Pension commutation: 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.  

Summary 

• 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 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? 

A commutation of pension is when you reduce your annual pension for a one-off lump sum. It is available to anyone with a defined benefit pension.

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 cash-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).  

Are there any limits when using pension commutation? 

You can commute up to 25% of your pension, but it shouldn’t exceed certain tax limits; otherwise, you could be charged.  

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 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.  

Here, you withdraw your pension as an entire lump sum.  

However, it’s worth noting this isn’t available for everyone, as it could 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 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.  

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.