Let Me Clarify
Lump-Sum Pension UPDATE

Recently, the IRS announced an increase in the interest rate used to calculate lump-sum pension benefits. In some cases, companies have notified employees of a 20-25% reduction in their estimated pension amounts.

While this may not have a huge impact on individuals planning to work quite a few more years, this could make a profound difference for those planning to retire within the next few years.

What pensions are affected by this change?

Pensions typically come in two forms: traditional annuities and cash balance plans. Traditional annuity pension plans are not as common today and are structured to provide a monthly income stream paid to retirees for the duration of their lifetime. A cash balance pension, on the other hand, is a bucket of money that retirees have the option to “cash out” at retirement (take the lump sum in cash to spend, save, invest, etc.) or convert into a monthly annuity.

The IRS interest rate announcement essentially has no impact on annuity options and specifically impacts lump-sum cash out options.

How exactly does the “interest rate” impact lump-sum pensions?

The relationship between interest rates and lump-sum pensions is similar to the way interest rates affect bond prices. As pension interest rates rise, lump-sum values drop. And as pension interest rates drop, lump-sum values rise. This has to do with background calculations used to determine the Net Present Value of cash balance pensions.

Without getting into the weeds, it boils down to how much you would need today, at a fixed growth rate, to provide yourself with the same monthly distribution as the annuity option payout

For example, let’s assume you had an eligible annuity option of $2,000/mo. and a life expectancy of 25 years; a total estimated payout of $600,000.

  • If your lump-sum had a 0% interest rate (no growth at all), you would need the full $600,000 today to pay out $2,000/mo. for 25 years.
  • As an alternative, if your lump-sum were to grow at a fixed 5% per year, you would need a little over $342,000 today to pay out the same $2,000/mo. for 25 years.

These may be two extreme examples, but it helps explain just how much of an impact interest rates have on lump-sum pension calculations. Regarding the recent interest rate change, companies have referenced an estimated 20-25% reduction in lump-sum values.

When will this change take place?

The announced change in interest rates will affect pension plans as soon as January 1, 2023. This leaves a short window to potentially make a crucial retirement decision.

What should I do?

First and foremost, you may not need to do anything unless you are 1.) planning to retire in the next couple years, 2.) have a cash balance pension plan, AND 3.) are considering taking the lump-sum payout option.

If you do happen to check off all three boxes, the decision you are left with is whether to consider accelerating your “retirement” timeline. Retirement is in quotations here, because there may even be some cases where it makes financial sense to “retire” to receive the larger lump-sum amount, even if you’d attempt to get rehired after a period of time or go back to work somewhere else.

As you might assume, there are many trade-offs to consider when factoring this into your broader financial plan. However, this is one of those times when “life happens”, which also happens to be the best time to have a plan in place. So, if this impacts you or someone that you know, I encourage you to evaluate your options before it’s too late.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.