Home > News > 2005 > November 2005 > What is Commutation?
What is Commutation?
Pensions Beginners Page
Welcome to the third in a series of articles designed to introduce readers to some pensions' related topics.
Commutation
The ability to take a tax free lump sum on retirement has long been a popular feature of pension arrangements. How the lump sum is generated depends on the type of pension arrangement. For instance in a defined contribution arrangement (such as a personal pension) part of the fund at retirement is paid as a lump sum with the balance being used to purchase a pension. In a defined benefit arrangement such as a 'final salary' pension scheme the cash is usually defined as an addition to the pension or by commutation.
So what is Commutation?
Commutation is defined as the forgoing of part or all of the pension payable from retirement for an immediate lump sum. Commutation factors (usually calculated by the Scheme Actuary) are used to determine the amount of pension which needs to be forgone in order to provide the lump sum. Therefore at retirement it is common for members to be offered the choice of taking their pension in full or as an alternative an immediate tax free cash lump sum and a lower residual pension (which allows for the pension given up to provide the cash).
How much Cash?
The maximum lump sum that a pension arrangement can offer is determined by HM Revenue & Customs (HMRC) as a condition of its tax approval. In a Personal Pension arrangement it is 25% of the fund, whereas under an occupational arrangement the limit is based on service with the employer and final remuneration at retirement date. The method of calculation depends on when a member joins the Scheme and hence which 'tax regime' applies to them.
For example if a member joined the Scheme before 17 March 1987 the maximum limit of one and a half times final remuneration at Normal Retirement Date could be achieved after twenty years whereas under later regimes it would take longer to achieve this (usually 40 years). Furthermore, final remuneration for the purposes of calculating the maximum lump sum under the two later regimes is restricted to the earnings cap (currently £105,600).
These limits are being replaced from 6 April 2006 under the Government's Pension Tax Simplification measures. More on this subject later.
Full Commutation
Currently, there are some circumstances where a member's pension can be paid entirely as a lump sum (even if it exceeds the limits above). One such instance is where a member's pension (from all sources under the same employment and before commutation) is less than £260 per year. HMRC deems these pensions to be 'trivial' and allows schemes to convert them for a one off cash sum using special commutation factors. Where the lump sum exceeds the maximum calculated according to the appropriate tax regime then a 20% tax charge is payable on the balance. These limits will also be changing after 6 April 2006 as part of the Government's Tax Simplification measures. Another circumstance where a pension can be fully commuted is in the case of serious ill health. Where life expectancy is sufficiently short (usually less than a year), such that a pension is not a reasonable provision, full commutation is allowable. As with trivial pensions a 20% tax charge applies where the lump sum exceeds the HMRC maximum limits. Unlike trivial commutation, however, the pension benefit is not entirely commuted because a spouse's pension would still be payable on death. Furthermore, where the pension contains contracted-out rights such as a GMP (see Beginners Page - August 2005) this benefit cannot be paid as a lump sum and therefore full commutation is not possible.
In what circumstances is commutation not allowed?
There are certain types of pension that cannot be forgone to provide a lump sum. These include:
- GMPS & Protected Rights - At present it is not possible to commute GMP except on the grounds of triviality (see above). Therefore only pension in excess of GMP can be commuted and if there is insufficient excess pension to provide the full lump sum then the lump sum may need to be restricted accordingly. Likewise Protected Rights funds in a money purchase arrangement must be used to purchase a pension although these restrictions (along with restrictions on GMPs) are currently being reviewed as part of the Government's Pension Reforms.
- Additional Voluntary Contributions (AVCs) - in general AVCs may not be taken as cash, except where arrangements to pay AVCs were made before 8 April 1987. After 6 April 2006 it will be possible for members to take the whole of their AVC fund as a lump sum (regardless of when they started paying) so long as this is within the overall authorised limits.
- Spouses & Dependents pensions - Generally it is not possible to commute spouses or dependents pensions other than on the grounds of triviality.
Forthcoming changes
Next year there will be significant changes in the way the maximum permissible lump sum will be calculated, although the general principle of giving up pension to provide a lump sum remains.
From 6 April 2006 (known as 'A-day') all existing tax regimes will be replaced by one new regime as set out in the Finance Act 2004. The limits that determine the maximum tax free cash sum that can be taken at retirement will also be replaced. Broadly speaking it will be possible (if scheme rules allow) to take 25% of the capital value of benefits (or £375,000 if lower) as a tax free lump sum. For a Defined Benefit arrangement the accrued pension is multiplied by 20 to determine the capital value.
In many cases this will result in a greater maximum lump sum than under the existing regimes as demonstrated by the following example:
Fred is in a Defined Benefit arrangement (offering 1/60th of final pensionable salary for each year of service). He is a 'Post 89' regime member and is retiring with 12 years service and a final pensionable salary of £20,000:
Pension = 12/60 x £20,000 = £4,000 per year
Max cash under Post'89 regime = £20,000 x ( 12 x 3 )/80 = £9,000 (or 2.25 x £4,000 = £9,000)
Max cash under A-Day regime = £4,000 x 20 = £80,000 x 25% = £20,000
In this example the cash is much bigger. Where this is not the case, it may be possible for the higher pre A-day cash sum to be protected in certain circumstances.
However, it is not quite as straightforward as this as the lump should not exceed the value of the residual pension and the cash lump sum at face value. The formula above therefore only applies where the commutation factor happens to be 20:1 or greater. Where the commutation factor is less the lump sum available is restricted by the following formula:
Lump Sum = Pension / [3/20 + 1/CF]
In the example above if the commutation factor were 10:1 then the lump sum would be:
£4,000/[3/20 + 1/10] = £16,000 leaving a residual pension of £4,000 - [16,000/10] = £2,400
In this example the value of benefits is [2,400 x 20] + 16,000 = £64,000
Therefore lump sum of £16,000 represents 25% of the value of benefits (i.e. £64,000).
To commute or not to commute?
Individuals often find it difficult to decide whether to take the cash lump sum at retirement and from a financial perspective this does represent something of a gamble (unless you know how long you are going to live!). For most people it will come down to a matter of personal choice. On the one hand an individual might want the freedom of an up front tax free lump sum to spend as they wish or possibly reinvest in other tax efficient ways. However, on the other hand they may prefer the stability of a pension (albeit taxed) which might ultimately represent better value if paid for a long time. As with all areas of financial planning individuals should seek independent financial advice if they are unsure on any of these areas.
Despite rumours to the contrary a few years ago the Revenue appears happy to continue allowing individuals to receive a tax free cash sum on retirement and indeed this position has been reaffirmed through the Finance Act 2004. While this remains the case the provision of a cash option at retirement will remain a popular feature of scheme design.
Julian Mainwood, November 2005.