January 17, 2005 11:19 AM
The Effect of Rising Rates
Excerpt: Rising interest rates could affect your retirement in ways you might not expect.
Rising interest rates could affect your retirement in ways you might not expect.
For the past few years, low rates have meant low returns on retirees' investment vehicles of choice, mainly certificates of deposit and bonds. In 2004, though, the Federal Reserve began raising its short-term interest-rate target. The figure (after five quarter-point increases) now stands at 2.25%, with additional increases predicted for coming months.
While that's good news for the CD crowd, the increases also pose some challenges. One of the biggest gotchas involves your pension: When interest rates go up, lump-sum pension payouts go down.
Lump Sum or Monthly?
Many employers with traditional pension plans offer a choice between monthly pension checks and one-time lump sums. In recent years, lump sums have been an attractive alternative, because low interest rates padded their size. Here's how it works: When interest rates are low, a company pension plan has to allot a larger amount upfront to produce the needed return for a retiree's monthly check. And if the retiree decides to take a lump sum rather than a monthly check, he or she would be entitled to that larger amount.
But now, with rates rising, the opposite is happening. Because it takes less cash to generate the same monthly pension check, the upfront lump sum is smaller, too.
Sylvester Schieber, research director of Watson Wyatt Worldwide, a human-resources consulting firm in Washington, offers the example of a 60-year-old retiree with a life expectancy of 25 years: If he were entitled to a $1,000 monthly pension check, and the long-term interest rate used to calculate the equivalent lump sum were 4%, he would be offered a lump sum of $195,460. But if the rate increased to 6%, the lump sum's value would drop to $165,400.
"That kind of swing probably isn't beyond the realm of reason over the next year or two," he says. "You could be facing a significant decline in the value of a lump sum."
Company pension plans typically use the interest rate on 30-year Treasury bonds to do their lump-sum calculations, and they either pick the rate from the same month every year or use a recent rate from, say, two months ago, Mr. Schieber adds. So, if you're trying to choose between a lump sum and a monthly check, be sure to find out what rate would be used in doing the final calculation of your big retirement check.
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