Pension commutation: what it is, how it works and the pros and cons
Curious about what pension commutation means and whether it’s the right option for you? We reveal what it is, how it works, and the pros and cons.
When you retire, you can opt to give up part of your yearly entitlement to your pension in exchange for a one-off lump sum, known as commutation.
We explore what you should know and why it’s essential to get financial advice before making such a big financial decision.
Reducing your annual pension for a one-off lump sum is known as commutation of pension.
While you can commute up to 25% of your pension value for a tax-free lump sum, there are tax implications to be wary of.
It’s worth getting expert financial advice before accessing your pension to ensure you make the right decision for your financial future.
What does pension commutation mean, and how does it work?
Pension commutation is when you reduce your annual defined benefit pension in exchange for a one-off lump sum.
It’s a major financial decision, and worth taking your time to get right. Giving up income now will mean getting by on less income for the rest of your retirement.
The availability and amount available depends on the terms and conditions of your scheme.
If you’re considering this option, you should check the maximum tax-free lump sum that can be taken and the cash commutation factor.
The cash commutation factor is the tax-free cash lump sum to be paid for every £1 per year of pension that’s given up.
This varies depending on the scheme but is usually between £12 and £15 of tax-free cash for every £1 of pension given up.
For example:
If someone was offered a tax-free lump sum of £50,000 with a commutation factor of £12 cash per £1 given up, their pension would fall by £4,166 a year to £10,834 (if they had an initial final salary pension of £15,000 annually).
What is the difference between pension commutation and a retirement lump sum?
Many schemes offer an automatic retirement lump sum, which is separate from pension commutation.
Here’s a quick comparison of how they work:
| Retirement lump sum | Pension commutation lump sum | |
|---|---|---|
| Is it automatic? | Yes | No, you choose to give up some of your pension income in exchange for a higher lump sum. |
| When will I receive it? | At retirement | You can choose to commute your pension at retirement. |
| Will it reduce my pension income? | No | Yes, your pension income will be reduced, depending on the size of your lump sum. |
| How much will you get? | Often a multiple of your pension income, for example, 3 x annual pension income. | How much you get depends on the terms of your scheme and how much pension income you give up. |
| How does tax work? | Lump sums worth up to 25% of the cash-value of your pension scheme are tax-free. (including both retirement lump sums and pension commutation lump sums). | Lump sums worth up to 25% of the cash-value of your pension scheme are tax-free. (including both retirement lump sums and pension commutation lump sums). |
Are there any limits when using pension commutation?
You can commute up to 25% of the value of your pension. This limit includes any other lump sums taken from your scheme.
It’s worth talking to your pension provider to see if you can use commutation for your specific pension and get expert advice from a financial adviser beforehand.
You can commute as much or as little of your pension as you want – as long as you don’t exceed 25% of your pension value or tax limits.
What is partial commutation?
Partial commutation is one option you can consider.
Here, you can get a lump sum for a portion of your pension and regular payments using the remaining amount.
It’s worth exploring the tax implications beforehand by getting expert financial advice.
What is trivial commutation?
Trivial commutation is another option if the combined value of your pension schemes is worth less than £30,000 and you are over age 55 (rising to 57 in April 2028).
Here, you withdraw your pension as an entire lump sum.
However, it’s worth noting this isn’t available for everyone, as it is be restricted to those with small pension funds.
Whether you can use trivial commutation depends on whether you’re paying into your pension, receiving income from one, or have deferred benefits.
There are many criteria you need to meet, and it’s highly advised you get financial advice, especially as the amount you’ll get may be different from its actual value.
Any payment you get will be subject to income tax, although 25% of it will be tax-free if you haven’t received your tax-free lump sum yet.
What are the pros and cons of using pension commutation?
Similar to most major financial decisions, there are major pros and cons to consider.
The advantages of pension commutation
Access to a tax-free lump sum: A lump sum can be helpful for those who need money for specific purposes such as buying a home or renovating.
Flexibility with your income: You can invest the money and potentially grow your income via higher returns or use an easy-access account to access your funds whenever you want.
The disadvantages of pension commutation
You may face a hefty tax bill: Getting a lump sum that exceeds the tax-free allowance could mean paying income tax either on part or all of it, depending on the amount received and your circumstances.
You’re responsible for the lump sum: You need to ensure you don’t spend your lump sum too quickly, as your overall pension amount will be reduced. There’s also a chance inflation can reduce the value of your money in real terms if your money is in a low-interest account.
The size of your pension will reduce: As you’re taking part of your pension as a lump sum, you’ll get a smaller amount of pension income throughout your lifetime. It could turn out to be a bad deal if you live a long time in retirement.
Unsure how to access your pension?
Accessing your pension during retirement has huge implications and can result in an unnecessary and hefty tax bill if you’re not careful.
Unbiased can match you with a qualified financial adviser who can help you with a retirement plan, including how to access your pensions tax-efficiently and ensure your money lasts.
)