As you near retirement, there are many decisions to make. For those lucky enough to have a pension, you must decide whether to take monthly pension payments for the rest of your life or take the lump sum distribution instead. If you choose the lump sum payment, you must also decide when to take it. Recent rising interest rates may play a role in this decision.
We understand the allure of lifetime pension payments, which you will receive for the rest of your life no matter how long you live. The downside is that most pensions are not flexible and do not include a cost-of-living adjustment to keep pace with inflation.
Lump sum distributions are one-time payments that are usually transferable into a retirement account. The distribution is not taxed until the funds are withdrawn from the retirement account. The lump sum provides you with control over the funds but invites market risk to the table. This means the value of your lump sum can fluctuate due to market conditions and the investment choices you make and is not guaranteed to be there for your lifetime.
Let’s assume you have decided on the lump sum payment option for this article. The next decision is when to take the lump sum.
The lump sum value is the present value of the stream of payments. Lump sum values are calculated based on three main factors:
- Life expectancy
- Amount of the monthly payments over the life expectancy
- Prevailing interest rate
There is a tendency for individuals not to touch their pension until they are required to make a decision. Over the past several years, that decision has been a good one because the lump sum value has increased. This has been due to the decreasing and low-interest rate environment we experienced. However, that might not be the case this year (or next). There is a potential surprise in store for individuals who are deciding on when to initiate the lump sum distribution option.
The current rising interest rate environment will directly and significantly impact the calculation of your lump sum pension. When interest rates rise, the value of the lump sum pension will decrease, with some institutions estimating an approximate 10% decrease for every 1% increase in rates. . Traditional pension plans typically adjust the factors used in calculating the lump sum values once per year.
If you are preparing to commence receiving your benefit from a pension plan, you may want to consider how interest rate changes might affect your financial plan. Interest rates have risen in 2022 and are expected to continue rising into 2023. Once you have made the decision that the lump sum pension option is right for you, consider taking the distribution in 2022 before the value of the pension is adjusted for current interest rates. Be sure to check with your financial planner before doing so to ensure that now is the best time.