Thinking of taking a lump sum from your pension plan? Tread lightly.

Rates Up Lumps Down

Richard Connor  |  Nov 29, 2022

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.

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