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Commuted value – money, risk or both?

Many associate a defined benefit (DB) plan with a guaranteed income for life. But, did you know that you could receive your pension as a lump sum either when leaving the company or at retirement? In such a case, you would be transferring out the “commuted value” to another account. This option is not offered by all plans or at all times. The availability of such an option depends on the regulations governing the plan and its funding status at a particular point in time.

What is commuted value anyways? In simple terms, the commuted value at retirement is the sum of all future benefits you are expected to receive in retirement. Estimates for the commuted value can vary from one date to another as a result of variations in the assumptions used. One of the most important inputs is the interest rate that is used to covert the total benefits to today’s dollars.

When the interest rate increases, the commuted value will decrease. Conversely, when the interest rate decreases, the commuted value will increase. What does this mean in a high-inflationary environment we are experiencing today? Well, the value of the commuted value is relatively low! However, this does not mean that your pension is reduced; The commuted value is only lower when expressed in today’s dollars by applying a higher inflation rate.

As sponsors of pension plans, companies have an obligation to pay benefits to current & future retirees. This obligation is reduced for every member who elects to transfer the value out of the DB plan. And wouldn’t companies like it if that could happen at a lower cost, in today’s dollars, to the company?! Therefore, companies are currently motivated to offer the transfer option to DB members.

The question is what should you do as a DB member? Given that everybody has unique circumstances and financial goals and plans, we can’t talk about individual cases. Even though receiving a large lump-sum payment is enticing, there are risks involved in doing so. A study by Metlife shows that 79% of people who elected to take the commuted value out of a DB plan made at least one large purchase within a year of receiving the funds. The study also found that 34% of retirees opting for a transfer depleted that amount within five years.

There are considerable risks involved when opting for a commuted value with the most prominent one being the loss of a guaranteed lifetime income forever. Is taking the commuted value option bad for everyone? Not necessarily. As long as you manage to invest the transferred amount, earn a higher return on investments compared to your DB plan and be financially responsible and disciplined in your spending, you could make it work. And all of that is easier said that done!

Stay tuned for more on this topic and have at look at this Barron’s article if you’re interested to learn more.

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