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Commuted value is a term that is often applied to the strategy of financial planning, in particular to the management of pension plans. The term has to do with the net present value that is associated with the funds that are maintained in the plan. Identifying the commuted value is important, since doing so makes it possible for fund managers to understand how much money must be allocated to the pension plan now and locked in at specific rates of interest in order to provide adequate payouts to plan members at various points in the future.
The general idea behind a commuted value is to relate the amount of funds that must be held in the pension fund in order to ensure the fund can meet its future obligations. This is accomplished in part by identifying the rate of interest that will apply to the funds held in the pension and projecting how much interest income will accumulate between now and the future date in question. Doing so makes it possible to understand what level of contributions are needed in order to ensure disbursements of a certain amount, given the rate of interest that will apply.
Calculating the commuted value requires understanding what is happening with the rate of interest that applies to the funds already invested in the plan. Typically, if the interest rate increases during the period under consideration, this will mean that a larger amount of interest income will be created, and less in the way of contributions is required to achieve the desired goal. At the same time, lower interest rates will mean the fund has to take in more contributions in order to maintain the same level of disbursements.
Determining the commuted value is somewhat easier when the investments that are made on behalf of the fund are primarily equipped with fixed returns of some sort. Typically, at least a portion of those investments will provide a fixed source of revenue for the pension. In addition, fund administrators may also choose to invest in holdings that provide some sort of variable return, hopefully one that is considered in line with the level of risk or volatility associated with that particular asset. This means that when projecting commuted value, it is necessary to consider both fixed and variable returns on investments, allowing for various scenarios that could emerge and lower the returns generated on some of those investments.
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