Commuted value is the present value of the future series of cash flows required to fulfill a pension obligation. Commuted value is, therefore, the net present value of a future financial obligation. The total pension obligation is a product of long-term interest rates and life expectancy based on mortality tables. Depending on the age at which an employee separates from service, the number of years they are expected to be alive to receive pension payments and the assumed rate of return on a lump sum investment needed to generate those payments are used to determine the commuted value. Upon separation from service, a retiring employee is given the option of taking a lump sum payout of their pension's commuted value.
Breaking Down Commuted Value
Pension fund managers must compute the commuted value to determine their payout obligations and reserve requirements. The process for this calculation is similar to computing net present value of a capital budgeting project. The higher the 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, and vice-versa.
Example of Commuted Value
For example, XYZ Corporation has a defined benefit pension plan for their employees. Bert is 65 and is retiring. He is entitled to a pension that will pay him 80% of his final salary every year for the rest of his life. Based upon current mortality tables, Bert is expected to live until 85 years of age. Since Bert started working at XYZ Corporation, XYZ Corporation has been putting away a portion of Bert's 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 for Bert that with the current rate of return on the investment and no additional additions, it can generate the expected stream of payments over the remainder of Bert's life. This is the commuted value. Bert can stay in the pension plan and receive the payments, or Bert is given the option to withdraw the commuted value as a lump-sum.