How can rising interest rates impact your pension value?
In this week's episode, we analyze a real-life scenario from our listener, Mark, who is weighing the pros and cons of an early retirement, a higher lump sum, or a commit to an annuity.
Learn how to calculate the imputed returns of an income annuity and how to determine if taking the lump sum and investing it would be the better option.
What considerations and calculations can be used to decide between a lump sum payout or an annuity?
Are you working against yourself by continuing to work?
2:40 Mark's question
4:24 Unpacking it
7:38 Don't do your analysis this way
14:09 Here's how to do your analysis
Create Your Custom Strategy ⬇️
Making the right decision about whether to collect your pension as a lump sum or as an annuity can be one of the most important and the most difficult decisions to make when it comes to your retirement. On top of this, the fact that interest rates are rising so rapidly makes this an even more challenging decision. So in today's episode, we're going to go over an actual example of how should you think about this decision in the context of your specific plan, so you can do what's best for you. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Many of the episodes I do are evergreen to an extent, meaning whether you listen to it in 2023 or 2020 or 2030, a lot of the principles will be the same. And while many of the principles of today's episode will be the same, it's very timely to an extent, at least for those of you who have some type of a pension, and the type of pension we'll be talking about today is really corporate pensions, so private pensions, not a government pension that just has different details about how it's run and the benefits that you can get from it. But the reason this is timely is because interest rates are rising. Not only are they rising, but they're rising rapidly. Now, if you understand how pensions work, typically within a corporate pension environment, you are given an option where, if I were to work for a company for some number of years, they might say James, we will pay you, let's say, $1,000 per month for the rest of your life with the annuity option for this pension or if you don't want to take a monthly annuity, that's guaranteed for the rest of your life, james will also give you the option of taking a lump sum rollover of maybe $250,000. I'm just making up some numbers here, and so that's an option that's presented. Here's the thing, though the lump sum option that $250,000 in this example I made up that number fluctuates based upon where current interest rates are, and as interest rates rise, typically the annuity company or the pension company is going to decrease the amount I'm eligible for as a lump sum. So even if the annuity stays the same, so the monthly amount of $1,000 per month, the lump sum amount that I could get instead typically decreases as interest rates rise. So that's why it's timely. Interest rates haven't just risen in the last 12 months 24 months but they've risen rapidly and so this is causing a lot of turmoil for people who have pensions as they're trying to determine what's the best option for them. So this episode is based upon a listener's question, and this listener's name is Mark Mark says this he says love the podcast. I really appreciate the real world use cases and the way you cover things to consider, as there's no one right answer that covers all scenarios. I am lucky enough to be part of a pension program at a major auto company. My question is what considerations and calculations can you recommend to decide between taking a lump sum payout or an annuity? I've always leaned towards a lump sum. However, with rising interest rates, the 2023 lump sum amount dropped by 20% and I expect the 2024 amount to drop significantly as well. My goal is to retire in 2024 or 2025. The company sets new pension rates each year based upon rates in August. Therefore, I may have to make a decision again this year to retire early to grab a higher lump sum. If I don't, I feel like I'm committing myself to taking the annuity. I would be 57 that year. Some data on my pension If I retired before November 30th of 2023, then I have two options, and those options are as follows. Option number one I could take a lump sum of $1,021,200. Or option number two, I could collect an annuity with a lifetime payment of $4,351 per month, with no cost of living adjustment. In addition to this, there would be an interim supplement of $950 per month between the time I retire until I turn 62. Marketing goes on to say if I retire next May, the annuity moves to a lifetime amount of $4,923, with a monthly supplement of $2,134 until I turn 62. There's a big jump when I hit 30 years of service. Of course, I don't know the lump sum value for next May until the new rates are published. Based upon this year's rate, however, next year's lump sum amount would be $1,194,267, but I suspect it might drop by 15 to 20% due to the rate increases that occurred since last August. I will learn these new rates at the end of September and I'm looking for guidance on how to make this decision on what option to consider. So that's Mark's question. Mark, it is a good question and there's a lot of details to it, so let me unpack that real quick for all other listeners as we look at these numbers. Mark's in a good spot. He has a healthy pension. He can select either a called a million dollars lump sum payment or he could collect $4,351 per month as an annuity, and that annuity would pay Mark every single month for as long as he lives. Here's the predicament Mark's leaning towards the lump sum payment, so leaning towards that million dollars. However, if he stays an extra year, the annuity amount would increase. So if he were to collect the annuity amount instead, instead of the lump sum, that's going to go up because that's based upon years of service. However, the lump sum amount, which is also based upon years of service, also incorporates current interest rates. So he's asked himself am I going to be essentially working against myself by continuing to work, because that might mean I actually collect less of a lump sum payment a year from now or two years from now than I'd be eligible for if I went to retire sooner than that. So that's his predicament and that's what we're going to address in today's episode. But before we do so, I want to quickly highlight the review of the week. This review comes from username Anne Ford Travel. Anne Ford Travel gives a podcast Five Stars and says I'm learning so much from James's YouTube and podcast on retirement. He's an excellent communicator and a thoughtful teacher. His contents are full of great information and thought provoking insights, and a listener's podcast will drive him to work gardening or doing house chores. I am much more confident about preparing for my retirement because of James. Thank you for being a great teacher. Well, anne Ford Travel, thank you very much for that. That's why I do this. It's amazing to see all the feedback that we get, so I'm so happy to hear that this podcast has helped you to feel more confident in your retirement. And for those of you who have left reviews, thank you very much for doing so. If you've not already done so, please take a moment and leave a Five Star review if this podcast has been helpful to you. And with that, let's get on to the episode. So multiple considerations. As with anything, there's very rarely a right or wrong answer, and very rarely does it just come down to one single consideration. In this case, there's considerations like maximizing income, there's maximizing peace of mind, there's understanding longevity risk, there's understanding tax implications. So there's a lot to it. But the first thing I'd want to look at is, quite simply, which option is going to maximize income? What option is going to put the most money in your pocket at the end of the day. This is what Mark is asking himself. He's asking himself should I take this million dollars as a lump sum? And, by the way, when you take it as a lump sum, if you roll it over to a traditional IRA, you avoid tax implications. So you know some people right away. They say, well, don't take the lump sum, there's a huge tax hit. Yes, there is if you take it as cash. But in this case I'm going to make in the assumption that he rolls it over to an IRA, which would be a tax-free transaction. So does he take the million dollars as a lump sum or does he take the $4,350 per month and collect that as an income annuity for the rest of his life? Well, here's how you shouldn't do the analysis. I'm starting with how you shouldn't do the analysis because this is where most people go to first. Most people do this. They would say, okay, well, mark is eligible for $4,351 per month. That equals $52,212 per year. So Mark could get $52,212 per year. And we want to compare that to what could the lump sum create in monthly or annual income if it had been rolled to an IRA instead. So the analysis would then continue. Okay, if the lump sums $1,021,200. And, by the way, quick side note, just because those numbers are kind of long, I'm going to round the lump sum to a million dollars. I'm going to round the annuity to $4,350 per month. The actual numbers I'm going to say to you, or the analysis, is going to be based upon the real numbers. But just to keep things simple, as you're trying to follow along with these numbers, I'm going to use nice round numbers. I think doing so might make your head hurt less as you're trying to follow along. Hey, everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. So let's do this. If you take the 52,200 per year, which is what the monthly annuity turns out to over 12 months, and divide it by the lump sum that Mark could receive of about a million bucks, what you come up with is 5.1%. So what some people would say is okay. Well, this is kind of like the same as taking that million dollar portfolio and generating 5.1% per year. Well, I've heard of something called the 4% rule, and the 4% rule is kind of the maximum I've heard I can take from my portfolio without running the risk of running out of money over the first 30 years or so of retirement. This is how the thinking goes. So if you continue with that thinking, you'd look at that and say, okay, well, the annuity is guaranteeing a 5.1% withdrawal rate. Why would I take that guarantee when the alternative is to take a lesser amount, aka 4%, from the lump sum? And that leads some people to electing the annuity. Be careful here, that's not the right comparison. Why? Well, for a couple of different reasons. Number one when you look at the structure and the assumptions of the 4% rule, it's assuming you're giving yourself a cost of living adjustment by inflation every single year. So to use a round, simple number, if you have a million dollars that you invest in your portfolio and you take 4% the first year, that's 40,000. But you're not then taking 40,000 in year one and two and three and 10 and 20, you're increasing that number every single year by inflation. That's important to understand because with these pensions, such as Mark's, for the most part, they're not paying cost of living adjustments or they're not providing cost of living adjustments. I should say so when you look at the first year. Sure, if you're comparing this annuity option that Mark could get to a 4% withdrawal rate from the lump sum, the annuity option is going to look a lot more attractive. But take a look at this. If we were to look at the 4% rule applied to the lump sum that Mark is eligible for after 10 years, the 4% rule has taken his income from a starting amount of 40,848 in the first year up to $53,300 at the end of year 10. So you started with a lesser amount but you're building in and I'm assuming 3% per year inflation adjustments every single year. At the end of year 20, you're now collecting $71,600 using the 4% rule, adjusting for inflation compared to the annuity, which is still paying $52,200 per year. And by the end of year 30, the 4% rule would now have taken your income up to $96,200 compared to the annuity, which is still paying $52,200 per year. So that's the first error in this thinking. Now some people say well, james, that's a fine tradeoff to me. I'd rather take more money up front in the first few years when I can travel and I'm healthy and there's activities, and then I'm okay with spending a little bit less in my 80s or 90s. Well, here's the thing the 4% rule isn't increasing so much as the annuity payment is decreasing. You have to look at the real return. The real return is what is your portfolio doing after inflation. In other words, how is your purchasing power being maintained? So, under this 4% rule example, your purchasing power is staying the same, even as the nominal amount of the income you're taking from your portfolio is increasing every single year Versus the annuity. Every single year, the nominal amount stays the same, but the purchasing power decreases, called by 3% per year, if that's what inflation is running at. So, as you look at this, the first mistake of approaching it this way is not accounting for the cost of living adjustment. The second reason this is a bad comparison and this is relevant if you have a spouse or heirs you want to leave money to is the survivor options. So if this is a single life annuity that we're looking at and you die after one year of collecting your annuity payment, the rest of your money just disappears. The rest of your money folds into the pension's general fund and they're done, paying you Now. Yes, you could do a joint and survivor benefit for your spouse. Now what that means is that benefit the mark outlined that would last for both his lifetime and his spouse's lifetime. So if he died after one year but his spouse lived until age 30 or 30 years into retirement, spouse would continue collecting those benefits for 30 years. But it decreases the amount you're eligible for in an annuity. So as you look at this, the bigger thing is if you have any intention of leaving money to children or grandchildren or heirs whoever it is the annuity really doesn't do that. It provides you a guaranteed income for the rest of your life and maybe the rest of your spouse's life, but then it stops If you compare that to taking the lump sum. So in Mark's case, if he took the million dollar lump sum, he collected income for one year and then he passed away, well, there's still a substantial amount of money that would then pass on to Mark's children or heirs or whoever would then be collecting it. So that's the second reason. It's not a perfect apples to apples comparison of just looking at the annuity and then comparing that to what would that look like if we were to take the lump sum and generate that same level of income. So if that's not how you run it, how should you do the analysis? This is really important to understand what you start by understanding the imputed return of the income annuity based upon how long you might live. What on earth does that mean? What you should be doing, if you want to do the full analysis on this, is you need to look at this, because if you could tell me exactly how long you live, I could tell you pretty precisely what your exact rate of return is by taking that annuity. Because here's what you have to do In Mark's case. If he's going to elect the annuity option, he needs to look at it like this. He needs to look at it and essentially say I have a million dollars in my possession. I am going to invest that or exchange that into something that's guaranteeing these payments for me for as long as I live. Now, what's the rate of return on that? Well, it depends on how long Mark lives. If Mark lives one year, the rate of return is very poor. Why is it a poor rate of return? Because he's essentially exchanged a million dollars of cash for payments, so for return of principal of $52,200, and then my investment's gone. My investment's gone because Mark passed, and so maybe Mark doesn't care so much about this as much as his heirs or spouse, but that essentially translates into a negative 94.9% rate of return. Again, this is an interesting way to look at it. Most people don't do this way, but it must be done this way. What's essentially happened is Mark invested in something that generated a negative 94.9% rate of return, paid him $52,200, and then the investment was worthless, because once you pass away, that pension is effectively worthless. So what you need to do is every single year. So what if I live one year or two years or five years or 10 years? And now you can build out an Excel spreadsheet and do this there, and that's the best way to do it, but what you're doing is you're starting to get a sense of okay, if I have a life expectancy of 20 years or 30 years or however long it might be, what rate of return am I effectively getting by electing this new option? Let's take this a little bit further. So if Mark lives for 10 years and now I'm using Mark's specific numbers for this, not just hypothetical but if Mark lives for 10 years and then he passes away, then that's the equivalent of investing a million bucks, receiving 10 annual payments of $52,200, and then having nothing left. So that would be the same as taking a million dollars in his IRA, generating $52,200, and having a negative 10.6% rate of return each year. That would also effectively zero out his balance at the end of those 10 years. At the end of 20 years, mark's return would be about 0.2%. By electing the annuity option, that would be the equivalent return when you look at what his annuity payments would be relative to what the lump sum would be. And at age 30 years it would be about 3% per year. Now one big disclaimer here Mark also has a supplemental annuity that would pay from, I think, age 57 or whenever he retires until 62. That dollar amount's not factored in here. It would change these numbers, but just slightly, not a significant increase, but just slightly. But what I would be looking at is I would be saying okay, mark, do you feel confident that if you live 20 years you could take that lump sum and invest it an average greater than 0.2% average return per year? If the answer is yes, you're probably better off taking that lump sum and growing it by more than 0.2% per year, which is the imputed return of what your annuity is going to pay you. If you think you're going to live 30 years and if you think that you could take a lump sum of a million bucks and invest it at more than 3% per year, then that's probably going to be a better option than taking the annuity payment that's going to give you that annuity for longer. But still the imputed return is 3% per year. The longer you live, the greater that imputed return on your investment, which just makes sense. The longer you return, or the longer you live with an annuity, the more payments you're going to receive before that annuity becomes worthless. That annuity essentially becomes worthless once you've passed away. That's the first general framework of how I think about this. When comparing options annuity versus lump sum what's going to put the most money in my pocket over the course of retirement? Some of it's guesswork. We have no idea how long we're going to live, we have no idea what the market's going to return, but when we can start to frame it this way of okay, over 30 years, could I outperform 3% per year hurdle that essentially becomes if I hit 3%, I've broken, even based on what the annuity is going to be, the annuity would have done for me. If I could do better, that tells me. Okay. Maybe I want to explore options of taking the lump sum. There's other considerations too, the first of which is just risk. Well, there's longevity risk the longer you live, the greater the value of that annuity. There's also sequence of return risk. So what if you retire and the market just plummets those first few years? Well, the annuity, that would give you consistent payments, whereas the lump sum would be more subject to that sequence of return risk. Now, side note, if you're invested the right way, you should at least lessen that risk to a very significant extent, but it still does exist. There's also peace of mind. Some people love the annuity option because it's like they never retired. Well, it's like they retired because they now have all day, they have 40 hours a week, freed up to do what they want to do, but it's like they're still working in the sense that there's still a paycheck coming in and that just feels good. One of the weirdest, oddest transitions for people is going from receiving a paycheck to creating their own paycheck, and so it's just easier sometimes for people to say let me just continue with this paycheck via the annuity as opposed to coming from my investments. So those are some of the considerations. Those are all very important considerations and, mark, to your question of how do I think about that, that's how I would think about that. Now, here's the planning point. I'm going to set those other considerations aside for a second, because there's a very important planning point that Mark and people like Mark are facing right now. That is, what should we do, james, given this analysis and understanding, these numbers are subject to change. You know, james, it'd be one thing if, okay, I work one more year, or two more years and three more years, and the lump sum in the annuity payment, they both increase proportionately because of the extra year of service. But that's not what's happening. In fact, it may even be the opposite the lump sum, as interest rates are rising, are going to be decreasing while the annuity payments are increasing. So that analysis that we just ran through, that was the analysis for one specific year of what if Mark retires. Now what he needs to do is Mark needs to do another full analysis on what would that look like next year. Because here's the takeaway for Mark and people like Mark who are in this position you need to run the numbers now. And you need to run the numbers and you might need to guess at what these numbers might be if you were to do the same thing and retire next year or in two years or in three years. Because if the annuity makes sense, then working longer can only increase that. Now, barring any type of arrangement or a thing where your annuity is actually reduced because some type of pension underfundment or whatever the case might be barring any of that. Every extra year you work, your annuity payment increases up to a certain threshold. So if Mark was already leaning towards the annuity, then working longer just makes that leaning even more compelling. Okay, that annuity is just becoming higher and higher and higher. However, if Mark looks at these numbers and said you know what the lump sum makes most sense, that's where the plan could change pretty dramatically. Because here's the issue. Let's say and I don't have no idea what Mark makes in terms of income, but I'm just going to assume he makes $150,000. To illustrate a point real quick what if Mark works one extra year before deciding to retire? That's one more year of earning $150,000. But what if, at the same time, mark's concern happens and his concern is does the lump sum get cut by another 20%. Well, 20% in this example is $200,000. So, effectively, what Mark's done is he's traded one more year of work to earn $150,000. But the other, the downside of that, is he just lost $200,000 in the value of what his pension lump sum is worth. So you have to ask yourself is that worth it to work one more year and effectively get paid to negative $50,000? Probably not. Now, maybe there's some other benefits that he's eligible for. You know, sometimes, people, if you work long enough at a certain company, you get lifetime medical benefits. Or maybe there's other financial benefits or other factors that are also involved. So, yes, look at the big picture. But if we're just looking at this of dollars earned versus dollars given up because of that pension decreasing as interest rates have risen, then it's not a really compelling trade-off, probably not one that Mark really wants to make. So that's where you have to start looking at trade-offs. Does it make sense to leave the company now and find a job elsewhere, even if that job pays less? Because my guess is that job's paying a lot more than negative $50,000 per year. Again, I just made those numbers up in terms of what Mark's earning. He would have to do the analysis for his specific scenario, but that's the way of looking at it. Or could he and maybe this is a unique planning thing you'd have to talk to your HR department. Could you leave the company, take the lump sum and then return to work in the same role that you were at before? A lot of companies might not go for that. You might not be eligible for the same pension benefits continuing to accrue, but it's at least one thing to consider. And then again, look at the big picture. Maybe staying longer makes you eligible for lifetime insurance benefits. Maybe staying longer the compensation you're receiving is greater than the decrease in pension you're taking or accepting because of those interest rate adjustments. Also, I've been talking in terms of Mark's pension. Mark's pension is on the healthier side compared to the average pension most people will be receiving. If your pension benefit was, say, $100,000, in this case, well then, a 20% reduction is $20,000. Still significant, still absolutely significant. But is that $20,000 reduction worth retiring a year early if now you're giving up much more income in order to do so? So look at this Are you continuing to have stock vest if you stay longer? Are there other benefits? Are there other things that are a benefit of staying. Don't just go jump ship because your pension lump sum balance is going to be decreasing with interest rates rising, but absolutely look at planning points. This is one of those things that probably caught a lot of people by surprise just these rising rates. So make sure that as you're looking at it, you're looking at it holistically, but as we've gone through this Mark. First and foremost, thank you for the question. I hope this was helpful for you to see how I would unpack this. But then for anyone who's deciding, what do I do here in light of these changing pension amounts that we'll be receiving, so there's some considerations we walk through, but then also some planning points of given those considerations, what should I now do for my specific situation? So I hope that was helpful. Thank you, as always, for everyone who's submitting questions, submitting reviews, taking the time to tune in each week. Appreciate you all being here. That's all I have for this episode. Thank you for listening and I'll see you all next time. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how root financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.