How would a decrease in the interest rate effect the present value of a lump sum?

Steven Pope, CFA, CFP®, Senior Director – Ameriprise Financial

AN INVESTMENT RESEARCH GROUP PUBLICATION

Sept. 16, 2022

Many employees today participate in a defined benefit retirement plan. A key feature of this benefit type allows some participants to choose, at the point of retirement, to either receive the vested benefit amount in a single lump-sum payout or through a series of payments over time.

Since choosing between these two payment options is often permanent and irreversible, making a thoughtful and informed decision is key for the participant.

Complicating matters in this decision-making process today, however, is rising interest rates. Particularly as it relates to the value a participant receives under the lump-sum distribution option.

In short, rising interest rates typically have a negative impact on asset values. This is due to the way present value is calculated for an asset. The economic principal, known as ‘discounted cash flow’, states that the current value of a financial asset is the present value of all future cash flows. Simply put, this means that the way asset values are determined is by discounting all future cash flows back to present time, using a stated discount rate (an interest rate).

Since future cash flows are reduced by the discount rate, a higher discount rate will result in a lower present value of an asset. The opposite is also true. A lower discount rate leads to a higher present value.

Consider the following example of this concept. Assuming a 4% discount rate, a participant would be indifferent between receiving $1,000/month for the next 10 years (a total of $120,000 over time) or $98,770 today. However, if the discount rate is increased to 6% the participant would accept receiving $90,073 today (roughly 9 percent less) or the same fixed payment of $1,000/month for the next 10 years. Intuitively, what the math behind these calculations is suggesting is that a participant receiving a lump-sum payout will be able to reinvest these assets at prevailing interest rates. Thus, at higher interest rates, less initial principal is required to generate future cash flows and at lower interest rates, more initial capital will be required. 

In 2022 interest rates are dramatically higher than a year prior as the economy wrestles with elevated inflation. For example, the yield on a 10-year Treasury bond, which acts as a common benchmark rate for the economy, has more than doubled this year, starting the year at 1.24% and closing at 3.41% on September 14, 2022. Furthermore, specific to defined benefit retirement plans, a blend of corporate bond yields is commonly used to calculate lump-sum payout amounts. Importantly, these corporate yields are typically higher than those on Treasury bonds with similar maturities.

Stark yield increases have not only increased borrowing costs for many consumers and businesses across the economy, but they may have notably caused a reduction in lump-sum payouts for participants in defined benefit plans. Many plan participants, especially those nearing or at their desired retirement age, could soon see their lump-sum value fall should interest rates move higher or retirement plan calculations catch up with current market levels.

Understandably, participants will have questions about their course of action. Including:

• Does it make more sense to take a reduced lump-sum from my pension or receive the annuity amount over time?
• Can I still afford to retire on this lump-sum value?
• What interest rate and inputs are used to calculate my specific lump-sum payout, and how likely are these inputs to change over the next year?

These are important questions, and your Ameriprise Financial advisor is uniquely equipped to guide you through this important decision-making process. As a plan participant your first step is to gather the necessary information. Contact your pension benefit provider and ask about the details of your specific benefit amounts. Once equipped with this information, an Ameriprise Financial advisor stands ready to discuss the path that best aligns to your retirement goals.

Want to see are most update to date blog on Chevron interest rates, click here.

Many Chevron employees who are waiting to commence their pension lump-sums, will now see a significant decrease in their value. With short, medium, and long-term rates rising significantly over the last month, the higher average rates will result in lower lump-sums for those retiring in June of 2022. This is because when Chevron employees elect the month they would like to begin their pension, Chevron looks back at the third, fourth, and fifth months' rates to calculate the pension disbursement. When these interest rates move up or down, your lump sum amount will move in an inverse direction, so if interest rates increase, your lump sum amount will decrease and vice versa.

Through the pandemic, interest rates dropped dramatically which greatly increased many lump sum payments. This trend culminated in record lows for individuals who commenced their benefits in December of 2020. However, since then this trend has shifted, as interest rates have been increasing quickly, causing a large reduction in pension lump-sum values.

Large increases in interest rates are important if you decide to take the lump-sum option since the calculation for your lump-sum is based on interest rates and your age. Your pension will be calculated based on your last date of employment and benefits start date. The benefit calculation is a defined benefit based on your years of service and final average pay. These, along with a Social Security Offset are used to determine your single life annuity. All other forms of pension payments are based on this figure.

Chevron Pension Lump Sum Calculation:

Chevron Interest Rates for April 2022

If you are planning to retire and start your pension in June 2022, Chevron would use the blended rate available through March 2022 (three months prior to your month of retirement). This example shows three months of rates and how they are blended to determine your rates for various segments of your pension.

For a June 2022 pension commencement date, the average of the March 2022, February 2022, and January 2022 rates comprise the blended rate.

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For a May 2022 pension commencement date, the average of February 2022, January 2022, and December 2021 rates comprise the blended rate.

For an April 2022 pension commencement date, the average of January 2021, December 2021, and November 2021 rates comprise the blended rate.

For lump-sum conversions, the annuity is discounted to a present value using the first segment rate for the first five years of expected payments, the second segment rate for the next 15 years of expected payments and the third segment rate for all years of expected payments over 20.

"If rates increase by 1% you could see a 8 - 12% reduction in your lump-sum.

The annuity is also discounted based on mortality, meaning the present value of each monthly payment reduces as the probability of living to receive each payment reduces. The older you are when you commence your pension benefit, the fewer the number of years that will be valued using the third segment rate (20+ years) and, conversely, the younger you are, the greater the number of years that will be valued using the third segment rate.

This methodology essentially means that there will be a unique monthly interest rate (lump-sum conversion factor) for each year and month of birth.

How Do Rate Changes Affect Your Chevron Pension?

Pension pricing is based on interest calculations, which means an adjustment in your retirement date may lead to avoiding a serious financial hit, due to avoiding months with high-interest rates.

The blended rates for June are: 1.91%/3.36%/3.67% . May rates are: 1.48% / 3.03% / 3.39%. April rates are: 1.20% / 2.82% / 3.18%.

Everything else held equal, a higher interest rate will produce a lower lump sum. The exact changes depend on your specific age, but on average a 1% change in rates can equate to an 8% to 12% change in lump sums. So, on average, a 1% change could increase or decrease your pension lump sum by roughly 10%.

The changes from just June 2021 to June 2022 may account for a 7-8% decrease in lump sums, as the second segment rates have seen a significant increase. Rates now are considerably higher than they were in 2020. For December 2020, the blended rates were 0.54 / 2.26 / 3.06. The June 2022 blended rate is 1.1% higher in the 2nd segment which tends to have the strongest effect. An increase such as this over just the last year and a half may have caused your pension to decrease by about 11%. For someone with a $500,000 lump sum, that could mean a move of as much as $55,000. For a $1,000,000 lump sum, it would be roughly $110,000. Interest rates trended upward for most of 2021, excluding the month of September. If rates increase again by 1% you could see another 8 - 12% reduction in your lump-sum. These rates are updated monthly, so every month you have options to commence your pension. It's important to note that you don't have to commence your pension immediately after you retire. If you wish to delay your commencement, you have the ability to defer it until a later date. Also, please be aware that if you decide to take your pension before the age of 60, there will be age penalties that prevent you from collecting 100% of your pension. 

Given the current interest rate environment, we highly suggest Chevron employees residing in the US discuss their options with The Retirement Group and allow us to monitor the rates and keep you up to date on the monthly changes. We can provide a complimentary cash flow analysis to show you how various retirement dates may play out.

It is important to remember that every situation is unique and that by getting a cash flow analysis you'll be able to compare different types of pensions and find the best fit for your situation.

To read "What Chevron employees Should Know About NUA" Click Here.

The Retirement Group is not affiliated with nor endorsed by Chevron. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Neither The Retirement Group or FSC Securities provide tax or legal advice. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

Securities through FSC Securities Corporation, member FINRA/SIPC and investment advisory services offered through The Retirement Group, LLC, a registered investment advisor not affiliated with FSC Securities Corporation. Office of Supervisor Jurisdiction: 5414 Oberlin Dr #220, San Diego CA 92121. 800900-5867

Tags: Pension, Interest rates, Chevron, Inflation

How would a decrease in interest rate affect the present value of a lump sum?

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