How to Retire With a Pension Plan
As you near retirement, and are due a pension, there’s a tricky decision that you’ll be faced with. This is whether you’ll take your benefits as a lump sum, or as a series of payments over time. For those leaning towards the lump sum option, there’s some information you may want to have: The choice may be a bit more complicated now, because of rising interest rates.
You see, lump sum payouts have dropped by as much as 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. Unfortunately for those nearing retirement, though, lump sum payouts fall, because they are calculated based on what future benefits cost today.
This situation has created quite a dilemma for employees: 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. For millions of people, this is one of the biggest financial decisions they’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 may make sense for some people. Provided, they have planned to leave their job soon, and are prepared emotionally and financially for such a thing. But, others 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. The decision to retire requires analysis and planning. As a result, fast-forwarding to retirement just for this benefit might not be the right move.
Pensions are Subject to Inflation Risk
In contrast to the effect that interest rates have on the lump sum option, the annuity/periodic payments option isn’t directly impacted by rate changes. That being said, this method is subject to inflation risk over time. This is because company plans don’t typically include an annual cost-of-living adjustment.
For example, to illustrate inflationary erosion, let’s look at some numbers: A 1% annual inflation rate reduces the value of a $25,000 yearly pension benefit to just 20,488 after 20 years. And, right now, inflation is running at a rate of 8.6%. This is the highest it’s been since 1981, and obviously far, far above the Federal Reserve’s target rate of 2%.
At the same time, the Federal Reserve increases interest rates to combat inflation. This is where the connection to pension lump sums comes back 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, has been rising alongside inflation.
So, in short, higher interest rates mean a higher lump sum. However, higher inflation means less valuable payments. So then, which choice is the superior one? Well, of course, interest rates are;t the only factor you should consider when making this choice. It’s more complicated than that.
Reach out to American Principal. We can discuss your finances with you, including this and other important decisions you may be struggling with.