As the Federal Reserve continues its pattern of
gradually raising interest rates off historic low levels, financial advisers will want to start recalculating the way they advise clients when it comes to pension payout options.
There are always
multiple variables to consider, but when rates are rising, some advisers believe the simple math favors taking a lump-sum payout instead of locking in for a few decades of monthly pension payments.
"If you think interest rates are going up, take the lump-sum and take it sooner rather than later," said Leon LaBrecque, managing partner and CEO at LJPR Financial Advisors, which manages $707 million worth of client assets.
Defined benefit plans, many of which
face billions of dollars' worth of unfunded pension liabilities, commonly offer current and future retirees the option of a one-time lump sum payout over a lifetime monthly pension benefit to get the liability off the books.
Depending on how long a retiree and his or her spouse live to collect benefits, the lump sum payment is typically less money than a retiree would be paid over an entire retirement, which is where many advisers and clients must weigh the options.
But, according to Mr. LaBrecque, the rising-rate environment combined with the
Pension Protection Act of 2006 that has driven more companies to offer lump-sum payouts, makes the decision much clearer and cleaner.
By Mr. LaBrecque's calculations, higher interest rates give retirees more options to generate returns on the lump-sum payout.
But, perhaps more significantly, simple math suggests that the size of the lump-sum payout offers will decline as interest rates continue to rise.
"Participants have a choice of what to do, but rising rates pushes down the size of the offers," he added. "You should take the offer sooner rather than later."
Jeff Snyder, vice president and senior consultant at Cammack Retirement Group, which works with employers on the pension side of the business, agreed that rising rates will put more lump-sum offers on the table.
"A rising-rate environment is helping corporate pensions with their actuarial assumptions and valuations," he said. "It's opportunistic, and now is the time to offer these lump sums to help shore up pension plans."
Lump-sum payout offers have been climbing for years as companies try to shed the less-predictable liability of decades of pension payments.
According to the Pension Rights Center, only
90% of state and local government pensions are fully funded, reflecting an average that includes such dire situations as the state of Illinois, which is only about 30% funded.
The situation isn't much brighter on the corporate side, where unfunded pension liabilities continue to rise.
A February
report by Russell Investments found that the 19 U.S. public companies with the largest pension liabilities had a combined pension deficit of $177 billion.
As Mr. LaBrecque details, pension math uses a formula similar to mortgage math, which calculates monthly mortgage payments based on an interest rate and time.
For example, a $100,000 mortgage loan with a 4% interest rate, set to be paid off in 30 years, would require a $477 monthly payment.
If the borrower could only afford $477 a month, and the interest rate was instead 5%, the loan amount would have to drop to around $89,000.
With pension math, the lump-sum offer is based on the long-term liability of monthly pension payments, among other factors including life expectancy.
Using the above mortgage example, the lump-sum payment offer to a retiree falls in direct proportion to interest rates, according to Mr. LaBrecque.
While the size of the lump-sum offer might adjust as interest rates rise, that is still just one of the factors advisers are considering when advising clients.
"When we're talking to clients about this, we consider the payout amount along with the financial stability of the organization, the health of the pension plan, and the need for survivor benefits," said Brett Anderson, president of St. Croix Advisors, which has $40 million under management.
"The biggest thing is whether those [pension] dollars are going to be there in 20 or 30 years from now," he said. "You have to run the math, but there is also an emotional side that has to be dealt with."
Part of the emotional and practical side of the evaluation involves weighing the potential to leave an inheritance, which is more likely through a lump-sum payout option.
"Most of the people I work with do cash out because they want the flexibility and a lump sum even though it might be less than what you could get over the full term of a pension," said Daniel Leonard, principal at Marathon Retirement Planning, which manages $45 million.
"It just boils down to whether you want a guarantee or not," he added. "The client that is not going to cash out, they want X number of dollars a month and they are OK with that. They want the certainty over the possibility."
