The mass exodus from traditional defined benefit pension plans is a reflection of several trends. Primarily, employees are living longer, and updated IRS life expectancy tables have increased the cost of providing a defined benefit plan accordingly. Additionally, the prolonged low-interest-rate environment has reduced funds’ investment returns, which means plans need additional capital to stay afloat. Lastly, underfunding of pension plans has led to more government regulations, which has increased the cost of offering defined benefit plans as well.
Amidst all of these issues and complex changes, employees are left to figure out which of their pension payout options will work best for their needs. As their trusted advisor, it’s important to understand how your clients’ choice can affect their income in retirement. With this in mind, I’ll review the components of a pension calculation, as well as each one’s potential pitfalls.
How Are Pensions Calculated?
There are three main components of a pension calculation:
- The monthly pension benefit
- IRS life expectancy tables
- The IRS discount interest rate used
Combined with the current environment, these components can have a drastic effect on the amount of money your clients can expect to receive.
Monthly Pension Benefit Affected by Frozen Plans
The main risk to this component of a pension calculation is a frozen pension plan. If an employer chooses to freeze its pension plan, the payment becomes stagnant—this means working for additional years will no longer increase the monthly benefit. Employees will still receive the benefits that they accrued before the plan was frozen, but the benefits will not continue to grow unless the plan is unfrozen.
Because pensions reach their greatest value in the client’s last earning years before retirement, the impact of the freeze on their pension payout can be dramatic. Employers that choose to freeze their pension may instead offer a defined contribution plan, such as a 401(k). They may also offer the client a lump sum to de-risk the plan.
You may have noticed an uptick in the number of clients who are receiving offers in the mail to take a lump sum early at a special rate. It’s no secret that employers are trying to move expensive defined benefit pension plans off their books. One way to do this effectively is to offer employees an attractive lump sum now in lieu of an annuity later. In order to determine if a lump sum is a good option for a client, you would need to find the breakeven rate of return used in the calculation. Once you identify this hurdle rate, you can determine the rate of return a client’s rollover lump sum would need to earn in order for it to outperform the annuity option, given a specific life expectancy. When considering a lump-sum offer, there are other factors to keep in mind as well; longevity risk, market trends, and inflation risk should all play a role in the decision of whether to take a lump-sum offer.
Increases in Life Expectancy Raise Required Plan Contributions
The IRS has issued new mortality tables for pensions, which took effect on January 1, 2018. The increased average life expectancy of a beneficiary is expected to raise the aggregate minimum required contributions to pension plans by 11 percent and the aggregate Pension Benefit Guaranty Corporation (PBGC) premiums by 12 percent.
As a result of this change, future annuity income streams are required to last longer. This means lump-sum offers will also increase in value, as the lump-sum payment is equal to the present value of the annuity stream, based on an estimated rate of return and the client’s predicted life expectancy. These changes will put additional pressure on defined benefit plans, increasing the likelihood that more plans will be frozen or terminated in the future.
Higher Discount Interest Rates Mean Lower Pensions
The IRS publishes discount interest rates for pension plans called Minimum Present Value Segment Rates. A pension plan’s documents specify the month that is used in the discount calculation for the year. If you look at the IRS segment rates chart, you will notice that there are three rate segments for every month listed. The first segment applies to life expectancy years 0–5, the second segment applies to years 6–15, and the third segment applies to years greater than 15. These interest rates can change the value of a lump-sum or annuity withdrawal from a pension.
As interest rates increase, the value of pensions will go down. For example, for a million-dollar pension with a 25-year life expectancy, a half-percentage increase in the IRS published rates can decrease the lump-sum offer by about $50,000.
Essentially, if rates are increasing, your client’s pension is decreasing. If a client has the option to take a lump-sum offer now, the rising interest rate environment should factor into the decision.
Making the Best Choice
When advising clients about pensions, it’s important to factor the current environment into your discussions on pension payout options. With a growing number of companies freezing, terminating, and de-risking their defined benefit plans, the prospect of a reduced pension is a real possibility.
How many of your clients are eligible for pensions? How do you help them decide among their pension payout options? Please share your thoughts with us below.