What Is Commuted Value?
Commuted value is the estimated cost, in today's dollars, of the total amount of money that an organization will need in order to fulfill its pension obligations if it is paid in a lump sum. It may also be described as the net present value of a future financial obligation.
A pension fund's obligation is primarily a product of long-term interest rates and the life expectancy of its beneficiaries, based on mortality tables.
- Commuted value is used by pension managers to calculate the sum of money that a beneficiary is entitled to receive as a lump sum payment at retirement.
- This commuted value is an estimate based on factors including the future life expectancy of the beneficiary.
- It is a calculation of the amount of money in today's dollars that will provide the promised income for life.
A retiring employee may be given the choice of a lump sum payout or a regular pension payment. The lump sum will be paid according to commuted value.
Understanding Commuted Value
Commuted value is, by necessity, an estimate. It is calculated based on the age at which the employee is retiring, the person's life expectancy, and the rate of return that can be expected if the lump sum payment is invested.
Pension fund managers must calculate commuted value to determine their payout obligations and reserve requirements. The process is similar to that for calculating the net present value of a capital budgeting project.
Interest Rate Assumptions
Both are dependant on assumptions about future interest rates. The higher the anticipated interest rate, the lower the amount required, and vice-versa. The further into the future the money will be required, the lower the commuted value will be, and vice-versa.
Similarly, interest rates are a key factor in the employee's choice of a lump sum payment or a monthly benefit amount. The employee who takes the lump sum payment is betting on earning an investment return that is higher than the interest rate used in the company's projection.
Example of Commuted Value
For example, say XYZ Corporation has a defined benefit pension plan for its employees. And employee, Bert, is retiring at age 65. He is entitled to a pension that will pay him 80% of his final salary every year for the rest of his life. Based on current mortality tables, Bert is expected to live to age 85.
Like net present value, the calculation of commuted value depends largely on the interest rate assumptions used.
Ever since Bert started working at XYZ Corporation, XYZ Corporation has been putting away a portion of his salary into the pension fund in anticipation of this future liability. Now that Bert is ready to retire and start receiving payments, there is enough money saved to generate the expected stream of payments for the remainder of Bert's life, assuming the current rate of return on the investment and no additional payments into the fund.
This is the commuted value. Bert can stay in the pension plan and receive the payments or can opt to withdraw the commuted value as a lump sum.