Interest rates have been soaring and bonds, typically seen as a more conservative or ‘safer’ investment, are seeing their largest loss in history as a result. In fact, if you look at the US Aggregate Bond Index (this is the most widely followed bond index and the largest ‘total bond market’ index fund in the world tracks this index as do many ‘target date’ retirement funds), it is now lower than when it came into existence over 30 years ago! This was something we warned about in our articles titled ‘How Low Can Rates Go?’ that were published in November of 2020 and July of last year. Since we first warned that there was likely a bubble brewing in bonds, this index is down over 18%. If you didn’t pay attention to the concerns we were raising about bonds and have suffered steep losses, you should probably not make the same mistake again, especially if you’re someone who has a pension buyout available to you and you’re considering retiring soon.

A lump sum pension buyout is typically calculated based on what your monthly pension amount would be (which is based on years of service and earnings), your age, and an interest rate average. If you’ve maxed out your monthly pension amount from your years of service, then waiting to retire can cause your lump sum amount to actually go down! Why? Well, pension funds figure as you get older you don’t need as much of a lump sum to get the same amount of monthly income as what the pension would supply since you now have fewer years to live. Similarly, if interest rates go up, they figure that you need a smaller lump sum to get the same amount of income.

Many employers only make these calculations annually or semi annually while others do it monthly or even more frequently. With the recent sharp increase in interest rates there will be many people that see their pension buyout lump sum decrease significantly when these recalculations occur. There will certainly be some that see their lump sum amount go down by more than the amount of their salary. If you’re considering retiring soon and are contemplating the lump sum option, it would be wise to find out when the recalculation would happen for you and consider retiring before then. Otherwise, the amount you get paid by continuing to work could be less than what the pension buyout amount decreases. It costing money to work makes little sense.

So why would someone consider a pension buyout instead of a monthly pension income stream? There are really 4 reasons: income flexibility, potentially higher guaranteed income, taxes, and legacy. One issue with a regular monthly pension check is that it will go less far every day. The check amount will remain the same, but prices will continue to increase. With just average levels of inflation over the average retirement length all prices will more than double. At the end of retirement you’d need over 2.5 times the amount of income in order to buy the same things and maintain the same lifestyle as today. This would mean a pension that pays the same amount each month would only buy 40% of what it can buy today. If you go with the traditional monthly pension check, you need to ask yourself what 60% you can cut out of your budget. Again, this is only assuming average inflation rather than the crazy 40 year high amount we’ve been experiencing recently! With a well constructed plan you can create a strategy to combat ever increasing prices with ever increasing income from a lump sum buyout. This is one kind of income flexibility. You might also want to spend more earlier in retirement while still young and healthy and less later on. You have that flexibility with the lump sum option. Maybe you’re in a different boat and are sick and have a shorter life expectancy. A lump sum would allow you to concentrate spending a large amount in the shorter time period you have left. When we’ve analyzed pension options recently for new and existing clients we’re often finding it would take 20-25 years for pension payments to total the same amount as a lump sum. If you happen to live less than that amount of time and took a traditional pension then you missed out. If you live longer, it doesn’t take much of a return on that lump sum to allow you to not only get the same amount of money as what the pension would have been, but likely more.

For those liking the idea of someone providing a guarantee of what that income stream is, there are many private companies out there that could provide you with a higher monthly income stream if you were to transfer the lump sum to them. This is in part due to them using the new higher interest rates to calculate what a monthly check would be compared to the older, lower rates that a pension fund may still be basing a lump sum on.

Taxes are another important consideration. If you take a lump sum, that money can go into your 401k or an IRA. You can then control how much comes out and when. Since taxes are paid when money comes out of these kinds of accounts you can better control what tax you pay and when. With historically low tax rates as part of the temporary Trump tax cuts, it could be wise for many to pay tax on much of this money now rather than later when tax rates could be higher. This would allow more spendable dollars on the same amount of income since less would be going to the government and more going into your pocket. If you just take a monthly pension check you’re at the mercy of whatever tax rates might be in the future. The last reason is legacy. By taking a lump sum there can be something left to some sort of beneficiary whether that is kids, grandkids, relatives, church, or some sort of charity.

We’ve been helping a lot of people recently figure out what pension option might be best for them from Hills, Evergy, BC/BS, and Frito Lay to name just a few. In some situations the lump sum is still so large compared to what the monthly pension check would be it is a complete no brainer to take the lump sum, but in a few instances taking the pension and the inflexibility that comes with it is the better choice, especially if a recalculation factoring in the new higher interest rates has caused the lump sum amount to plummet. Helping people figure out which pension option to take for their particular situation and minimizing the taxes on that option is just one of the many things we do as part of our complementary 3 step review for new clients. If you’re considering retiring sometime soon, having this kind of analysis completed would be smart as waiting to retire and working longer could cause a significant loss because of recently rising interest rates.

Material discussed is meant for general/informational purposes and is not intended to be used as the sole basis for any financial decisions, nor be construed as advice to meet your particular needs. It is also not a recommendation to buy or sell any particular investment. Investing in securities involves risk and profit cannot be guaranteed. Please consult a financial professional for further information.