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Commuted value is the net present value of funds held in a pension plan, which helps fund managers allocate money and lock in interest rates to ensure adequate payments to plan members in the future. Calculating commuted value requires understanding interest rates and fixed and variable returns on investments.
Commuted value is a term often applied to financial planning strategy, particularly pension plan management. The term has to do with the net present value that is associated with the funds held in the plan. Identifying the commuted value is important, as doing so enables fund managers to understand how much money needs to be allocated to the pension plan now and lock in to specific interest rates to provide adequate payments 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 to ensure that the fund can meet its future obligations. This is accomplished in part by identifying the interest rate that will be applied to the funds held in the pension and projecting how much interest income will accrue between now and the future date in question. By doing so, it is possible to understand what level of contributions are needed to guarantee disbursements of a certain amount, given the interest rate that will be applied.
Calculating the commuted value requires understanding what is happening to the interest rate that is applied to funds already invested in the plan. Generally, if the interest rate increases during the period considered, this will mean that more interest income will be created and fewer contributions will be required to achieve the desired objective. At the same time, lower interest rates will mean that the fund must receive more contributions to maintain the same level of disbursements.
Determining the commuted value is somewhat easier when the investments being made on behalf of the fund are primarily equipped with fixed returns of some kind. Typically, at least a portion of those investments will provide a fixed source of income for the pension. In addition, fund managers may also choose to invest in holdings that provide some type of variable return, hopefully one that is deemed in line with the level of risk or volatility associated with that particular asset. This means that when projecting the commuted value, it is necessary to take into account the fixed and variable returns on investments, allowing for various scenarios that could arise and reduce the returns generated on some of those investments.
Smart Asset.
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