Individuals nearing retirement who have pensions often have the option of taking that pension in the form of a monthly annuity payment for life or as a lump sum payment taken at retirement. There are a lot of factors that go into deciding between the annuity and lump sum options, and there are benefits and drawbacks to both. One major factor that needs to be considered when choosing the lump sum option is the impact current and future segment rates can have on the pension lump sum payment.
The IRS publishes the Minimum Present Value Segment Rates monthly, and companies use these rates to determine the rates for their plans. These rates can have a significant impact on the value of a pension lump sum payout, so understanding what goes into determining the rates can be critical in making a sound decision when choosing the lump sum option.
The IRS calculates spot segment rates from corporate bond yields. The three segment rates the IRS employs are used to discount three time periods representative of expected retirement time periods. These time periods include the first five years of retirement (valued using short-term corporate rates), six to 20 years of retirement (valued using medium-term corporate rates) and more than 20 years of retirement (valued using long-term corporate rates). These rates are used to discount the present value of the annuity payment that would have been made during a specific time period of an individual’s retirement.
A company will then use the rates provided by the IRS to determine its own segment rates applicable to its pension plan. For example, a company may take the average of the three most recent IRS segment rates to come up with its own pension segment rates. It is important to keep in mind that each company will have its own methodology in determining the segment rates for its plan. If an individual is thinking about taking their pension as a lump sum, it is a good idea to understand how the employer calculates the rates used in the plan.
In general, as interest rates rise, the value of the lump sum payout will decrease and vice versa, so the timing of this decision is critical and can make a difference in lump sum value to the tune of thousands of dollars. In recent months, IRS segment rates have been trending downward, which in turn means segment rates related to some pension plans have also been trending downward. A good indicator on which direction segment rates will trend in any given month is the corporate bond market.
Most months, the IRS publishes the updated segment rates around the 15th of the month. In July, the IRS released the Minimum Present Value Segment Rates for June of 2020. The First Segment was 0.74, the second was 2.57 and the third was 3.32. All three segments were down from the previous month. See below for the list of published rates going back through January of 2020:
|Month/Year||First Segment||Second Segment||Third Segment|
When deciding to take a lump sum pension payout, it is important to understand the critical role segment rates can play in the value of that payout and how proper timing can be vital in getting the most out of a pension. Speaking with a financial planner can help individuals better understand the complexities and timing of this decision.
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Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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