2022 has been an eventful year in financial markets. To cool inflation currently running at multidecade highs, the Federal reserve has enacted a series of short-term interest rate hikes, raising rates from 0.25% in March to the range of 3.75%-4% as of November. With rising interest rates impacting borrowing costs and, as a result, potentially impacting consumer demand and corporate revenue, stock markets have fallen year to date. Bond prices have also decreased, as their prices tend to fall in a rising interest rate environment due to more attractive yields on new issues that come to market. What may be less clear is how pensions may be affected by interest rates.
Pension Basics
Before discussing how interest rates can affect pensions, it’s important to review some pension basics. Typically, your pension benefit is based on your years of service and the plan formula for lifetime payments. As a simplified example, the plan may define your pension factor as your years of service multiplied by 2%. To determine your retirement benefit, the plan may then use final earnings, or an average of your final earnings, at normal retirement multiplied by this factor. Your retirement benefit could look something like this:
(20 years of earnings x 2%) x $5,000 per month final pay = $2,000 per month retirement benefit
How Is Your Pension Benefit Paid?
Looking at different pension benefit payment options is where interest rates can come into play. Based on our example, the monthly retirement benefit shown above is a single-life benefit, or, in other words, a benefit that lasts for the duration of the plan member’s life only. Depending on your pension, you may also have the option for joint benefits. With this option, your joint annuitant (typically your spouse) can receive anywhere from a partial pension benefit to 100% of the member’s benefit when he/she passes away. The primary benefit will generally be lower with survivorship features than it would be for a single-life payout, but payments will continue for the duration of the member’s life and the life of the joint annuitant.
Pension plans may also offer a cash payment option, or a lump sum. This payment is the present value of the benefit payments when factoring in life expectancy and interest rate assumptions. The latter assumption is based on what’s known as minimum present value segment rates.
What Are Minimum Present Value Segment Rates?
Each month, the IRS reports their minimum present value segment rates, which are based on current corporate bond yields. The first segment represents short-term corporate bond yields, the second segment represents intermediate corporate bond yields and the third segment represents — you might have guessed it! — long-term corporate bond yields. On an ongoing basis, pension plans incorporate these rates to revalue the lump sum value of their benefits.
How Do Minimum Present Value Segment Rates Affect Pension Lump Sums?
During periods where interest rates are somewhat stable, you may not notice much of an effect. However, during periods where interest rates experience significant changes, minimum present value segment rates can have a meaningful effect on a lump sum payout.
To illustrate this effect, let’s assume a pension plan going into 2022 held an interest rate assumption of 2% with a 25-year life expectancy. If we go back to our pension member with a projected benefit of $2,000/month, their lump sum payout would be approximately $472,000. Fast forward to the end of 2022, and the interest rate assumption in the plan has jumped to 4%. This would result in a lump sum payout of about $379,000, or a reduction of about $93,000. If we experienced a declining interest rate environment and the rate dropped to 1%, the lump sum would be roughly $530,000. In short, interest rates have an inverse relationship on the value of future cash flows.
If You Have a Pension, Should Rising Interest Rates Affect When You Retire?
Your retirement decision depends on your specific situation, and there are several factors involved. If you’re years from retirement, changes in interest rates may be a non-factor, as you’re still accumulating assets for retirement and those rates may ebb and flow over time. If you’re close to retirement, it’s important to evaluate your pension closely, including the relative value of single-life benefits, joint benefit options with survivorship and lump sum payments both before and after revaluation for current interest rates. Your plan may also be less sensitive to interest rates based on its revaluation method, and a plan that revalues benefits more frequently or uses minimum present value segment rate averages, rather than spot rates alone, could experience smaller swings. For example, the Aramco Retirement Income Plan, or RIP, calculates a lump sum benefit by using a 24-month average of minimum present value segment rates or by using a four-month lookback. Once calculated, the RIP recipient would receive their lump sum based on whichever of the two calculations provides the larger benefit.
Crucially, consider retirement by looking at the big picture, which includes your desired goals, non-pension resources (such as your investment portfolio and other sources of retirement income) and expected longevity. As always, it’s a great idea to your review your pension in the context of your overall financial plan with your Wealth Manager and Financial Planner.
References:
https://www.irs.gov/retirement-plans/minimum-present-value-segment-rates
https://www.irs.gov/pub/irs-drop/n-22-60.pdf
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