A commuted value of a pension is a lump sum payout of an employee’s earned pension based on its present-day value. It is equal to the value that, if left invested, the pension would have reached, according to long‐term interest rates and mortality rates. This payout is used to generate monthly cash flows equivalent to what the pension payment would be. If you leave your job – for retirement, voluntarily or otherwise – prior to the age when your pension plan would kick in, you must decide whether you wish to roll the commuted value into a self-owned account or stay in the plan.
To calculate commuted value, use the formula PV = FV/ (1 + k)^n.
What Does Commutation Mean in Pensions?
When it comes to pensions, commutation is defined as giving up part or all of the pension payable from retirement so that you can receive an immediate lump sum. When employees retire, they are often offered the option to take their pension in full or to take an immediate, tax-free cash lump sum and a lower residual pension. Deciding which is the better option should be discussed with someone skilled in this area of retirement planning if at all possible. At the very least, the use of a commutation formula can help you to decide whether your decision is the best possible one for you financially.
How to Calculate Commutation
In addition to taking into consideration long-term interest and mortality rates, commutation also accounts for indexing for inflation, bridge benefits payable to age 65 and death benefits. Clearly, there are a number of factors that must be considered when it comes to a commutation formula.
Before you can begin, you will need to determine long-term interest rates, the total value of your pension that will be paid out and the number of payment periods over the lifetime of the pension plan. To calculate commuted value, use the formula PV = FV/ (1 + k)^n. In this formula, "PV" is equal to your pension value. "FV," or future value, is the total amount of your pension that you expect to be paid out in the future. The interest rate is represented as "k" in this equation, and "n" represents the plan’s total duration in years.
A Commutation Example
Let’s say, for instance, that your pension would pay out $50,000 per year over a period of 30 years. Interest rates are usually estimated for long-term investments to remain at an average of 8 percent. Based on these numbers and the formula PV = FV/ (1 + k)^n, we could calculate PV = $1,500,000/ (1+ .08) ^ 30. This would then be equal to PV = $1,500,000 / 10.062656889073, or $149,065.99. You can use a scientific calculator to help you compute the answer to this equation.