Published by Julian Mainwood on
Commutation is defined as giving up part or all of the pension payable from retirement in exchange 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 given up 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).
Since 6 April 2006 (A-Day), the Pension Commencement Lump Sum (PCLS) that can be taken on retirement is broadly calculated as 25% of the total value of a member’s crystallised benefits.
One basic method of calculating the PCLS available is shown below. Please note that this method will only calculate cash by commutation and will not work for schemes where cash is calculated in addition or for schemes with Additional Voluntary Contributions (AVCs).
PCLS = Pension ÷ [3/ 20 + 1/Commutation Factor]
Assuming a commutation factor of 10 and a pre-commutation pension of £10,000 a year, the PCLS would be £40,000.
£10,000 / [3/20 +1/10] = £40,000
The residual pension available is calculated as follows:
Residual pension = full pension - [PCLS/ commutation factor]
So using the example above
£10,000 – [£40,000/ 10] = £6,000 a year
Commutation factors are not fixed and will vary from scheme to scheme and often change depending on the member’s age. The higher the commutation factor used, the greater the cash that can be generated.
It is therefore important to ensure that the PCLS does not exceed 25% of the value of the member’s crystallised benefits.
Based on the example above, the value of the benefits crystallised is:
[Residual pension x 20] + PCLS amount
[£6,000 x 20] + £40,000 = £160,000
PCLS available = £160,000 x 25% = £40,000
If a scheme has retained links to the pre A-Day limits, there is the possibility that the member may have a protected entitlement to a PCLS greater than 25% of the value of the member’s retirement fund.
This amount will have been calculated based on the member’s cash entitlement at A-Day calculated on the pre A-Day tax regime limits and will be revalued in line with the increase in the standard lifetime allowance. From 6 April 2012, this increase factor is 1.2 (1.8/1.5), despite the lifetime allowance reducing from £1.8 million to £1.5 million.
There are some circumstances where a member’s pension can be paid entirely as a lump sum (even if it exceeds the limits above).
Post 6 April 2006, members may be entitled to take their entire pension as a trivial commutation lump sum as long as certain criteria are met.
HM Revenue & Customs (HMRC) sets out strict conditions under which schemes can offer trivial commutation payments to a member. The conditions are:
Assuming that these criteria are met, a member may take a trivial commutation lump sum where 25% of the fund is paid tax free and the remainder is taxed through PAYE. For defined benefit schemes, the actual amount payable is calculated using scheme specific commutation factors as prescribed by the Scheme Actuary.
Benefits must be valued on a specific date chosen by the member known as the nominated date. If no date is chosen, the nominated date starts on the date that the first trivial payment is made.
Any trivial commutation lump sums must be paid out within twelve months of the date of the first payment and the first payment must be made within three months of the nominated date.
Post A-Day, it is the member’s option to elect commutation on the grounds of triviality; schemes are not permitted to force a member to commute their benefits. Members must complete a declaration confirming their total benefits before any trivial commutation lump sum payment can be made. Payment of a trivial commutation lump sum is not a Benefit Crystallisation Event, but the member needs to have available lifetime allowance for the payment to be made.
GMPs may be fully commuted subject to the following Department for Work and Pensions (DWP) provisions:
Subject to the provisions above, you can commute the spouse’s GMP at the same time as trivially commuting the member’s GMP. If the spouse’s GMP is not commuted at the same time, it will need to be held in a separate arrangement as one condition for the payment of a trivial commutation lump sum is that it extinguishes the member’s entitlement to benefits under the scheme.
Once a spouse’s GMP comes into payment, it may be trivially commuted provided that it, along with the remainder of the spouse’s entitlement to benefits under the scheme, is within the £18,000 limit.
Please note that the commutation of benefits including GMP on triviality is subject to the scheme rules allowing for such commutation to take place. The scheme rules should be checked to ensure they have been updated to reflect the new limits.
With effect from 1 December 2009, assuming that scheme rules have been amended to allow for it to take place, it is possible for a member to commute their entire benefits from an occupational scheme in return for a one-off 'small lump sum'. A ‘small lump sum’ payment may be made if the scheme has more than 50 members and the following criteria are met:
In addition, the scheme must satisfy at least one of the following conditions:
For schemes with less than 50 members:
In the event of a member’s serious ill health (usually defined as life expectancy of less than one year), it is possible to commute the member’s benefits in return for a one-off lump sum. It is possible for GMP rights to be commuted on the grounds of serious ill-health subject to the scheme retaining sufficient funds to provide for a survivor’s pension if the member is married or has a civil partner.
There are certain types of pension that cannot be given up to provide a lump sum. These include:
With effect from 6 April 2012, the abolition of contracting-out on a defined contribution basis means that protected rights are no longer categorised as a separate class of benefits. Therefore, previous restrictions on these benefits no longer apply and such benefits can be treated in the same way as contracted-in benefits. Please note that this change in legislation does not override scheme rules and therefore restrictions may still remain unless scheme rules have been updated accordingly.
Individuals often find it difficult to decide whether to take a 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.