As you near retirement, you are faced with several decisions, including where you’ll live, what you’ll do with all your newfound freedom, and how you’ll handle cash flow needs. If you are 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.
There is a certain allure to lifetime pension payments, which you will receive for the rest of your life no matter how long you live. The downside of lifetime payments is that most pensions are not flexible and do not include a cost-of-living adjustment to keep pace with inflation.
On the other hand, lump sum distributions are one-time payments that are usually transferable into a retirement account. The distribution is not taxed until you withdraw the funds from the retirement account. The lump sum gives you control over the funds but invites market risk. 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.
Evaluating the Lump Sum Payment
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
It is common for individuals not to touch their pension until they are required to make a decision. Over the past several years, that decision has been good 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).
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 decreases, 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 receive your pension plan benefits, 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. If you decide 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.