Many retirees depend on pensions to fund their retirement, and many employers still offer Defined Benefit pension plans. At retirement, Defined Benefit Plan participants typically have the option to receive their pension as a lump sum (single) payment or in the form of annuity payments.

Annuity payments are generally a fixed amount per year, determined by a formula based on factors such as age and years of service. Some employers offer various annuity payment options, including annuity payments based on the employee's life or the employee and their spouse (at a reduced monthly payment).

Because pension payments are a fixed amount per month and don’t typically have cost of living adjustments, inflation eats away at the value of those annuity payments over time.

Alternatively, retiring employees may elect to take a lump sum distribution. Lump sums have three main components: the monthly pension plan itself (in theory, the larger the plan, the larger the lump sum), the interest rate used to calculate the lump sum, and the value of the pension plan's monthly annuity payments. However, as interest rates rise, the lump sum payout from a Defined Benefit Pension Plan may be lower.

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Inflation and the Time Value of Money

Why do rising interest rates cause payouts to be lower? Simply put, it’s because of the “time value” of money. Future dollars are worth less over time because those dollars can be invested today and earn a higher rate of return.  

The amount of the lump sum payments are based on stated interest rates published by the IRS. Some employers calculate the interest rate used on a rolling basis (e.g. Exxon Mobile, Chevron). Other employers may use periodic reset dates where the interest rate for the next 12 months is determined once per year. For example, 3M and AT&T use November and Honeywell uses October.

Many pensions have reset dates coming up, which can mean a big difference in lump sum pension payouts as interest rates have risen dramatically over the last year. For example, with a 3% interest rate, a $5,000 monthly pension benefit over 20 years would result in approximately a $901,555 lump sum payout. With a 6% interest, that lump sum payout decreases to $697,904, a decrease of $203,651!

Other Factors to Consider

The decision to take a lump sum distribution shouldn’t be based solely on interest rates. Other factors should be considered: Does the pension have a cost-of-living adjustment? Does the pension provide joint and survivor options? When a lump sum payout is distributed, the funds should be invested appropriately for the retiree, planning for cash flow needs in retirement.

Each employer's Defined Benefit Plan is unique, and you and your financial advisor must review the terms outlined in the plan document carefully.

Additionally, tax consequences need to be considered. If you take a lump sum distribution from your Defined Benefit Plan, you have the option to roll the lump sum distribution to an IRA account. The distribution will be subject to ordinary income tax if it isn't rolled over. Also, from an estate planning standpoint, a lump sum distribution becomes part of a taxable estate and must also be considered.

As you consider retirement and how these Defined Benefit Plan decisions fit into your overall financial plan and tax strategy, Wealth Enhancement Group can help you navigate the options that are available to you.

This information is not intended as a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.