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Urgent News Regarding Your Pension
Many Americans are learning a very tough lesson in regards to how pensions work due to the inflation pressures we are now witnessing. Although it might not sound intuitive, when rates increase, the lump sum value of your pension will likely decrease.
The reasoning behind this a lump sum pension is calculated by discounting the monthly amount due amount by the current interest rates. A pension monthly payout is typically fixed and is calculated based on several factors, including your age and service time. Hypothetically, let’s assume that calculation equals $1,000 per month for the rest of your life and your life expectancy is 30 years. This is nothing more than a 30-year immediate annuity. To find the present, or current, value of that annuity, you discount each payment back to today based on the current rate. To better see how this works, think if you are company providing the annuity. If you started with $200,000, you would only need that to earn 4% per year on that amount to fund $1,000 a week for 30 years.
However, if I could earn 6% each year on the you would only need to start with $168,000 to be able to fund that $1,000 per month. The higher the rate of return assumed, the less money you need to start with fund the $1,000 per month. This is why when interest rates are higher, the actual lump sum you could receive is typically lower.
This is creating a dilemma for some people who are close to retiring. A difficult choice could possibly become even more difficult.
- Should you take the lump sum or the monthly fixed amount?
- Should you retire earlier to lock into a higher lump sum?
- What if interest rates keep increasing?
The answer to these questions depends on many factors. The first thing one close to retiring should do is find the date in which the calculation includes the increased rates. Many plans only update the rate used to calculated the lump sum once or twice a year. You may still have a chance to lock into a higher lump sum.
As to whether you should take the lump sum or the monthly fixed amount, the first question you should ask yourself is how good are you with your money? If you take excess risks and are big spenders, taking a lump sum may be very dangerous. A monthly amount helps prevent people from squandering their money.
The big risk to a fixed monthly amount is inflation. How much car would a $1,000 buy you back 30 years ago versus today? Even plans that have an inflation adjustment rarely keep pace with the true inflation people experience. A lump sum invested wisely and with diversification may protect you against the inflation risk much better.
The other major advantage to a lump sum payout is the wealth stays in your bloodline if you want. Pensions typically have options for the fixed amount to keep paying a spouse, usually a lower amount, if you happen to die before your life expectancy. It is really is a gamble on how long you, or you and your spouse, live compared to your life expectancy. If you live longer, you win because you actually received more money than your annuity was supposed to pay. However, if you die earlier than your life expectancy, the remaining amount goes to pay those that lived longer. You are funding their pension.
Thus, even though the pension may have a value of $500,000, if you, or you and your wife in shared pensions, die a year later, the entirety of that pension goes into the pot to pay people who live longer instead of to your beneficiaries. In a lump sum, the remaining amount would go to whomever you designate as your beneficiary. You earned that pension; do you want to see that wealth continue in your bloodline if you pass away?
One last comment, if you decide on the monthly amount and are trying to decide if you should take the 100% option or an option that you receive less but the monthly pay continues for your wife after your death, consider a term life insurance instead for the pension owner. If the life insurance premium is less than the amount you lose in monthly income, it will actually save you money long-term.
If you have any questions regarding your situation, please feel free to call us at 817-717-3812.