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Commutation (Factor)
Introduction
A “Commutation Factor” is an exchange ratio for Defined Benefit (DB) plan participants who choose to receive a lump-sum payout. Electing to receive this lump sum may reduce their monthly income partially or entirely in the instance of a full commutation.
Usage And Applications
DB plan participants have the option to receive a cash lump sum, although the default drawdown method is usually monthly payment.
Plan participants can work out how much of their annual pension needs to be given up to receive a lump sum using the commutation factor. Commutation factors take the form of a ratio. For example 12:1.
Factors will vary based on the age of the plan participant at the time that they consider receiving the lump sum. Many plan administrators will provide a table that shows the full range of age-based factors so that participants can calculate the trade-off by themselves.
Examples Of Use
Mr. Client had a successful career in the offshore gas industry where he worked for Noxious Gas LLC for 40 years. His current defined benefit plan pays him an annual income of 212,000 USD. Based on his current age, and commutation factor of 14:1 he understands that to receive a lump sum of 400,000 USD he would have to give up 400,000 / 14 = 28,571 USD in annual pension.
Conversely, if he were willing and able to give up 50,000 USD in annual pension then he could receive a lump sum of 50,000 USD X 14 = 700,000 USD
Sources & Further Reading
- Internal Revenue Service – Publication 15-B (2022), Employer’s Tax Guide to Fringe Benefits
- Internal Revenue Service – Topic No. 410 Pensions and Annuities
- Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans)