earn higher interest rates than I could have a year ago. Doesn’t that offset the reduced payout?

Likely but not necessarily. Higher yields improve the income I might earn on the money I receive, but they also reduce the amount I receive in the first place. Whether the two effects offset each other depends on the details — including the rates used to calculate the lump sum, the investments available to me when I invest the money, and when I actually receive the money in my brokerage account,

The website notes that rates have been updated, and that the company updates them only once a year.  If rates drop before I cash out, I lose out, and if they rise, I come out ahead.   In this plan, rates change only once a year.

My experience is a good example for those with a DB plan who count on cashing out: the lump sum isn’t set in stone, and you need to make sure your long-term financial plan reflects the lump sum as variable, not fixed. Think of it as a bond whose value will fluctuate with interest rates.

My firm fights elder financial fraud and helps seniors monitor their financial data, so I would be remiss not to remind you to check in once a year on former employer DB  and DC plans to make sure that they have your correct contact information, that you have the right website and login credentials.  I would also make sure your spouse or your ‘final directions’ have the information to collect a death benefit.  In my experience, this plan provides one piece of mail a year, so it is easy for an old DB plan to get overlooked.

Interest rates touch our lives in many ways. Don’t overlook one of them: the value of a pension benefit you earned years ago.

Matt Halperin, CFA, is the founder of Act2 Financial, an app that helps seniors avoid financial fraud. For 30 years, he worked as a portfolio manager and risk manager at large U.S. money managers. Matt currently serves on the investment committee of two endowments.  He has a BA and MBA from the University of Chicago, and resides outside of Boston. Matt’s previous articles were Taking the Keys and Where It Nets Out.