Most people are aware that interest rates have increased significantly over the last few months. Mortgage rates have increased from under 3% to over 5%. Everyone knows that means higher monthly payments if you buy a house. But what do higher interest rates do to pension plans?
Motive to quit or retire
One of the most significant impacts may be a change in the benefits people can receive from the plan, primarily if provisions allow for a lump sum payout. When interest rates rise, lump sum cash outs drop, essentially reflecting that a lump sum could generate more retirement income at higher interest rates, replacing larger monthly payments from the plan.
Many plans use interest rates published by the IRS at the beginning of the year for an entire plan year of payouts. Participants who understand that plan rates will increase soon – for example starting with January 2023 payouts – may be strongly motivated to quit towards the end of 2022 before rates reset. Some plans reset rates more frequently, such as quarterly, and are already observing this pressure to retire in the workforce.
Participants who request benefit estimates, or are considering retirement, need to understand the ramifications of leaving now versus (for example) next year: The lump sum payable under the plan could drop by 25% if there is a significant increase in interest rates.
Impact on investment strategy
Another significant impact is the effect rising interest rates can have on plan assets. Plans that have fixed-income investments will see them declining in market value as interest rates rise. This can lead to increased accounting and funding costs. However, plans that are using a Liability-Driven Investment (LDI) strategy may see liabilities go down in tandem with the assets, depending on the extent to which assets and liabilities are hedged and how valuation discount rates are set.
Equity investments can also be affected by rising interest rates, when bond pricing makes fixed income investments more attractive or the present value of anticipated earnings/dividends from equity holdings are reduced.
Finally, some pension plan measurements smooth changes in assets and/or liabilities using averaging periods or corridors around applicable values. Estimating the net effect on plan costs, considering all the offsetting or reinforcing impacts, is best left to the actuary responsible for the specific plan.
Don’t be caught out
What should a plan sponsor do? The implications of higher interest rates will vary by plan, depending on what kinds of benefits are provided and on how assets are invested, so talk to your actuary or investment consultant. Don’t be surprised as significant changes become apparent.