We didn’t see this coming so soon but our financial advisor did.
Why the rush?
The Fed Rate.
Cue the crying “Elf” walrus who doesn’t like math…or politics…”wuhuhuhh..”
It’s ok, lets walk through this together…
The Fed announced that it will raise The Fed Rate (the rate at which banks can loan to each other overnight) by 0.75% by the end of 2017.
“Oh, that’s not so much…”
It is on a lifetime pension of $1,000,000 OR MORE.
Mr and Mrs Average:
Bankrate assumes that Mr & Mrs Average both worked about 30 years as a teacher ($94,500/year by career’s end) and firefighter ($110,000/year at career’s end) and both will have pensions. Their pension is $3.7 MILLION*
How a pension payout works:
1. Mr & Mrs Average, both age 58,call their HR departments and tell them they intend to retire 1Q 2017 and want it paid in a lump sum in 2Q 2017 (April).
2. Their HR departments then look at a couple of things to figure out how much the lump sum will be. (Hint: not $3.7 Million today).
HR has a formula:
Of course they do…wuhuhuh…
PV=FV(1+r) to the -nth power
You’re killing me…
don’t worry, there is a really cool calculator to use and videos with pictures and cuss words.
First, 2 videos with 2 cuss words. Sorry. Choose Parts 1 and 2 to watch. The guy sounds a bit like Jesse Pinkman if you miss Breakung Bad…
PV=Present day Value (of the promised total pension of $3.7Million in the future in 2042). We need to find what the present day lump sum would be.
FV=future value (the $3.7 Million promised total pension in 25 years in the year 2042).
r=the discount rate in percent. It’s the percent HR discounts the $3.7Million in today’s dollars. It’s like time traveling to the year 2042, ordering groceries with your mind, and realizing that milk costs $9 in 2042 instead of $4 in 2017.
More about this later-this is where the Fed comes in.
*Find “n”: How long will Mr & Mrs Average live?
“Oh, that’s morbid!”
You didn’t know math could get so goth, did you? Get your black lipstick and guyliner…I’ll bring the Black Parade…
HR departments need this number to figure “n”. N(n) is the number of years they would have paid out the pension if the couple got monthly checks (annuity) up to the year 2042.
Let’s say each HR dept thinks our retiring couple will each live to age 83. That’s 25 years (the year 2042). N=25
r=Discount rate: In December 2016, the discount rate for the top 100 corporations in the US was 3.99%. That number includes the Fed Bank Rate of 0.75%. For younger people, the rate could be higher, like 4.99%. Federal workers usually have a high discount rate of around 8%. HR departments usually have a company who manages their pensions. That company uses graphs & complex tables called “actuarial tables” to figure out their discount and then add it to the Fed Bank Rate. An example today might be this: (3.24%+0.75%=3.99%).
“Calculus” is really just “graph class”, so don’t be intimidated.
Why are rates rising?
So that we don’t repeat the 1970s when interest rates skyrocketed to 20%. The Fed usually likes to keep the interest rate at which banks can borrow from each other at around 2%. In 1Q 2017, the rate is 0.75%. To get to the target rate of 2%, they need to raise this rate, but slowly. They purport that this keeps inflation (cost of things) down and the economy out of recession (people and companies not buying things, unemployment high).
The plan for 2017, is to raise this rate from 0.75% to 1.5% by December 2017. See how we’re getting closer to 2%?
So, how does this affect the lump sum?
Let’s have a look at a real lump sum calculator. I found this nifty one:
You see that the lump sum is $1.4 Million. That’s what the couple will receive in cash by retiring by March 31st. (As a side note, the idea is that then they invest this money in fairly conservative-moderate risk things for 25 years and live off the earnings that the $1.4M would generate).
What happens if the couple waits until April to retire? (3.99+0.25%=4.24%)
If they delay retiring until the end of December 2017?
The fancy “discount rate” on a “lump sum” you may hear at cocktail parties just means “ok, we will give you the pension in cash all at oncenow, but at today’s dollars. You invest it in conservative things instead of us doing it and you may make more money than the promised pension amount in the long run, plus your loved ones and charities will continue to benefit from it after you die.” (If you take an annuity, it stops when you and spouse die).
Do you see?
Now you don’t have to get your MBA 😉
Just use this handy dandy calculator and talk to your HR department and your financial advisor: