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Mayo Clinic and Fortress Financial Group are not affiliated

We received a lot of feedback from clients in 2022 about pension changes. For employers that still offer pension plans, some provide the option for an employee to take a lump sum at retirement, in lieu of a stream of payments. Last year, concerns about a significantly decreased lump sum option caused some people to pull the trigger on retirement a little earlier than expected. Here is what caused the decrease in value, what some companies have done to address it, and what to expect for the future.

Why the Decrease

When a company calculates what your lump sum payment will be at retirement, they are determining the present value of your stream of payments. No different than lottery winners having a choice between a lump sum or payments for the rest of their life. To determine the present value, you need a few things:

·         Rate of return

·         Number of periods

·         Payment Amount

The number of periods is determined based on your age and life expectancy.  The payment amount is what you would receive if you elected the annuity (monthly payments) option, and the rate of return is what caused a ruckus is 2022. Rising rates in 2022 didn’t just increase the cost of borrowing money for a house or car, it also impacted what someone could expect for their pension lump sum.

Here is an example of how changing interest rates can impact a pension:

Example 1:

Rate: 2.92% (November 2021 Treasury High-Quality Market (HQM) 30-year Corporate Bond Yield Curve)

Number of Periods: 30 years

Monthly Payment: $2500

Present Value: $599,086.92 (What you could expect your lump sum to be)

Example 2:

Rate: 5.22% (November 2022 Treasury High-Quality Market (HQM) 30-year Corporate Bond Yield Curve)

Number of Periods: 30 years

Monthly Payment: $2500

Present Value: $454,258.83 (What you could expect your lump sum to be)

In this example, rates increasing by 2.3% caused a 24% decrease ($144,828.09) in the lump sum payment. Note that the monthly payment is not impacted by changing rates. The Pension Protection Act mandates that the Treasury publish a corporate bond yield curve for calculating the present values of pension liabilities and lump sum distributions. [2]

Stable Pension Options

Some employers have implemented a stable pension option, one that does not drastically change based on rates. This change is designed to help employees can have a better idea of what their benefits will be at retirement.  

Here is one example of how a stable lump sum benefit might work:

Base Benefit + Supplement Benefit = Stable Lump Sum at Retirement (age 65)

The base benefit is your Annual Compensation X 18% X Benefit Service in Plan Year (1.0 for a full year)

The Supplement Benefit is any compensation over the Social Security wage base ($160,200 in 2023) X 8% X Benefit Service in Plan Year (1 for a full year)

Under the new program, someone earning $60,000 today and receiving a 2.5% pay increase per year would need to work 31 years to have a lump sum just under $500,000 ($496,802).

What to Expect for the Future

Determining if you should take the lump sum versus the monthly payment is a very personalized choice. If you are unsure about what to do, give us a call or stop by and we will be happy to help. 

A quick fun fact - Only 15% of private sector employees have access to a Defined Benefit Pension plan[1].  Defined benefit plans have given way to defined contribution plans(401(k), 403(b), etc.) where the employee takes the driver’s seat in making contributions and investment decisions.

New to Fortress Financial Group? We are a Minnesota Based, Fee-Only registered investment advisor, held to a fiduciary standard. We are focused on helping our clients find financial clarity through direction and guidance.

 

Disclosure

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

[1] Congressional Research Service Worker Participation in Employer-Sponsored Pensions: Data in Brief November 23, 2021

[2] The Corporate Bond Yield Curve for the Pension Protection Act" by James A. Girola-10/11/2007

The views in this page are the views of Fortress Financial and not the views of Mayo Clinic.

Mayo Clinic and Fortress Financial Group are not affiliated