Many employers with Defined Benefit Plans provide an option for a retiree to take a lump sum instead of a monthly pension. With interest rates rising quickly, the calculations used to value a lump sum will likely change dramatically and may offer a significant timing opportunity.

**Lump Sum Math:** Lump sums are computed with a mathematical calculation very similar to the math used in mortgage loans. The Lump Sum is the present value of the monthly pensions. It’s based on three ingredients:

· The monthly pension

· The rate of interest used to compute the lump sum, and

· The life expectancy of the individual

**The Benefit**. The monthly pension is simple: the bigger the monthly pension, the bigger the lump sum, all things being equal.

**Life Expectancy.** The life expectancy, or mortality, of the individual, also has an effect. Two employees with identical monthly benefits will have different lump sums based on their age. For example, suppose Tom and Susan both work at a company for 30 years and have monthly pensions of $3,200. Tom is 62, Susan is 66. According to IRS Mortality Table for 2022, Tom will live about 23.08 years and Susan about 19.68 years. Note the IRS mortality table is a little bit of a math lift; you have to actually build a life expectancy table. Drop me an e-mail if you’d like an explanation of how to do it.

**Interest Rate: Threat and Opportunity.** Because of the mathematics, interest rates have a major effect on a lump sum calculation, particularly considering the rising rate environment. The mathematics of lump sums are a present value calculation, meaning the lump sum is the present value of a stream of payments at an interest rate for a period of time. Think of a mortgage – a mortgage loan is the present value of the payments. A $3,000 monthly mortgage payment on a 3%, 30-year mortgage would sustain a mortgage loan of $711,518. If the rate was 5%, the amount of a mortgage loan would be $558,845. If these were pension lump sums, the higher interest rate causes the lump sum to decrease substantially (by over 21%).

The method the IRS uses to compute interest on lump sums affects the outcome as well – there is a blended rate for the first five years of payments, years 6-20, and payments 20 years or later. Using the IRS Minimum Present Value Segment Rates for May 2022, the first segment is 3.23%, the second segment is 4.59% and the third segment is 4.69%. With those rates, Tom would have a blended rate of about 4.502%, and Susan a rate of 4.69%, however, it’s the interest rate calculation that has the biggest impact.

The rates used by the IRS in the Minimum Present Value Segment are divided in three segments: the first segment is for the first five years (of the participant’s life expectancy) of the calculation, the second segment is for years six through twenty, and the third segment for years after twenty. Using the IRS computed mortality for a 66-year-old, the life expectancy is 19.68 years, which would utilize only the first and second segments. The life expectancy of a 62-year-old is 23.08 years, which would use all the segments. A blended rate can be used to approximate the valuation of a lump sum.

These are the IRS Present Value Rates for the last 12 months:

The rates have substantially increased in the last 12 months. The consequences on a lump sum calculation are significant. Here are calculations based on the IRS life expectancy and the blended rate. Note that we did not take in to account the mortality change (the individual got older), nor did we switch mortality, but instead chose to illustrate the change from the rising rates.

**The Threat. **In 2022, we are experiencing a rising interest rate environment, with more prospective interest rate increases on the horizon. As the above chart illustrates, the present value of a lump sum for a 62-year-old computed in June of 2021 was over 19% greater than the same present value in May of 2022. A further 1% increase in rates for the above illustration would reduce the present value of the lump sum by another 8-9%. By way of illustration, in December of 2021, the Moody’s seasoned Aaa bond yield was 2.65%. In May 2022, it was 4.12%. Rising rates decrease the lump sum.

**The Opportunity.** The opportunity lies in the fact that pension plans typically change their lump sum calculations once a year. Many large plans use an October or November rate to make computations for an entire year. This means that many eligible retirees can get their lump sum based on the older lower rates. Using the calculations above, there is a significant difference between the October 2021 calculation versus the May 2022 calculation. Here’s the opportunity: You may be able to get a large lump sum going into a down market. For example, the 62-year-old in the above example may be able to take a $617,452 lump sum, when the market itself, both stocks and bonds, are down. Check with your company to see when they compute the lump sum.

**Bottom Line:** Rising rates reduce lump sums. Pension Plans offer lump sums periodically, but typically change once a year. If you are eligible for a lump sum, you may be able to get a significantly larger lump sum by timing the payment before the re-set. You might also get an opportunity to buy into a down market. As always, I’ll do my best to answer questions at [email protected] I also have a White Paper on the topic with more detail, you can download it HERE.

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