Commuted Value: Understanding What It Is and Examples

What Is Commuted Value?

The term commuted value refers to the estimated cost that an organization needs to fulfill its pension obligations if they are paid out in a lump sum. A retiring employee may be given the choice to take a lump sum payout or a regular pension payment. The payout is made by the pension plan according to the commuted value, which is calculated using today's dollars. 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.

Understanding Commuted Value

Companies offer a range of benefits in order to attract new hires and retain their existing workforce. These perks include time off, bonuses, commissions, employee stock purchase plans (ESPPs), and pension plans. Pension plans are designed to allow employers, employees, or both parties to make contributions (using pretax dollars for employees) to an investment portfolio that is administered by an investment professional.

When an employee retires, they have two options on how they can receive money from their pension plan. They may opt for regular, fixed payments, which guarantees them a source of monthly income, or they can take a lump sum from the plan. The latter option is referred to as commuting your pension or cashing it out. The value of this lump sum payment is called the commuted value.

Pension fund managers must calculate the commuted value to determine their payout obligations and the reserve requirements of their plans. The process is similar to that of calculating the net present value (NPV) of a capital budgeting project. The commuted value is, by necessity, an estimate. It is calculated based on the age at which the employee retires, the person's life expectancy, and the rate of return (RoR) that can be expected if the lump sum payment is invested. Therefore, it is the present value of future benefits.

Both of these factors depend 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.

Special Considerations

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 bets on earning an investment return that is higher than the interest rate used in the company's projection. Regardless of what option an employee chooses, it's always a good idea to crunch the numbers before making a firm decision.

But what happens if an employee leaves the company before retiring and takes up a job with someone else? Some employers may provide individuals with the option to keep their pensions intact. But this is very rare, as it requires maintaining and paying for an account for nonemployees.

The vast majority may require employees to either transfer the amount in their pension plan to an external account or to take the commuted value. This, of course, should be a last resort as there may be tax implications that apply when individuals cash out retirement plans earlier.

Example of Commuted Value

Let's use a hypothetical example to show how commuted values work. Suppose XYZ Corporation has a defined benefit plan for its employees and Employee D is retiring at 65. They are entitled to a pension that will pay them 80% of their final salary every year for the rest of their life. Based on current mortality tables, Employee D is expected to live to age 85.

Ever since they started working at XYZ Corporation, the company put away a portion of Employee D's salary into the pension fund in anticipation of this future liability. Now that they are ready to retire and start receiving payments, there is enough money saved to generate the expected stream of payments for the remainder of their life, assuming the current rate of return on the investment and no additional payments into the fund.

This is the commuted value. Employee D can stay in the pension plan and receive the payments or can opt to withdraw the commuted value as a lump sum.