For individuals with pension plans, interest rates may impact retirement wealth. When starting a pension payout, several options will be available. The typical choices are: 1) payments for life, 2) payments for life plus the life of a survivor, and 3) lump sums. Plans will typically offer a few variations of the life payment and survivor options.
On average, all of these payment choices should result in the same payout over the retirement period. Pension payers use formulas to achieve equivalence between options. Many retirees selection a lump sum because they believe, for their specific case, investing the cash at the beginning of retirement will yield more money throughout their life. An additional benefit is that the lump sum, and any earnings from investing it, can be passed on to heirs.
The two key factors of the formulas that determine lump sums are longevity and interest rates. Longevity assumptions are standardized from IRS data. While longevity numbers may be adjusted through time, they are fixed in the short term.
Interest rates have no affect on anyone opting for a steady stream payment. For those selecting lump sums, the impact is significant. Pension payments are largely based on interest rates. Therefore as interest rates rise, less cash in needed to produce a fixed stream of income. Since the goal is total payout equivalence for all options, lump sum payments must decrease to maintain equivalence.
The Federal Reserve has made their intent to increase interest rates clear. While there is not necessarily a direct linkage between Fed rates and the lump sum that will be offered by a pension, there is a positive connection between rising interest rates and lower lump sum pension payments.
A decreased lump sum does not necessarily mean that retirees should steer away from lump sums. As with all aspects of retirement, the best choice for an individual depends on many factors. However, those nearing retirement should be aware of the connection between interest rates and lump sum payment amounts. If you would like more assistance in determining how this could impact your plans, please contact us.