Since the lump sum equivalent of a monthly pension moves inversely to interest rates, this year’s historic run-up can reduce lump sum cashouts by 30% or more
As Ryan Seacrest counts down the final seconds of 2022 on Dick Clark’s New Year’s Rockin’ Eve with Ryan Seacrest along with throngs of revelers in Times Square, the huge, reflective, LED ball won’t be the only thing suddenly dropping. For many pension plan participants who have not started benefits, the equivalent lump sum amount of their monthly pension in single-employer defined benefit (DB) plans will also abruptly fall.
The culprit, as is usually the case in pension blogs, is interest rates. However, in this instance, it’s not persistent low rates causing the problem, it’s sharply increasing rates. Corporate bond rates are up more than 250 basis points this year to levels not seen since Dick Clark’s New Year’s Rockin’ Eve was actually hosted by Dick Clark.
Since the lump sum equivalent of a monthly pension moves inversely to interest rates, this year’s historic run-up can reduce lump sum cash-outs by 30% or more—larger reductions for younger payees, with smaller reductions for older payees. And for many, this change will arrive suddenly and possibly unexpectedly.
IRS 417(e) Lump Sum Equivalents
$1,000 monthly benefit payable at age 65
| 2022 assumptions | 2023 assumptions | Percentage drop | |
|---|---|---|---|
| Age 45 | $94,000 | $53,000 | 44% |
| Age 55 | $134,000 | $87,000 | 35% |
| Age 65 | $191,000 | $150,000 | 21% |
Other assumptions:
Single life annuity form of payment deferred to age 65
2022 results based on Sep. 2021 IRS 417(e) rates and 2022 unisex mortality
2023 results based on Sep. 2022 IRS 417(e) rates and 2023 unisex mortality
Calendar year plan with annual stability period
Note: The chart above is for illustration purposes only. This lump sum reduction is the result of converting a monthly accrued pension benefit to a single sum. Many plans that directly express the accrued pension as a single sum (like certain cash balance plans) are unaffected.
The witching hour
Most qualified DB plans convert lump sums using rules dictated by IRS code section 417(e), which specifies the interest rates and mortality tables required to calculate minimum lump sum conversions. Sponsors are always free to amend plans to pay more than this minimum if they so choose.
The regulations also specify a “stability period” for which lump sum rates are locked in. The most popular stability period is plan year, and most plan years coincide with the calendar year. So when December 31 becomes January 1, potentially millions of lump sum values will drop briskly through the cold New York air in 3…2…1… Happy New Year!?
Just catching up
Of course this big reset is simply a delayed result of artificial IRS lump sum rules. Bond rates have been on a meteoric rise all year, so DB plan liabilities and risk-hedging bond investments have already experienced unprecedented reductions as discussed in my previous blog, Surprise pension funding de-stabilization. The same is true for lump sums for some noncalendar year plans and those with shorter stability periods (quarterly or monthly). One could say this is just correcting actuarial equivalent values to reflect current market conditions.
It’s not business—it’s personal
Correcting actuarial equivalent values is a fairly dispassionate assessment of a choice that’s much more personal for those at the crossroads. The decision of whether and when to retire can change dramatically based on the size of the potential payout. And many non-actuaries (aka “people”) not familiar with the chapter and verse of IRS 417(e) are likely oblivious to the upcoming change.
To address the potential impact on those close to retirement, some sponsors are temporarily extending the more favorable lump sums conversions, giving those affected a bit more time to make important life decisions. These plan amendments can have funding, accounting, and workforce management implications, so consultation with actuaries and legal counsel is highly recommended.
In the end, employers may decide that the cost of holding the 2022 lump sum ball up for several more months is well worth it to give their employees a more comfortable retirement experience.
