When Donald Trump was elected the next President of the United States, a lot of questions were raised. The stock market did not know how to react. Futures sold off election night, which was followed by the market going up . . . and up, and up over the following weeks. Since the end of 2008, the Federal Funds Rate has been at or near all-time lows. For years, investors prepared for the inevitable increase in rates that never seemed to come. The Federal Reserve has now raised the Fed Rate twice since 2015, and the consensus is that there are more increases in the rate to come. Trump’s proposed $1 trillion infrastructure spending plan along with proposed tax cuts also point to higher interest rates going forward. Investors are understandably anxious about how this will affect them. While many will focus on hedging their bond portfolios or refinancing their mortgage, this white paper will focus on a specific area that affects Chevron employees: How will rising rates affect the Chevron Retirement Plan (CRP) lump sum?
To understand how rising rates impact the CRP lump sum, you must first understand the basics of how the lump sum calculation works. The calculation is complex, but focusing on single life annuity amount, segment rates, and applicable interest rate will allow a general understanding of the calculation. We will then look at the concept that could be called “back-heavy rates” and how this can impact the lump sum.
Your age-65 single life annuity amount is calculated based on your highest-paid years of service and your total years of service. A composite of corporate bond yields known as “segment rates”, discussed below is used in the calculation to project the return expectation. Interest rates do not affect the monthly annuity amount which is determined by the combination of age, years of service and your highest paid years of service, but they do impact the lump sum calculation, which is why rising interest rates are bad for your lump sum, but do not change your monthly annuity payments.
The segment rates are three interest rates calculated from corporate bond yields. They are published monthly by the IRS and can be found here https://www.irs.gov/retirement-plans/minimum-present-value-segment-rates. It is not as important to understand where they came from, but how they are used to “discount” or calculate the present value of your lump sum. Present value is used to figure out how much something in the future is worth today given an assumed rate of return, in this case, your annuity payments. The capital set aside to fund your annuity payments is expected to earn a return, so the IRS releases the segment rates to allow for a uniform assumed rate of return for pension plans. A lower interest rate benefits someone choosing the lump sum because the return they would receive on their investment would be less, meaning their starting value would need to be higher. The three segment rates are used to discount three different time periods. The first rate discounts the first five years of your retirement, the second discounts years 6-20, and the third discounts years 21+. Life expectancy for a typical retirement age Chevron employee is around 22-27 years. Therefore, the second segment rate will affect the calculation the most, and the third segment rate the least because the second rate covers most of the calculation and the third covers only years that are further away and much fewer.
The applicable interest rate is which months’ segment rates the CRP lump sum will use for a specific benefit commencement date (BCD), which is the first day of the month that you receive benefits, not the day you actually retire. For example, if you retired January 15th, your first available BCD would be February 1st. The CRP uses the average of the rates from the fifth, fourth, and third months preceding the BCD. Therefore that February 1st BCD would be calculated using the rates from September, October, and November.
With the basics out of the way, let’s look at a real-life scenario with the current rates for a February 1st BCD. Below are the actual rates used to calculate the lump sum.
As you see, each consecutive month in the calculation has increased from the previous month. This white paper will refer to this directional change in interest rates as “back-heavy rates” because the higher interest rates are in the back months of the calculation. It is important to understand the effect of these increasing segment rates as it relates to the lump sum. If we take a hypothetical retiree with a single-life annuity payment of $7,000 and a 22-year life expectancy and perform a basic present value calculation using the February 1st BCD segment rates, we get a lump sum calculation of about $1.278 million.
If we want to compare the February 1st BCD lump sum to a March 1st BCD lump sum we must consider how these back-heavy rates change the lump sum amounts. We know that the September rates will no longer be in the calculation and the December rates will replace them for a March 1st BCD. In order for the average of the segment rates to stay the same, not only must the December rates not rise, they must go down to where the September rates were to keep the average the same as for a February 1st BCD.
We will now look at a hypothetical scenario where the December rates are unchanged from November as seen in the table below.
Using these rates, but all the same variables as before, the March 1st lump sum comes out to $1.26 million for a decrease of 1.4% from the $1.278 million in February. Even if the segment rates were to stay the same for a third consecutive month, you would still see a drop in the lump sum for April because the October rates would fall out of the three-month average. These examples illustrate how back-heavy rates can erode a lump sum even if rates are not necessarily increasing every month. The structure of the lump sum calculation creates this wave-like effect of erosion because new segment rates are constantly being added and removed from the three-month average. On the bright side, a quick spike in interest rates will only make up one-third of the three-month average, but once momentum gets going in one direction, it is hard to stop the lump sum from continually changing.
Front-heavy rates are the opposite of back-heavy where the older rates are higher than the newer rates. The CRP experienced this in early 2016 and it caused the wave-like momentum to be positive for lump sum receivers over that period of time.
Going forward, if the Federal Reserve raises the Federal Funds Rate the two or three times the market expects in 2017, and market interest rates continue to rise steadily, it could mean significant erosion of the lump sum. If we run the same lump sum calculation, but with an increase of .5% in each segment rate, the lump sum drops 4.6% to $1.219 million from a February 1st BCD.
There is a saying that one of our retired partners used to use when someone used to ask what the market was going to do: “My crystal ball is a little fuzzy on that one.” No one knows exactly what is going to happen in any market, and at best, the “experts” are making educated guesses. This white paper aims to educate a Chevron employee on what possibly could happen if the consensus is correct. We do not want you to plan on your lump sum eroding, but to plan for it.