How Interest Rates Affect Your Pension Plan [Video]

Welcome back to the channel! I’m Trevore Meyer with Financial Design Studio and today we are following up our conversation about pensions. We want to discuss what might make the most sense for you, your family, and your financial plan.

Reviewing Your Pension Plan Choices

In our last video, we talked about pensions. We figured out the annuity payment, the lump sum options, and calculated which would actually be the best financial option for you and your family. Now we also walked through different scenarios where sometimes the best financial option wasn’t always the best family option. 

If you remember, that comes back to the aspect that, we are only picking the right financial option when we are being wise with those dollars we have. Our example previously was if we had $800,000 given to us today versus $50,000 each year for 30 years, what would make sense for you and your family? 

Today, I want to assume that we now have all the pension estimates available through our employer. Now, we are trying to determine current interest rates and how might those affect any pensions lump sum offers.

Your Pension Options

Now depending on your employer, you may have one of two very common pension types. If you work for a company like Advocate, the pension type available to you is called a Cash Balance Pension. If you work for an employer like Allstate, the pension type available to you is called a Traditional Pension.

Now why does this matter? This matters because it factors greatly into how your pension amount is calculated. 

How Does the Cash Balance Work?

So let’s pick on the cash balance pension. With the cash balance pension, we essentially receive service credits each and every year. The company, or the employer, in this case may determine how they are going to calculate these service credits. Generally speaking, it’s a factor of the amount they pay you times the number of years of service. 

Each and every year your employer is going to add money to this plan, like a 401(K) match, directly into your account. This account balance is going to grow and grow for a time. In addition to receiving service credits, you are also going to receive interest payments on this amount. 

The great thing with this type of pension is this amount never goes down. It’s only ever invested in safe securities that only ever earn interest. The downside is that you don’t get a chance to grow these amounts like you do with a 401(k), IRA, or Roth IRA by investing. 

As a recap, we have service credits and we have interest. Those are the contributions that get added to the cash balance pension plan. So that’s how a cash balance account works. 

How do Traditional Pension Benefits Work?

But what about a traditional pension benefit? You may see a traditional pension benefit with older employers because these were the original type of pensions that were handed out. Now, let’s say we have one of these available to us and our employer is offering us a $2,300 payment a month for the rest of our life. That’s our single life annuity amount. 

Now we can do some math and we can look to see what is the lump sum offer that might be available. If they are using the discount rate of let’s say 3%, we could expect to say that maybe that lump sum offer that they would give us is around $900,000, if we rolled that into an IRA. 

Where do Interest Rates Come Into Play?

But as we know, through 2022, interest rates have significantly increased this year. So, why does that matter? Because interest rates have a direct reflection on the lump sum offer that our employer is offering us. We’ve actually seen this happen for a couple of clients. 

As interest rates continue to rise, so too, does the dollar amount our employer or insurance company think that they can receive on the dollar they have invested to pay your monthly annuity amount. Boiling it down, essentially what that means is that if we are looking at $900,000 at 3%, what does that number mean if it’s at 4%? 

Roughly speaking, we can see a number around $600,000-$650,000 as a lump sum offer. Now if we are approaching retirement, that’s a pretty significant gap. Whether or not we can receive a higher interest rate is directly dependent on our own financial goals, planning set up, and tolerance for accepting risk. 

But as one of the things to be mindful of as we approach retirement. As interest rates continue to risk and as they have risen this year, this may be a significant factor in how much money you may have available to you at retirement. 

Next Steps for Interest Rates and Pension Plans

So bringing it all together, trying to understand how we can retire, when the right time to retire is, and what chances we might need to make in anticipation of retirement are all critical aspects. Things that we can keep in mind are, what is the pension type available to us. We know the cash balance lump sum offer is not going to change. 

But if we have a traditional pension lump sum offer, through our employer, if interest rates continue to rise as we have seen this year and perhaps into the future that may make a significant impact. 

You might realize you are going to receive less dollars from our pensions offer than you would have anticipated. But there are opportunities, where you could say I’m going to accelerate my retirement so that you can earn more money in doing so while leveraging lower interest rates and high lump sum amounts. 

If you’ve got questions about your retirement plan or how this might affect your pension plan, reach out! We’d love to be of help to you. 

If you are looking for more answers to your questions, check out our YouTube channel; we have videos on a lot of retirement planning topics.