# Why You Might Want to Retire Soon If You Have a Pension

Imagine you are on the verge of retirement and you have a pension plan with your employer. Every year you have to make two decisions regarding your plan. First, you have to decide whether to retire (and start claiming benefits) or whether to work for another year. Generally, every additional year of work increases the future benefits you will receive from the plan, all else equal. Second, if you do decide to retire, you then have to decide on how to take those benefits. You can either: (1) receive a fixed monthly payment for the rest of your life, or (2) receive a large lump sum (at retirement).

What you may not know is that your lump sum payment isn’t consistent over time. It changes every year on what the plan calls the recalculation (or revaluation) date. On this date, the plan takes the prevailing interest rates (i.e. the minimum present value segments rates provided by the IRS) and uses them to calculate the lump sum value of your benefits.

In most years, this recalculation is a formality and your lump sum barely moves because interest rates typically don’t change that much throughout the year. However, with the rapid increase in interest rates in 2022, pension participants are in for a rude awakening once these plans recalculate lump sums for 2023 and beyond. Though this might seem like a bad thing, it actually presents a rare opportunity to arbitrage your pension plan for a riskless profit. Let me explain.

## The Pension Plan Free Lunch (Thanks to Rising Rates)

Imagine its the beginning of 2022 and you just received your statement from your pension plan. On the statement it says that, if you retire in 2022, you will receive either: (1) \$1,600 a month for life or (2) a \$500,000 lump sum. Let’s assume that your plan uses a 1% interest rate (for calculating the lump sum) and that you will live for 30 years in retirement.

Well, as 2022 unfolded, interest rates shot up from 1% to 4%. If your plan were to recalculate your benefits based on this change in rates, the value of your lump sum would decline to \$337,000, or about \$163,000 lower than what it was at the beginning of the year. As a reminder, when interest rates rise, future cash flows become worth less today, and when they fall, they become worth more.

Given this, you can understand why your lump sum declined by \$163,000. That’s the bad news. But, there is good news too. Your pension plan won’t be recalculating your benefits until 2023. This means that, for the next few months, you can still claim your \$500,000 lump sum offer from the beginning of 2022 before the recalculation occurs. This is where your opportunity lies.

More importantly, if you do decide to retire and take the \$500,000 lump sum, you would be able to buy an annuity for \$337,000 that pays you \$1,600 a month for the rest of your life. In doing so, you would replicate the benefits provided by your pension plan (i.e. \$1,600 a month for life) while also pocketing an extra \$163,000 in the process. It’s true arbitrage. Of course, money isn’t the only factor to consider when thinking about when to retire, but it can be the deciding factor in the extremes.

While this example is a bit simplistic and ignores many other issues, it is representative of the choice that many near retirees will need to make in the coming months. As you can see on the IRS website, from Aug 2021 to August 2022, the first segment rate went from 0.66% to 3.79% (similar to the 1% to 4% example I used above). This large change in rates will wreak havoc on the lump sum payouts offered to pension plan participants in 2023 and possibly for the plans as well.

## Will Pensions Have a Problem?

Given the issues highlighted above, you can see how a tidal wave of early retirements might be coming for pension plans. However, I’m not worried. Since only 15% of private sector workers have a defined benefit pension plan in the U.S., I doubt that there will be any major impact across the industry. Some near retirees won’t know about this opportunity, some won’t be able to take advantage of it (i.e. because they can’t retire), and some won’t want to take advantage of it (i.e. because they won’t retire).

Either way, the obvious solution to this problem is for pension plans to recalculate the lump sum amounts offered to participants more frequently (i.e. quarterly). In doing so, they would prevent these kinds of arbitrage opportunities from ever existing in the first place. Given this, why haven’t they adopted a more frequent recalculation schedule for lump sum benefits? I’m not sure, but incentives may play a role. As Ben Hunt recently stated:

The problem is that interest rates have been going down for 30 years, and really going down for the past 15 years. Which means that, from this accounting perspective, pension fund liabilities have been going up for 30 years, and really going up for the past 15 years.

When interest rates are going down, participant benefits are going up. As a result, if you are pension fund manager, you have no incentive to recalculate benefits any more frequently than you are required to (i.e. annually). But, now that rates are going up, the opposite is true. You are incentivized to recalculate more frequently to lower the amounts you offer to participants. Though a change in calculation frequency is unlikely to happen, I am interested to see how this plays out over the next few months.

## The Bottom Line

While deciding whether to retire early to take a lump sum from a pension plan probably doesn’t apply to you, the framework for thinking about this decision does. Anytime you have an arbitrary pricing mechanism (i.e. annual pension recalculations) pitted against a real-time pricing mechanism (i.e. interest rates), there are bound to be moments when you can take advantage of timing (and pricing) mismatches.

And I say this as someone who isn’t a market timer. I don’t believe that you should try and time most of your financial decisions. However, some opportunities are too good to pass up. For example, when you have historically low interest rates, refinancing your mortgage can be a great idea. When you have historically large market declines, buying the dip can work wonders. And so forth.

These kinds of moments are rare, but they can be impactful to those who take advantage of them. There is no silver bullet to our finances. We must always consider the context and how that context might change when we make our decisions.

Lastly, special thanks to Rick Ferri for bringing this idea to my attention at the recent Bogleheads conference. Happy investing and thank you for reading!

If you liked this post, consider signing up for my newsletter.

This is post 317. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

This content, which contains security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this “post” (including any related blog, podcasts, videos, and social media)  reflects the personal opinions, viewpoints, and analyses of the Ritholtz Wealth Management employees providing such comments, and should not be regarded the views of Ritholtz Wealth Management LLC. or its respective affiliates or as a description of advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client.

References to any securities or digital assets, or performance data, are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.