When a person stops working and retires, he still needs a reasonable income on which to live. Most people thus save for their retirement years if possible, often with the help of pensions and similar plans from employers. Some plans have two payout options: lifetime annuity payments or a total lump sum payment. People offered a lump sum option should understand how interest rates used to calculate the payment influence the overall payment amount.
Total Lump Sum Calculation
When you opt to have a total lump sum pay out instead of lifetime payments, the person or organization providing the payment has to determine what the value of the total lump sum payment should be. He adds the interest you would earn to the basic one-time payment amount. The total ideally equals what you would have gotten if you'd selected annuity payments. The amount you get in a total lump sum payment thus always is influenced by the rate of interest used.
Total lump sum payments are a tally of earned interest and the basic one-time payment amount. This means that if the interest rate rises, the basic one-time payment amount has to decrease in order to keep the total lump sum payout equivalent to the lifetime annuity payment amount. Put another way, a higher rate of interest means the basic one-time payment will earn more over time. Conversely, if the rate of interest goes down, the basic one-time payment is higher because the one-time payment will not earn as much.
What It Means for Payees
The way interest impacts total lump sum payouts means that those who are opting for a total lump sum payout instead of lifetime annuity payments should find a pension or other retirement plan that offers the lowest rate of interest possible. If interest rates rise, people may have significantly less for their retirement than they otherwise would.
What It Means for Payers
If a company uses a low interest rate with their lump sum calculations, then they end up paying larger lump sum payments overall. This means that funding for the retirement program depletes faster. The payer thus has to decrease the number of people who can opt for the lump sum payment, find alternate funding sources to cover the larger payments or stop offering retirement plans altogether. Payers often struggle to find a balance between providing fair, attractive retirement options while simultaneously maintaining a workable budget. As of 2011, regulations favor higher interest rates to the benefit of payers.
- Institute of Certified Financial Planners; GATT Could Reduce Your Pension Payout; Joseph Hoffman; 1999
- Library of Congress Congressional Research Service; Lump-Sum Distributions Under the Pension Protection Act; Patrick Purcell
- IRS. "Rollovers of Retirement Plan and IRA Distributions." Accessed Sept. 3, 2020.
- IRS. "Publication 505 (2020), Tax Withholding and Estimated Tax." Accessed Sept. 3, 2020.
- IRS. "Retirement Topics - Exceptions to Tax on Early Distributions." Accessed Sept. 3, 2020.
Wanda Thibodeaux is a freelance writer and editor based in Eagan, Minn. She has been published in both print and Web publications and has written on everything from fly fishing to parenting. She currently works through her business website, Takingdictation.com, which functions globally and welcomes new clients.