In an earlier article on statutory interest rates, published in April 2022, I summarized the impact on lump sum payments upon retirement (or termination) from traditional defined benefit (DB) pension plans if rates were to spike. In an update published in November 2022, I stated that the initial estimates were too optimistic and highlighted the impact based on September 2022 segment rates.
Since the update, the Federal Reserve has once again increased its benchmark federal funds rate in an effort to stave off the result of historically high inflation. As a result, the one-year increase in the segment rates used to calculate lump sums is potentially the largest increase over any previous 12-month period.
Let’s look at an example to emphasize the potential impact the recent rise in interest rates has on lump sums.
The IRS published its November 2022 “segment rates” of 5.09%, 5.60%, and 5.41% for the first, second, and third segments, respectively.
The increases from September to November are roughly 30-60 basis points higher for each of the segments.
For readers who track such details, the first “segment rate” has not exceeded 5.00% since April 2009, and the second segment rate has not exceeded 5.50% since April 2010.
The prior articles modeled the impact on a hypothetical lump sum for a 51-year-old with a $1,000 monthly benefit payable at the deferred age of 65 (which have now been updated to reflect actual 2023 applicable mortality). If we were to add the impact based on the actual November 2022 rates, the results are rather astonishing, as seen in Figure 1.
Figure 1: Impact on lump sums based on segment rates
| Segment rates used | Estimated lump sum | Percentage decrease in lump sum payout value |
|---|---|---|
| 1.02%, 2.72%, 3.08% (actual November 2021 rates) | $116,800 | |
| 2.02%, 3.72%, 4.08% (adding 1% to each rate above) | $92,600 | ~21% |
| 4.48%, 5.26%, 5.07% (actual September 2022 rates) | $71,500 | ~39% |
| 5.09%, 5.60%, 5.41% (actual November 2022 rates) | $66,300 | ~43% |
This decrease would be even larger for younger participants, but smaller for older participants.
Residual consequence of lower lump sums
As previously noted, the large lump sum interest rate spike could cause the present value of benefits for younger terminated vested participants or participants with small vested benefits to fall below the $5,000 small lump sum threshold. When the value of a qualified pension plan distribution is no more than $5,000, the plan sponsor can start the process of distributing these benefits by asking the participants whether they prefer the receipt of a payout in cash or a rollover to an IRA. (These payouts are referred to as small plan cash-outs, and are the subject of an article by my colleagues at Milliman that can be read here.) For plans with larger lump sum payout thresholds, this would increase the number of participants who are eligible to elect a lump sum distribution.
Consequence #2 for cash balance plans
Lump sums in cash balance DB plans are unaffected by the surge in interest rates. However, as mentioned in the prior update, cash balance plans must offer an equivalent annuity to the cash balance amount. An increase in interest rates decreases the actuarial factor used in the conversion, perhaps enough to make a significantly higher 2023 monthly payment quite attractive when compared to the 2022 monthly payment. For example, for a 65-year-old retiree, a $100,000 lump sum converted to a single life annuity under the November 2021 rates would get a single life monthly annuity of approximately $530. Under the November 2022 rates, the single life monthly annuity would increase to approximately $690 (that’s $1,920 more per year for life!).
One final item of note: Lump sums limited by Section 415
For participants with large benefits, one final item to keep in mind is that the lump sum that can be paid under Code Section 415 has a maximum limit. The lump sum limited by Code Section 415 is, with some exceptions, the lesser of (1) the lump sum calculated using the plan’s applicable mortality table and 5.5% interest, and (2) the lump sum calculated using 417(e) mortality and interest. In recent years (1) will yield the lower lump sum, primarily because of the 5.5% interest rate used to calculate the lump sum factor. Depending on the plan’s applicable mortality table, it is possible that (2) will yield the lower lump sum, although the decrease will not be as severe as the results seen in Figure 1.
Plans that have not started looking at what can be done in 2023 to take advantage of the increase in Section 417(e) rates should be doing so as soon as possible so that they can be ready to act early in 2023.
Please contact your Milliman consultant for additional information.