Bogleheads

[FrugalInvestor]

What is the effect of rising interest rates on a lump sum defined benefit calcualtion and on the associated fixed lifetime annuity calculation?

More specifically, let's assume that at retirement I could take a lump sum of $100,000 or monthly lifetime annuity of $500 (not real numbers) immediately. If I decided to wait for one year and in the meantime interest rates rose, what would be the effect on the lump sum and monthly annuity calculations?

For some reason I was thinking that rising rates would cause the lump sum to go down and the annuity payment to go up but I may be all wet.

I hoping someone here understands this better than I.

[bob90245]

Annuity payouts generally track interest rates:


Source: http://www.annuityshopper.com/....hopper.pdf

[patriciamgr2]

either the lump sum or the annuity payment needs to be certain to do the calculation. if you're talking about a lump sum from e.g. a company pension plan, the monthly pension payment is usually determined by reference to your pay. to determine the lump sum equivalent, you do a present value calculation discounting the future stream of monthly payments by the current interest rate. so, in general, if interest rates go up, you're discounting by a higher number and the lump sum will go down. (theoretically, it's as if you're asking how much money do you need today to invest at today's interest rates to produce that stream of monthly pension payments). Caution: many pension plans have set interest rates or look-backs, etc. so it may not be as simple as I described--just ask your HR dep't to calculate a lump sum at two different interest rates for you--they may even have an online calculator.

if you're an employee considering a lump sum, in effect, you're Selling the annuity you could receive back to your pension plan.

if you're thinking about buying an annuity from an insurer, you're in the opposite position. interest rates going up between now and when you buy the annuity will mean that your initial investment will give you bigger monthly checks. (many people suggest splitting your investment into a few pieces and buying from different insurers over a few years to get an average of interest rates & reduce credit risk at same time). i believe bob90245' post is responsive to this point. Vanguard has an online calculator that lets you specify how much you want each month (and then gives you the lump amount you need to invest now to get that stream of payments) or lets you input the amount you want to invest (and then spits out what the monthly payment would be).

i apologize if this wasn't what you were asking.

[FrugalInvestor]

Thanks patriciamgr2, that helps a great deal especially in confirming my understanding with respect to the lump sum.

I continue to be somewhat (okay, very) confused by the possible effect of rates on the annuity stream when given the choice within a defined benefit company pension plan.

According to the company documentation there are two rates used when calculating the possible lump sums/annuity payouts. The first is described as a Treasury Constant Maturity rate (no duration specified). The second is a blend between the 30-yr Treasury Constant Maturity rate (also known as GATT) and the Pension Protection Act (PAA) rate. The blend of these two rates is changing year-by-year in order to phase out the GATT rate and phase in the PAA rate by 2013, I believe.

I believe that the first rate increases the lump sum payout over time and is presently just under 3%. I can't figure out the impact of the second (blended) rate but suspect it is used to calculate the annuity stream and I'm trying to figure out how and to what extent it is likely to impact it in order to help a relative determine whether to lock in the annuity now or wait until next year. I'm also trying to pin down the relationship between the GATT and PAA rates since as the proportions change just that would impact the calculation.

If you (or anyone else) has additional insight on these calculations and the likely effect of rising rates on the annuity stream it would be much appreciated.

Unfortunately, the company people don't seem to have the in-depth knowledge to answer such questions. When they run out of answers they tell us that they can't say because it's "actuarial" which, I come to believe, means that some higher power does the calculation and they don't understand it either.

[Harold]

It's still not clear from your posts whether the benefit defined is a lump sum or an annuity. As Patricia pointed out, that makes a difference. (Also, it's unclear when the benefit is commencing - but since I saw the word immediate, I presume your relative can retire now.)

To answer your questions generally though:

The 30-year Treasury rates used by GATT are typically lower than the corporate bond rates used by PPA (reflecting the differences in risk between the two), so interest rates would seem to be rising with the phase in. (But they don't have to, since interest rates and risk can change.)

If the benefit is defined as an annuity, an additional year would increase the annuity payment (presuming benefits are still accruing), and the rising interest rates that you're assuming would decrease the lump sum. Whether the increase in benefit is enough to still give you a higher lump sum depends on the richness of the plan and the interest rates in effect when you commence.

If it's a plan where the benefit is defined as a lump sum, the additional year would increase the lump sum by whatever the formula contribution is and whatever interest rate the plan stipulates. For the associated annuities, the plan would likely project the current lump sum (at the plan interest rate) to a normal retirement date, then convert it to an annuity. Your assumed higher interest rates would give a higher annuity, in addition to the benefit accrued by working an additional year.

The general principle is that the lump sum is the amount of money needed now to provide the stream of periodic annuity payments. So the higher the interest rates, the lower the lump sum of money needed.

For specific answers, we'd need more detail about the plan.

[FrugalInvestor]

[Harold]

[FrugalInvestor]

Harold and patriciamgr2...your willingness to lend me your time and expertise on this matter is greatly appreciated!

I know you cannot predict interest rates or the future shape of the yield curve. Given that, I have some further questions to help me better understand of the possible impacts of delaying the initiation of the annuity payments. It seems that a (very large) company's pension representatives should be able to answer such questions but it seems that they can only talk in generalities and provide numbers that a very incomplete online calculator can provide (i.e. it only allows for adjusting the withdrawal date and the 1-yr blended treasury rate).

The account balance increases by the average of the 1-yr treasury rates for Aug-Sept-Oct of the prior year (2.8% for 2009).

The annuity calculation is made using the blended PPA/GATT rates. The GATT rate is the same average but using the average of the 30-yr treasury rates (4.3% for 2009).

Can you shed any light on the comparative magnitude of a change in the two rates? In other words, holding the 2.8% rate constant, how much would a 1% increase in the 4.3% rate (to 5.3%) have on the annuity calculation?

And then holding the 4.3% rate constant, what would the impact be of an increase in the 2.8% rate to 3.8%?

Also, how much higher is the PPA rate than the GATT rate? Is the difference fairly constant?

The initial account balance we're working with is $180,000 and the associated monthly annuity payout is currently calculated at $1,155.

[Harold]

1-yr Treasury rates can change significantly from year to year (affecting the account balance)

30-yr Treasury rates can change significantly from year to year (affecting the GATT component of the average)

Corporate rates can change significantly from year to year (affecting the PPA component of the average)

So, as you can see, generalities may be the safest way for an advisor to approach this. Anyone attempting to give you a numerical quantification would be giving you false precision (or tying to a set of numbers that may or may not occur in the future).

Even quantifying the difference between GATT (i.e. Treasuries) and PPA (i.e. corporate) is imprecise. It is probably reasonable to assume that Treasury rates will be lower than corporate rates, because of the difference in risk, but even that could change.

More likely than not (and with all the caveats above), because Treasuries are typically less risky than corporates, waiting for PPA to fully phase in would give a higher annuity.

[Igglesman]

Your company pension plan should have a "calculator" that you can test taking the lump sums at different future points in time...I highly recommend that you run a scenario for taking the lump sum in Dec. 2009 and Jan 2010....should be a huge difference.

Each year the mix of 30-year treasury to the corporate bond rates changes by 20%.....in 2009 it should be 40% corporates and 60% 30-year treasuries. When this ratio changes every January, your lump sum will decline (considerably). As you know, corporate bond rates are higher than the treasury rates...which forces the lump sum required to fund the annuity to decrease. In my case, the lump sum decreased by 12%.

In addition, the quarterly rates can also change....my lump sum decreased by $40,000 from Apr 31 to May 1 just because of the quarterly adjustment. In my opinion, your lump sum will never be higher than it is today...in my case is was 20% artificially higher (by comparing the amount of the annuity I could purchase on the outside vs. the pension annuity).

Hope this helps.

[FrugalInvestor]

Thanks again Harold (and Igglesman) for the responses. Harold, I understand all your caveats and your reluctance to respond to my last question too specifically. Quite honestly I wasn't even expecting a response.

We've now gathered enough information to make an informed decision on the annuity which, of course, is only one moving part of many in the big picture. The information provided by all of you has been very helpful in that process. Now we're on to the next decision!

I must admit, I now know much more about how this particular company's pension plan works that I ever imagined I would, or cared to for that matter. That said, in some perverse way, I actually enjoy this stuff. Am I okay?

[FrugalInvestor]