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Pensions are subject to inflation risk
In contrast to the role that interest rates play in lump sum calculations, pensions are not directly affected by price changes, said Linda Stone, senior fellow for pensions at the American Academy of Actuaries.
These payments are generally determined by a formula — based on factors such as age, years of service, and salary — and are a fixed amount per year.
At the same time, to combat inflation, the Federal Reserve last week raised its key interest rate by 0.75 percentage points, marking the third increase this year and the largest since 1994. Additional upward adjustments are expected.
This is where the correlation to total pension amounts comes in. The specific set of interest rates published by the IRS – generally based on the corporate bond yield curve – that companies must use in calculating the total amount has been increasing along with inflation.
“Higher rates mean a lower lump sum,” Stone said. “You are discounting [the value] for a stream of future payments.”
How interest rates affect pension payments
Stone said that while the IRS updates interest rates monthly, many companies use one-month numbers — say, from August or November — to calculate those one-time payments for the following year.
In other words, the total amount paid this year and based on a lower rate set in 2021 will be more than the 2023 payments set at a higher rate this year.
Simplified explanation: If the rate used is 4%, a pension benefit of $5,000 per month ($60,000 per year) over 20 years would result in a lump sum of about $815,419, Titus calculates. At 6%, the one-time payment would be about $688,195 – a difference of $127,224 and about 16% less.
So, if the upward trajectory continues and you plan to retire in a lump sum in 2023, you can have more if you retire this year.
The “financial resources” needed to manage a lump sum
Of course, interest rates aren’t the only factor you should consider when it comes to a one-time payment.
“A total is not better for everyone,” Stone said. “People have to manage that lump sum and make it last their whole lives…Some people have the financial resources to do it, and some don’t.”
Plus, talking about when to retire may be easier said than done. It could also mean losing the income you would have on temporary or additional benefit credits that you might have earned from your pension.
The Stone’s Group offers a free program that provides actuaries to help answer people’s questions about their pension plans. However, she said, there may be a range of other things to consider that are beyond their expertise, such as taxes, estate planning, etc.
“There are many factors that play a role, and people should speak to a financial advisor before making a decision, especially if it is a large amount,” Stone said.