Posted in Finance, Accounting and Economics Terms, Total Reads: 224
Definition: Commuted Value
It can be defined as the net present value or the lump sum value of cash flows of a pension obligation at a given rate of interest. Alternatively it also represents how much a person needs to invest today in any pension plan to receive certain amount of monthly payment after retirement.
This is used by the fund managers to estimate their reserve requirements and pay-out obligations. There are 2 major factors which affect the commuted value which are age and interest rates. Age and commuted value are directly proportional which means that the older one is higher is the commuted value even for a young worker who has same accrued pension as the older worker. This can be argued on the basis of time value of money.
The younger employee has a lot of time to invest the money and realise higher interest by investing that money. This luxury is not afforded to the older person as he is closer to retirement and has less time to invest the lump sum. The interest rate also affects the commuted value. The interest rate is indirectly proportional to the commuted value. The concept is attributed to the time value of money in which one has to invest a higher amount at low interest rates to end up with same amount of savings if lower amount is invested at higher interest rates.
A business owner can use either present value or commuted value to calculate cash flows for pension plan. If he believes present economic conditions will improve or stay similar he will create employee retirement accounts using commuted value method or if he estimates that economic conditions will deteriorate then he will invest in present value method. For example in present value method for a 500000$ pension amount at maturity date accrued over a 40 year period at an interest rate of 6% the cash flow each year should be 48,611.09$. This amount needs to be contributed towards the employee pension account by both the employee and employer to get this amount at the maturity date. In commuted value method a desired amount of 250000$ at an interest rate of 10% acquired over a period of 30 years yields an initial cash outlay of 50000$. Both the methods differ in their choosing of interest rates. Commuted value uses prevailing interest rates at time of calculation while in present value method owner sets the interest rate used in calculation which allows the fund manager to remain conservative.