Interest Rates, Bonds and Lump-Sum Pension Buyouts

By Christopher L. Hudson, CIMA

As the financial news focuses more and more on inflation, higher interest rates, hyperinflation and stagflation, let’s take a moment to look at the intertwining relationship between interest rates, bonds, and lump-sum pensions.

As many people already know, there is an inverse relationship between interest rates and bond prices.  In a high (or rising) interest rate environment, the price of fixed income investments (bonds) goes down - reflecting the fact that you can now purchase a newly issued bond (with a similar quality, maturity, rating, etc….) with a higher coupon. Therefore, the price of existing debt in the marketplace must go down in order to be more attractive and reflect a similar yield.

When interest rates are falling, the price (or value) of outstanding bonds goes up reflecting the fact that they pay a higher coupon than similar, newly issued, bonds and therefore will be more attractive to investors.

The longer the maturity of a bond (either individually, within a bond mutual fund, bond index, ETF, etc…..) the more price sensitive, or volatile, that bond will be given a move in interest rates.   

In a high inflation / high (or rising) interest rate environment, holding bonds can be problematic as you are not only experiencing a fall (decrease) in the principal value  (due to rising rates), but also a loss of purchasing power (due to higher inflation and the higher costs of goods and services) as bonds are fixed income investments.  

There is also an inverse relationship between interest rates and the value of a lump-sum pension distribution. When interest rates are high, the payout value of your lump-sum pension goes down (decreases). In a low, or falling, interest rate environment, the value of your lump-sum cash out is higher (goes up). The reason for this is that a lump-sum pension is simply the present value of a stream of income payments (monthly annuity payments) over a certain period of time (your life expectancy).

The easiest way to think about this is by asking the question:

How much money would I have to invest at a 5% rate of return to be able to draw $2,500/month (as an example) for the next 30 years?  Versus:

How much money would I have to invest at a 2% rate of return to draw the same $2,500/month (as an example) over the next 30 years?   

Well obviously, you would have to invest more money upfront at a 2% rate of return, versus a 5% rate of return, to be able to withdrawal $2,500/month over a 30 year period. Therefore when interest rates are lower, the amount of your lump-sum buyout will be larger than when interest rates are high.