If you have a pension plan, there’s a tricky decision you’ll be faced with as you near retirement. Will you take your benefits as a lump sum, or as a series of payments over time? For those leaning towards the former option, there’s some information you may want to have: That choice is a bit more complicated now. There are pluses and minuses to both options. This is because of inflation, and rising interest rates.
You see, lump sum payouts have dropped by around 30%. Why is this? Rising interest rates can, in some cases, be a blessing for pension plans. This is because their bonds can earn more interest, making it less expensive to fund future payments. But, unfortunately, for those nearing retirement, lump sum payouts fall, because they are calculated based on what future benefits cost today.
This situation has led to quite a dilemma for employees. On one hand, they could retire soon and lock in a lump sum. Or, they could remain on the job, and risk reduced payouts if interest rates continue to rise. This could be one of the biggest financial decisions that you’ll make.
Workers with pension plans that update their lump sums annually may still get 2021’s higher lump sums. However, this is only if they retire soon. Retiring early in order to take a higher lump sum payment might make sense for some people. But for others, who aren’t emotionally or financially prepared to retire yet, may be better off remaining on the payroll to bolster their finances. For example, if you have a 401(k) account that has lost ground this year.
This decision to retire requires extensive analysis and planning. As a result, retiring early just for this benefit may not be a good decision.
Pensions are Subject to Inflation Risk
In stark contrast to the effect that interest rates have on the lump sum option, the annuity/string of payments option isn’t impacted by rate changes. However, it is subject to inflation.
To illustrate inflationary erosion, let’s take a look at the facts. Just a 1% annual inflation rate reduces the value of a $25,000 per-year pension benefit to just $20,488. Right now, inflation is running at a rate of 8.6%, the highest it’s been in over 40 years, and obviously far, far above the Fed’s target rate of 2%.
At the same time, the Fed increases interest rates to combat inflation. This is where the connection to 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, have been rising alongside inflation.
So, in short, higher interest rates mean a lower lump sum. However, higher inflation means less valuable payments. So then, which choice is the superior one? Well, interest rates aren’t the only factor to consider when making this choice. It’s even more complicated than that.
Reach out to Messina’s Wealth Management. We can discuss your finances with you, including this choice and other important decisions you may be struggling with.