Many employers that provide defined-benefit pensions offer employees the ability to take their pension as a lump sum instead of an annuity.
Employers like this option because it gets the pension liability off their books, and some retirees prefer the flexibility a lump sum provides. If you’re considering taking a lump sum and there’s an offer on the table, you may need to act before year-end to get the most out of your nest egg.
Lump sums are typically calculated based on the present value of guaranteed monthly payments, using mortality tables and interest rates published by the IRS. Under the formula pension plans use, the lower the interest rates, the higher the lump-sum payout.
Large plans typically calculate the value of lump sums annually, which means many plans are offering lump sums based on interest rates published in October and November 2021, says Hogan Fulghum, a certified financial planner in Charlotte, North Carolina. Those rates were much lower than they are now.
Lump-sum offers in 2023, however, will be based on rates from late 2022 and could be much lower, says Josh Hawkins, a CFP in Hudson, Wisconsin. He estimates that every percentage-point increase in the interest rate used to calculate a lump sum reduces the value of the payout by up to 10 percent.
For example, consider a 61-year-old worker who is eligible for a lump sum based on the present value of a $40,000 annual pension. A lump sum based on November 2021 interest rates would total about $660,000, Hawkins says, while one based on rates for August 2022 would total about $549,000. With that in mind, it could pay off to accelerate your retirement date to take advantage of 2021 rates, Hawkins says.
That may sound counterintuitive, because working longer typically results in a larger pension, along with additional income and potential bonuses. But if an employee is leaning toward taking a pension as a lump sum, Hawkins says, the higher payout may eclipse the advantages of staying on the job for a few more months.
But the decision to take a lump-sum payout or a lifetime annuity is deeply personal. Even a more generous lump sum must be invested—an unnerving prospect even when the markets are on the upswing. You may sleep better at night if you know that you—and perhaps your spouse—will receive a monthly check for the rest of your life.
But if you want both guaranteed income and the flexibility a lump sum provides, you may be able to have your cake and eat it too, Hawkins says. You could take the lump sum now—which means you’ll enjoy the more generous payout—invest the money and use part of the payout to purchase an immediate annuity down the road, he says.
With a single-premium immediate annuity, you give an insurance company a lump sum in exchange for monthly payments for the rest of your life (or a set period of time). And in this case, rising interest rates are your friend. Payouts are tied to rates for 10-year Treasuries, which recently rose to about 3.8 percent. And with rates expected to continue to rise in 2023, payouts could continue to increase.
(Sandra Block is a senior editor at Kiplinger’s Personal Finance magazine. For more on this and similar money topics, visit Kiplinger.com.)
