What is Commuted Value and How Does It Work

The employers or the corporate organisations use several innovative ways to attract and hire new talents and retain their talented workforce. And one of the most effective ways is to offer a wide range of perks and benefits like annual bonuses, commissions, health insurance protection, etc. While most of these benefits are only temporary and last only till the employee is associated with a specific company, one benefit that secures their financial future even after their retirement is the pension plan.The pension plans are designed in a way that allows both the employers and the employees to make contributions towards the employee pension fund. The percentage of the contribution can vary based on the designation you hold in the company and the employment terms and conditions.Generally, most organisations contribute a specific percentage of the employee’s basic salary and dearness allowance. Some companies, based on the pension plan they hold, allow the employees to voluntarily contribute an additional amount towards their pension fund account. This allows you to build a robust corpus for the future.While you receive the funds from the pension account after you retire, you keep making contributions towards the fund throughout your working years. So, the longer you keep contributing, the better your chances of building a sizeable corpus. When you retire, you may have two options for receiving the money in your pension fund account. You can either opt for a lump sum pay out or you can choose regular and fixed payments wherein you will get the amount in smaller instalments over a period. This acts as a monthly income source when you no longer have regular income from salary.If you choose to receive the amount from your pension fund account in lump sum, the pension fund makes the pay out as per the commuted value. So, in simple terms, the commuted value is the value of the pension pay out you receive post-retirement. The commuted value of the pension pay out is estimated based on several factors like future life expectancy of the eligible recipient employee.The pension fund managers calculate the commuted value to determine the amount they must pay out to the retiring employees and reserve the amount accordingly. The process of calculating the commuted value is like calculating the NPV (net present value) of a capital budgeting project.One of the critical factors that you must consider taking the pension pay out in lump sum is the interest rates. If you take the payout in lump sum, you may have better chances of getting better returns on your investments than the returns projected by the company. However, irrespective of whether you take the pension pay out in lump sum or choose regular pay out, it is advisable that you do the calculations and make an informed decision.If you decide to quit the organisation before retirement and join another organisation, you may have the option to keep the pension intact. However, the chances of this may be rare as the previous organisation may not be willing to bear the cost of paying and maintaining the pension account of a non-employee.Majority of the organisations give employees the option to either transfer the funds accumulated in their pension fund account to their external account or withdraw the amount at commuted value. However, as an employee, it is advisable that you refrain from withdrawing the full amount before retirement as this may have tax implications and your overall take away value will be less.Let us understand the working of a commuted value with an example.Let us assume that a company named Shalimar Corporation has a defined benefit pension plan for its employees. Now, an employee named Mr. Ashok Mishra has reached the retirement age (60 years) and is about to retire in a couple of months.Now, Mr. Mishra is entitled to receive a pension to the extent of 80% of their last drawn salary for the rest of their life. Shalimar Corporation has been investing a portion of Mr. Mishra’s salary in the pension fund since they first joined the company with the anticipation that they would have to bear this pension liability in the future.As Mr. Mishra is about to retire, the organisation may have saved enough in the pension fund account to take care of the pension payments for Mr. Mishra. Assuming that the no additional payments are required in the funds and the total interest the funds has earned over the years is the commuted value that Mr. Mishra is entitled to receive post retirement.When the employee (Mr. Mishra) retires, he has the option to either stay in the pension and receive the payment or he can withdraw the commuted value as a lump sum.

As a salaried employee, you must be aware of the commuted value so that you can make the right decision while withdrawing the pension funds.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.