I plan on retiring in 4 years. I have a traditional defined benefit pension plan as well as a 401K. The pension plan will be worth at least twice what the 401k will be. I don’t know if the actual dollar values are important for purposes of this thread but I can provide them if it makes a difference.
When I retire, I have the option of taking a lifetime annuity that provides half of my current income or a lump sum. The formula for the lump sum takes interest rates into account and the lower the interest rates, the higher the lump sum payment. It seems unlikely that interest rates will be lower in 4 years and I believe that they will be higher. That would decrease the value of my lump sum. I have quite a bit of flexibility in how my 401k is invested. Is there something I could do with it that could act as a hedge against potentially rising interest rates?
If you’re over 59.5 years old, your plan may give you options for taking the lump sum now. If not, a discussion with your benefits department may be useful - maybe they can “terminate” you now to get that lump sum in your pocket, and then “rehire” you to restart it for the remaining years. Who knows - it’s worth a phone call. (Unless you don’t want to tip them off you’re planning on retiring.)
That’s the good “out of the box” thinking that I’m looking for. Unfortunately, the way our pension plan is designed, the last 5 years are much more heavily weighted than the other years. So if I quit and get rehired, I’ll lose a significant amount.
We’re a small company (400 employees) but I know everyone in the HR department very well because I’ve supported their ERP for the last 25 years.
The financial instrument is called an Interest Rate Future. You bet that in 3 years a treasury bond (or something else) will be paying 5%, and somebody else bets that in 3 years a treasury bond will be paying 1%, and in three years you settle the difference in cash: the interest rate has the same effect on treasury bonds as it does on your cash lump sum.
If you have enough money, you can get a bank to write a special contract. That’s not you. You may be able to get a standard contract on something like 30 year treasury bonds rate. You may not be able to get the interest rate spread you want, but buying a larger contract is exactly the same cash outcome as buying a larger spread.
I’m far to conservative to suggest doing something like that with my own money, so I can’t point you at a retail broker, or tell you what kind of margin they charge. But it is a kind of standard contract.
You can make the same kind of bet with a fixed-rate loan. You mortgage your house (30 years), borrow as much as you can at fixed rate, invest it for 3 years, and in 3 years you’ve got the lump sum, and you pay off the loan with the fixed-income pension. The size of the lump you can borrow (at todays fixed rate) is determined by the size of the fixed-income pension, not the size of the lump-sum payout.
You have to find a bank that will loan to someone your age, and pay whatever their profit margin is on the loan/investment. Obviously, borrowing money and re-investing it just to hedge an interest rate rise is inefficient and expensive: that’s why treasury transactions are done as futures.
Not to mention risky - it’s far from guaranteed, especially in the current environment, that your investment over three years will generate better returns than the interest rate on the loan.
If I were in the OP’s position, I think I would consider putting the 401k into investments that might be considered higher-risk than would typically be recommended for a 58 year-old. This is on the assumption that your essential living costs in retirement will be covered by the defined benefit pension. The reason for this is that by investing the 401k mainly in equities (aka shares), as opposed to bonds (which would be the traditional go-to for someone close to retirement), you likely get more protection from rising interest rates/inflation - at the ‘expense’ of greater investment risk. Plus there is the fact that bonds appear to me (and many others) to be very highly-valued right now - as and when interest rates rise, the capital value of bonds could fall quite significantly. Then again, plenty of knowledgeable commentators have been saying this for years, and it hasn’t happened yet. It’s possible the actions of the Fed and other central banks over the last decade and a half have rendered obsolete the sort of thinking in this post, we just don’t know it yet.
Anyway, I digress - on the assumption that this is not the case, my idea is simply that by investing the 401k more in equities, you should be better diversified than having it in bonds. As has already been pointed out, trying to do something more complicated/specific with regard to hedging interest rate risk is likely to be expensive and have its own risks.
One more thing - you mention in the OP simply taking the entire DB pension as a lump sum (I think), presumably on the assumption you can generate a better return by investing it than what the lifetime annuity will provide. This may be true, but it involves you taking on all the investment and longevity risk. Personally I think there’s a lot to be said for having a good baseline of guaranteed ‘forever’ income, even it comes at the cost of investment returns/being able to pass more on to your beneficiaries when you die. And I think most financial advisers would say the same. Of course, that cost is higher the lower interest rates are. But on the other hand, if you agree with it, it means higher interest rates in 4 years’ time are not necessarily all bad news for you.
I hope this makes sense - I’m not sure I’ve explained it very well. As usual, I’m not your adviser, not qualified in your jurisdiction, worth exactly what you paid for it etc.
I agree in general with your point. But it’s worth noting that the cost of what you suggest is not just investment returns/being able to pass more on to your beneficiaries.
If in fact interest rates are higher in 4 years, it’s likely that inflation will also be higher. And inflation will steadily eat into the value of that income (unless it happens to be indexed to inflation).
Thank you for this “definitely not advice” post. I’ll just call it a wisdom nugget. As it should turn out, investing in equities has long been the preferred strategy for those in our plan because of the DB pension plan safety net. I do own some bonds in my 401K but they’re just in case the market tanks. I’m not buying bonds currently.
A very good point and one I should have mentioned, thank you. I was using the unstated assumption that your ‘secure’ income is linked to inflation, yes.
Here in the UK, buying an annuity with inflation-linking generally cuts the initial payment in half compared with the equivalent non-increasing annuity. If your scheme only cuts it by a third, that might be a good deal. But yes, it’s rarely taken because most people would rather have more money now, instead of the promise of more later. This can be quite sensible; after all, time-value of money is a thing, plus most people hope to spend more money early in their retirement, expecting to spend less later (on the basis they’ve lost interest in expansive holidays or new cars by the time they hit their 80s). On the other hand, there is the spectre of care costs - having a solid plan for that is important and not at all easy.
It’s certainly true that you have to live a long time to see the benefits of taking the lower-to-start-with-but-increasing income. But there is definitely a danger of outliving your money if you turn out to be longer-lived than you expect. Most people underestimate their life expectancy.
FWIW, the value of the COLA option is itself highly dependent on interest rates. It’s likely that the “almost a third” reduction is based on today’s low interest rate entvironment. If interest rates have risen by the time you have to make your election, then it’s likely that the reduction would be even more than that.