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Is It a Good Idea to Commute Some of Your Pension for a Cash Lump Sum?

Cruncher is the pseudonym of an actuary working in London with experience in insurance, pensions and investments.

Commuting your pension sounds like a good deal, but is it?

Commuting your pension sounds like a good deal, but is it?

What Is "Commuting" Your Pension?

In certain pension schemes, you have the option to convert some of the pension you have built up into cash. This is known as "commuting" your pension. Typically you can only commute some of your pension, but in some circumstances, you may be able to take all of it as cash. But is it a good deal?

The answer, like a lot of things in financial matters, is "it depends".

This article is not advice—only a discussion in general terms. If you need personalized advice, consult a qualified financial planner or independent financial adviser in your locale.

In this article, I talk about the situation in the UK, but similar principles apply in other countries.

What Kind of Pension Scheme Do You Have?

In general terms there are two sorts of pension schemes: in some, you accumulate money in your pot which you then use to buy an income when you retire (these are called money purchase or defined contribution schemes); in the other sort you build up a guaranteed amount of pension often linked to your salary (these are called defined benefit schemes, for example, final salary schemes or career average schemes).

In a defined contribution scheme you have your own pot of money and convert all or some of that into a pension when you retire. In a defined benefit scheme you have a guaranteed amount of pension and you can then convert some or all of that into cash. So in this article, we will only think about defined benefit schemes.

Converting a pension into cash is a bit like turning your euros into pounds at the bank. The bank sets an exchange rate for pounds to euros. The pension scheme sets an "exchange rate" telling you how many pounds of cash you get for every pound of pension you give up. However, just like the exchange rate offered by your bank, the commutation rate offered is not guaranteed to be a good deal.

There are a number of different scenarios where you can commute pension to get cash instead.

Commutation at Retirement (or, Pension Commencement Lump Sum)

This is the scenario that applies to most people. In most defined benefit pension schemes (such as final salary or career average schemes) you have the option to commute some of your pension for cash when you retire. This is a one-off option, once you have retired and taken the money, you can't change your mind.

Each pension scheme will have its own commutation terms or "exchange rate". You will have to think about whether or not it is a good deal for you, in your circumstances.

If You Are Seriously Ill, You Might Be Able to Take the Cash

If you have paid into a pension scheme your whole life, you might feel hard done by if you die young and don't see the benefit. Because of that a lot of schemes allow members who are very seriously ill (usually not expected to live more than a year) to take their benefits as a lump sum payment. There will be special terms for this which may or may not be the same as the terms for taking cash at retirement.

There may be tax and state benefit implications of taking a lump sum so you may find it useful to take some advice and consider all your options. It may also affect the benefits the scheme would pay to your partner or other dependants.

Trivial Commutation for Small Pensions

On the other hand, if you have a really small pension it is not cost-effective to pay you £2 a year or 50c a month or whatever, so many schemes will allow you (or even force you) to take these small pensions as a lump sum, to avoid the costs of having to administer a small pension.

The Trade Off

Commuting some or all of your pension does mean you get cash now. That can be very attractive especially if you have some urgent costs or loans to pay off.

But don't forget what you are giving up. A pension for life protects you against living too long. And your pension probably includes some protection against inflation.

This is true whether or not you are expecting to "win" on the deal. Don't forget you are taking on extra risks—make sure the extra freedom and flexibility are sufficient rewards.

Choose Carefully

Commutation can be a useful option as it gives you flexibility over when you take money, and sometimes has tax advantages. But just because you can commute pension for cash does not make it automatically a good idea! You should think carefully about whether it is a good idea for you in your personal circumstances.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

Comments on March 29, 2019:

I took a retirement policy which paid me 1/3in 2015 and was told the rest will be paid in 2019. When I approached the company in January 2019, I was told to write a letter of cancelation of the policy so that I can be paid. Later I received an email from the company informing me that the policy can not be commuted. I should be satisfied with the amount of money that I am paid on monthly basis which R331.00 and taxed. They say the only time that the money could have been commuted would have been if it was less than R75000 and mine was R91000 as such it can't be commuted. The amount of money paid is taxed so it's better to be paid all my money be taxed accordingly rather than being paid this meagre amount which doesn't assist me in any way.

Thanking you in advance

Mngadi M D