Workers who opt for lump-sum pension payouts stand to take less and less as interest rates rise more and more.
Kiattikhun Nilsophon/Dreamstime.com
Workers who are considering taking a lump-sum payment from their employer-sponsored pension in retirement shouldn’t wait much longer to decide, as the Federal Reserve’s planned series of interest-rate increases stands to reduce the size of the payout.
Lump-sum payouts are calculated by determining the present value of your future monthly guaranteed pension income, using actuarial factors based on age, mortality tables published by the Society of Actuaries, and the Internal Revenue Service’s minimum present value segment rates, which are updated monthly.
That means there’s an inverse relationship between interest rates and lump-sum pension payouts. When rates are low, the calculated payout would rise because it takes a higher initial sum to arrive at the same future value of your lifetime monthly payments. As interest rates climb, as they are doing now, it takes a lower initial sum to arrive at the same future value of those monthly payments, so the lump-sum buyout decreases.
Why are these dynamics crucial to understand now? Companies sometimes offer lump-sum pension buyouts to workers at or near retirement and former employees with vested pension benefits who haven’t begun taking monthly payments. That reduces the total obligations and risk within their plans, according to Oleg Gershkovich, a pension liability specialist with Voya Investment Management.
With rising interest rates, more corporations likely will offer pension buyouts, seeking to reduce the pension obligations on their balance sheet while paying out smaller lump sums, Gershkovich said. “If rates are higher, sponsors may want to do that in a more intensive way,” he added.
However, taking a lump-sum payment comes with considerable risk, Gershkovich said, pointing to research published in February by MetLife. In an online survey of 1,911 Americans ages 50 to 75 last fall, the insurance giant found that 34% of retirees who took a lump-sum buyout from their defined-contribution plan depleted that sum within five years.
That’s why financial pros say retirees in most cases would be better off collecting monthly payments for the rest of their lives, and their spouses’ lives, if a survivor benefit is available, Gershkovich said. Those monthly checks provide longevity protection, ensuring that seniors don’t deplete their assets during a lengthy retirement, he said. Once workers take lump-sum payments, he adds, “they’re on the hook to make that money last, which is a risk.”
Seniors with limited assets and those concerned that they or their spouse may spend too freely probably should opt for the security of monthly payments, said Wayne B. Titus III, a managing director and investment advisor at Savant Wealth Management. According to the MetLife survey, 79% of retirees who took a lump sum made at least one major purchase, such as a vehicle, vacation, or a new or second home, within a year of getting their money. Monthly payments can serve as “guard rails” and limit such splurging, he said, giving seniors a clear picture of what they can spend each month.
Still, Titus said, there are times when taking the lump-sum payment is the right move. Seniors in poor health, for example, may not live long enough to collect very much money in monthly payments, and taking the lump sum may allow them to leave more money to heirs, he said. Single retirees also may opt for the lump sum since they don’t have to worry about what would happen to a spouse if they die, Titus added.
Some pension plans have capped benefits, so workers who have been with the company for most of their lives might not earn higher monthly payments by sticking around. In those cases, it might make sense to retire early, before interest rates rise further, take the lump sum and work somewhere else, Titus said.
Wealthy seniors may opt for the lump sum since they have other assets besides their pension and Social Security, so they can afford the added risk of investing their buyout and seeking a better return, Titus said. Similarly, seniors who plan to work full or part time may want to invest part of their lump sum, knowing that their regular paychecks will help them weather a market downturn, he added.
Concerns about inflation also may make the lump sum attractive to seniors. Assuming an annual inflation rate of 3%, a $2,000 monthly payment today will be equivalent to about $1,107 in 20 years, according to online inflation calculators. So, retirees should sit down with a financial adviser and calculate whether “it makes sense to take the lump sum and try to get a better return over a longer period of time,” Titus said.
Mark Charnet, CEO of financial-planning firm American Prosperity Group, said that “more often than not,” he recommends that clients take the lump sum. Putting that money in an indexed annuity, which offers a return based on the performance of a specified market index, can be a better option, he said.
Indexed annuities offer principal protection and the opportunity for investment gains when the market rises, serving as a hedge against inflation, Charnet said. However, seniors should be aware of high costs associated with many annuities and understand the details before purchasing one, he added.
“That is something that could be a phenomenal opportunity as opposed to a fixed-income pension,” Charnet said. “But I have to beat the pension in order to make that recommendation. Unless I can show equal income today and greater income tomorrow, it’s very hard to compete with what they already have, which is guaranteed and will come in forever.”
Using a lump sum to buy an annuity might make sense if retirees fear that their employers aren’t financially stable. Private-sector workers should ask whether their companies participate in the Pension Benefit and Guaranty Corp., which will cover a portion of their monthly benefits if their employer’s pension fund becomes insolvent.
Last month, Democratic Sens. Patty Murray of Washington, Tina Smith of Minnesota, and Tammy Baldwin of Wisconsin reintroduced a bill that would require sponsors of pension plans to provide detailed information to participants about proposed pension buyouts. The bill, known as the Inform Act, includes provisions that would require sponsors to provide a comparison of the benefits participants would receive if they take the buyout or accept monthly payments, as well as an explanation of how the lump sum was calculated.
Gershkovich, of Voya Investment Management, said the bill would help seniors “make a fully informed decision” about lump-sum buyout offers. Workers also can take advantage of online educational resources, including this paper from the Society of Actuaries.
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