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Retire soon with retirement? How interest rates affect your preferences

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 Retire soon with retirement?  How interest rates affect your preferences

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One of the main decisions faced by almost retirees who are entitled to a pension may be whether to accept these payments as a one-time advance payment and not as an annuity.

If you are among those who are inclined to a one-time payment and are approaching retirement, you may want to think about how raising interest rates – the current state of affairs – affects this amount.

Simply put, the higher the rate used to calculate the lump sum – to make it actuarially equivalent to an annuity – the lower your payout.

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“The calculation works the opposite of what you think,” said Wayne Titus, CPA and managing director of Savant Wealth Management in Plymouth, Michigan.

About 15% of all private sector workers have access to a traditional pension, which is usually funded by the company and sometimes employees, and provides monthly payments for the rest of the retiree’s life. Most employees (65%) work for employers who offer 401 (k) plans, which are mostly funded by staff.

Unlike the role that interest rates play in lump sum payments, retirement annuities are not directly affected by changes in rates, said Linda Stone, a senior fellow at the American Academy of Actuaries.

These payments are usually determined by a formula – based on factors such as age and seniority – and are a fixed amount per year.

However, pension annuities run the risk of inflation over time because the company’s plans typically do not include annual cost-of-living adjustments, although state and local pensions may include it.

To illustrate the erosion of inflation: an annual inflation rate of 1% would reduce the cost of $ 25,000 in annual pensions to $ 20,488 in 20 years, according to the National Association of State Pension Administrators. A rate of 2% will result in a benefit of $ 16,690.

The calculation works the opposite of what you think.

Wayne Titus

CEO of Savant Wealth Management

Now, inflation is 8.3% year on year – the highest in almost 40 years and much higher than the Federal Reserve target rate 2%.

At the same time, to combat inflation, the Fed recently raised a key interest rate by one and a half percentwhich means the second increase this year and the largest increase in more than 20 years. And in the coming months, additional adjustments are expected in the direction of growth.

This is where the connection with one-time pension payments arises. The specific set of interest rates published by the IRS – usually based on the corporate bond yield curve – that companies must use when calculating lump sums is rising along with inflation.

“Higher rates mean less lump sum,” Stone said. “You make a discount [the value] the flow of future payments ”.

While the IRS updates rates monthly, many companies use one-month figures – say, from August or November – to calculate these one-off payments for next year, Stone said.

In other words, the lump sum paid this year and based on the lower rate set in 2021 will be more than the 2023 payout determined this year at a higher rate.

Simplified illustration: if the rate used is 4%, a pension of $ 5,000 a month ($ 60,000 a year) for 20 years will give a one-time amount of about $ 815,419, Titus estimated. At 6%, the one-time payment will be about $ 688,195 – a difference of $ 127,224 and about 16% lower.

So if the upward trajectory continues and you plan to retire with a one-time payment in 2023, you could get more if you retire this year.

Of course, interest rates are not the only factor you need to consider when it comes to a one-time payment.

“One-time payment is not for everyone,” Stone said. “People need to manage this lump sum and make it last a lifetime … some people have the financial means to do it and others don’t.”

And rescheduling a retirement date may be easier said than done. It could also mean a loss of income that you would have earned in the interim, or additional loans that you could have earned on your retirement.

Stone Group offers a free program that provides expert actuaries to help answer people’s questions about their retirement plans. However, she said, there are many other things to consider that go beyond their knowledge, such as taxes, property planning, etc.

“There are a lot of factors that affect the game, and people need to really talk to a financial advisor before making a decision, especially if it’s a large amount,” Stone said.

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