Many baby-boomers have earned pensions over their working careers and are confronted with the complex decision of how best to optimize it. Some plans offer the choice of a lump sum that can be rolled over pre-tax to an IRA instead of a lifetime monthly payment. Next year, 2021, will likely be an optimal year to elect the lump sum for many.
While you can and should obtain pension projections from your employer, understanding the key variables will help optimize your benefit. Interest rates and life expectancy are the two key variables that determine lump-sum amounts. An inverse relationship exists between rates and lump sum values. The lower the rates, the higher your lump sum.
Specifically, most plans use the IRS segment 417(e) rates to determine your lump sum. For example, Goodyear uses August segment rates to determine lump sum values for the next calendar year while Akron Children’s uses November rates. Year 2020 rates determine lump sum values in year 2021. It is essential to know the measurement month for your plan.
There are three segments with varied interest rates. Segment one applies to pension income in years 1 – 5, segment two years 6 – 20, and segment three years 21 and more. Like mortgage rates, the longer-term rates are generally higher than the shorter-term rates and thus have a greater discounting effect.
Let’s assume Sue is 65 and is considering when to elect her pension lump sum. Sue is entitled to $60,000 a year for her or her spouse’s lifetime. IRS life expectancy assumes she will live another 23 years to age 88.
To determine lump sum values, the $60,000 will be discounted by the segment interest rates for each year through life expectancy back to today’s dollars. For example, the $60,000 at age 85 may only be worth half this amount in today’s dollars. (Recall that a dollar in the future is worth less than a dollar today because of inflation.)
Interest rates fell sharply through 2019 and again in 2020. In analyzing Sue’s pension, we found the lump sum value was approximately $1 million in December 2020 but increased to ~$1.1 million in January 2021. What a difference one month makes!
It is often helpful to consider what hurdle rate you need to earn on your invested lump sum to produce the same monthly income promised under the pension. In Sue’s case, we found a 1% return is requested if they live twenty years or 4% if living for thirty years.
While these hurdle rates may seem low, remember lump sum values are higher because of low interest rates. If you are investing in bonds, you generally should also expect low returns. Thus, eclipsing the hurdle rate may be difficult. However, if you own more stocks in a diversified fashion, you will be more likely to earn the hurdle rate or more over time.
The hurdle rate analysis above assumes the average return is achieved each year without variation. In reality, returns will vary. Variability always makes the compounded return less than the average return. Average returns are theoretical while compounded returns support your retirement spending.
Think of it this way. Would you prefer:
- Portfolio “A” with 20% year one return and -10% year two return or
- Portfolio “B” with a 5% return in both years
Each portfolio has an average 5% return. Yet portfolio “A” grows by a cumulative 8% after two years while portfolio “B” grows by 10%. The volatility in portfolio A’s return makes the growth less than portfolio B. Factoring in regular distributions may further increase the dollar disparity.
In addition to the investment risks you assume by electing the lump sum, there is a slew of other considerations as well. These include life expectancy, legacy goals, tax planning opportunities, and integration of Social Security claiming strategies to start.
While a lump sum can often make sense, it would be wise to consult a subject matter expert to evaluate the decision in the context of your financial plan before making an irrevocable decision.
Kevin Kroskey, CFP® | November 2020