What is commutation of a pension?

We offer trustees and sponsors the support and guidance they need when it comes to pension administration. Here, we summarise pension commutation, what options are available to members, and what they may need to consider.

The ability to take a tax-free lump sum on retirement has long been a popular feature of pension arrangements. How the tax-free lump sum is generated depends on the type of pension arrangement. For instance, in a defined contribution (DC) arrangement (such as a personal pension) a percentage (usually 25%) of the fund can be taken as a tax-free lump sum. The remainder of the fund is usually taxed either as a pension (through a purchased annuity) or through income withdrawals (known as drawdown) or as a cash lump sum. 

In a defined benefit (DB) arrangement (such as a final salary pension) the lump sum is usually defined in the scheme rules. This lump sum can be provided in addition to the main pension or by commutation. The rest of this article focuses on ‘what is commutation’ and how lump sums from DB schemes are calculated.

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).

How much 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).  The formula is:

• 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 calculated as:

• £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 important to ensure that the PCLS does not exceed 25% of the value of the member’s crystallised benefits otherwise it will no longer qualify as an authorised payment and may no longer be tax free.

So based on the example shown we can check the value of the benefits crystallised as follows:

• Value of benefits crystallised = [Residual pension x 20] + PCLS amount
• [£6,000 x 20] + £40,000 = £160,000
• PCLS check = £160,000 x 25% = £40,000

Lump Sum Allowance

Legislation limits how much of a lump sum may count as a tax-free PCLS.  The lump sum allowance is currently set at £268,275. There is no provision for this amount to be increased automatically, for example by the rate of inflation and it could be reduced.  

The availability of a member’s lump sum allowance is tested at a relevant benefit crystallisation event. A relevant benefit crystallisation event for lump sum allowance purposes in a DB Scheme occurs when a member becomes entitled to a PCLS. 

Protected cash

It is possible for individuals to have lump sum rights at A-day greater than 25% of the uncrystallised value of their benefits, particularly in DC schemes. Where this applies schemes are able to protect these higher lump sum rights, but this is not an automatic entitlement for individuals. Where schemes offer this protection then it is possible for a member to receive more than 25% of their crystallised rights as a lump sum.

For members with either Enhanced, Primary, Fixed or Individual Protection it maybe possible to receive a tax-free PCLS greater than £268,275.

Trivial pension commutation

There are some circumstances where a member’s pension is small enough that it can be paid entirely as a lump sum (even if it exceeds the limits above).

HM Revenue & Customs (HMRC) sets out strict conditions under which schemes can offer trivial commutation payments to a member. 

Broadly members may be entitled to take their entire pension as a ‘trivial commutation lump sum’ as long as they are over minimum pension age (currently age 55), have sufficient unused lump sum allowance and take all their benefits under the scheme at the same time.

A further condition is that the ‘trivial commutation lump sum’ along with the member’s pension rights under all other registered pension schemes must be less than £30,000. 

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.

Assuming that these criteria are met, a member may take a trivial commutation lump sum where usually 25% of the fund is paid tax free and the remainder is taxed through PAYE.  

Small lump sum payment

These are not "trivial commutations" but are commonly called “small lump sum” payments which allows occupational pension schemes to avoid paying a small pension to a member.

The conditions for paying a small lump sum are broadly the same as a trivial pension however the lump sum paid cannot exceed £10,000, however the requirement for benefits under all registered pension schemes to be below £30,000 does not apply nor the concept of a nominated date. 

Full pension commutation for serious ill health

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 known as a serious ill health lump sum’. There is no minimum age for the payment of a serious ill-health lump sum.

Before making the payment the scheme must have received written evidence from a 'Registered Medical Practitioner' confirming that the member is expected to live for less than one year.  With a couple of exceptions the serious ill health lump sum payment must use up all of the members benefits under the scheme that have not come into payment. 

Pension commutation - to commute or not to commute?

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.