Pension Plan
Taking a lump sum at retirement – A guide for members
How is the tax-free cash lump sum calculated?
HMRC has strict rules about the maximum tax-free cash you can receive; and broadly, this will equate to 25% of the overall Value of your benefits. The calculation of the Value of your benefits is prescribed under pension legislation.
There may be further restrictions on the maximum cash you can take, but the Plan administrator will tell you if this applies to you.
We calculate the amount of annual Plan pension you give up by dividing your lump sum value by the commutation factor, which depends (amongst other things) on your age at the point of commutation. The commutation factor represents the amount of cash you would receive for each £1 of annual Plan pension that you give up. See example in the pink box.
Example:
Member with pension of £10,000 per annum.
With a commutation factor of 25:
Cash = £52,631.58
Pension given up for cash = £52,631.58/25 = £2,105.26
Reduced pension = £7,894.74 per annum
The value of a pension is prescribed as 20 x pension, so the
Overall Value of benefits = £52,631.58 + (20 x 7,894.74) = £210,526.38, and the cash is 25% of this value.
How are the commutation factors calculated?
The commutation factors that are used for calculating the tax-free lump sum take into account expectations about investment returns, levels of future pension increases and how long members will live. These expectations can change from time to time, and so the commutation factors are reviewed regularly, which means they are subject to change at any time and could go either up or down in the future.
What happens if the commutation factors change?
Changes to the commutation factors can have an impact on the maximum tax-free lump sum and remaining annual Plan pension that are available to you when you retire. Also, commutation factors vary by age at retirement (because the younger you are at retirement, the longer your pension is expected to be paid for).
If the commutation factors increase, the maximum lump sum you can take and your annual Plan pension will be higher; but if they decrease, the maximum lump sum and your annual Plan pension will be lower.
Change to commutation factor example:
Member with pension of £10,000 per annum.
If the commutation factor has changed from 25 to 22:
Cash = £51,162.79
Pension given up for cash = £51,162.79 /22 = £2,325.58
Reduced pension = £7,674.42 per annum
The value of a pension is prescribed as 20 x pension, so the:
Overall Value of benefits = £51,162.79 + (20 x £7674.42) =£204,651.19 So as the overall value of the benefit reduces by 2.8%, there is also a 2.8% reduction in the cash and reduced pension.
Why has my tax-free cash sum reduced since my previous quotation?
Although there were some significant market changes in the last few years, the Trustee made the decision to not immediately change the commutation factors. So, more generous commutation factors were in place as they had not been fully adjusted to reflect market conditions. In particular, significantly higher interest rates in recent years mean that future returns on investments are expected to be higher. All else being equal, this results in lower commutation factors. As a result, the tax-free cash sums may have been higher than if the factors had been changed to reflect market conditions. Commutation factors have now been updated to reflect current market conditions which is likely to result in lower tax-free cash sums. These are also updated on a monthly basis.