2023 lump sums from defined benefit plans will be much lower than predicted due to sharply higher interest rates
Update to “What if Defined Benefit Lump Sum Rates Were to Spike?”
Our most recent update on the topic of DB lump sum rates and rising interest rates.
In an earlier article on statutory interest rates, published in April 2022, I had summarized the impact on lump sum payments upon retirement (or termination) from traditional defined benefit (DB) pension plans if rates were to spike.
In that article, I had modeled the changes by increasing the rate(s) by 1% in each of the statutory “three segments.” Then actions by the Federal Reserve increased its benchmark federal funds rate several times to stave off the result of historically high inflation. These sharp sudden interest rate increases made my estimates look too optimistic for plan participants.
Let’s look at an example.
IRS published its September 2022 “segment rates” of 4.48%, 5.26%, and 5.07% for the first, second, and third segments, respectively.
The increases far exceeded the hypothetical 1% increase in my prior examples. In fact, the rates increased by nearly two percentage points for each segment, and over three percentage points on the first segment.
For readers who track such details, the first “segment rate” has not exceeded 4.00% since May 2009, and the second segment rate has not exceeded 5.25% since February 2011.
The prior article modeled the impact on a hypothetical lump sum for a 51-year-old with a $1,000 monthly age 65 benefit if each segment rate (published for November 2021) increased by 1%. If we were to add the impact based on the actual September 2022 rates, the results are rather astonishing, as seen in the table in Figure 1.
Figure 1: Impact based on September 2022 Rates
| Segment Rates Used | Estimated Lump Sum | Percentage Decrease in Lump Sum Payout Value |
|---|---|---|
| 1.02%, 2.72%, 3.08% (actual November 2021 rates) | $115,800 | |
| 2.02%, 3.72%, 4.08% (adding 1% to each rate above) | $92,000 | ~ 20% |
| 4.48%, 5.26%, 5.07% (actual September 2022 rates) | $71,500 | ~ 38% |
As the original article noted, this decrease would be larger for younger participants and smaller for older participants.
Residual consequence of lower lump sums
For younger vested terminated participants or participants with a small vested benefit, the large lump sum interest spike could cause the present value of their benefit 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 asking the participant 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.)
Speculation on accelerated lump sum payments
It would not be unreasonable to speculate that the number of participants retiring before the end of 2022 will accelerate to lock in these higher amounts, perhaps to make up for the significant deterioration in savings plan balances. DB plan sponsors may wish to consider this when planning any 2023 lump sum window programs.
Consequence #2 for cash balance plans
Lump sums in cash balance DB plans are unaffected by the surge in interest rates. However, there is another consequence of this surge that perhaps plan participants would find favorable.
By law, 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 making 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 September 2022 rates, the single life monthly annuity would increase to approximately $670 (that’s $1,680 more per year for life!).
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 they can be ready to act early in 2023.
Please contact your Milliman consultant for additional information.