Retirement is a reality for almost all of us, and it signifies a distinct phase of life. Looking at retirement from a financial perspective, some of the desirable requirements of retired life are : (a) No liabilities in the form of unpaid loans (b) Fulfillment of most of the major financial objectives like house, children’s education and marriage, by either completion, or by having secured arrangements for the same, and (c) adequate retirement corpus to cater for retired life. One of the major retirement benefit is Commutation of Pension. One can factor it in planning for either, or all of the above mentioned requirements. However one needs to evaluate the option to commute pension in individual context. It is therefore desirable to understand the benefits as well as implications of commuting pension.
What is Commutation?
The dictionary meaning of commutation is replacement i.e. “A substitution of one form of payment or charge for another”. In simple terms it is giving up part, or all of the pension payable from retirement, in exchange for an immediate lump sum. Commutation Factor determines the amount of pension which the retiree foregoes in order to receive the lump sum. All government employees, at retirement exercise the choice of either taking their pension in full, or as an alternative an immediate tax-free cash lump sum and a lower residual pension.
How Much can one Commute? The formula for calculating Commutation Amount is
(Commutation Factor) X (50% of pension) X ( % of Pension to be Commute) X 12
Factors affecting Value of Commutation
The following factors affect the commutation value :-
(a) Commutation Factor– The commutation factor table is the expression of commutation value as number of years of purchase. The government of India publishes this table. It gives the various factors as applicable to retiree’s age at the next birthday. The factor is derived using actuarial mathematical calculations factoring the life expectancy at various ages and a discounting interest rate. You can view the table here.
(b) Pension amount. This 50% of the average of the last pay.
(c) The date of Birth and Date of Retirement. The age on next birthday will always be higher than the age today, and higher age corresponds to lower commutation factor. While in most cases it is not under control, but in case of PMR one can factor that to remain on the favorable side.
(d) The Proportion of Commuted Pension. The upper ceiling of portion that can be commuted for civilian employees is 40 %, and defense personnel it is 50%. One can commute any amount of proportion within the laid down ceiling.
To simplify understanding, the following graph indicates the commuted amount corresponding to each Rs 1/- of pension commuted for different age profiles. An individual retiring at the age of 40, receives for each Rs 1/- of pension an amount of Rs 109/-. One can see that had he not commuted, he would have received Rs 1/- for each month for next 15 yrs equaling Rs 180/-. So by commuting the retiree is foregoing Rs 71/-. The commutation amount for someone retiring at the age of 54 is equal to Rs 104/- ie, he foregoes Rs 86/- on each Rs 1/-. This understanding is important to relate to the required rate of return which is discussed later.
Evaluation of Options
Any retiree has the option not to commute, or to commute up to desired proportion, subject to the prevailing ceiling. Let us evaluate both these options.
Option A – No Commutation, or Part Commutation
(a) The present value of non-commuted Rs 1/- after adjusting for tax is about 20% less than the present value of commuted Rs 1/-. In financial decision making, we most commonly do a comparison of Net Present Value (NPV). The option which gives higher NPV is what would benefit us. The following chart indicates a comparison of Present Values of Commuted and Non-commuted Rs 1/- for different age profiles.
(b) It is evident that the NPV in the case of not commuting is lesser till the age of 58. The discount rate applied for the purpose of calculating the PV of post-tax cash inflows in case of not commuting, is 5%. This is the assumed rate of inflation. A higher inflation will reduce this further.
(c) The pension not commuted will be taxed when received at applicable rates. For every one Rupee of pension not taken as commutation, one would receive only 80 paise after deducting approx. 20% tax (a rough estimate). This is a distinct tax disadvantage vis a vis commutation and one should keep that in mind.
(d) In some specific cases where government exempts tax on pension benefits, the PV in case of not commuting will certainly be high. However, one should keep in mind that the tax provisions are subject to review by the government and can be changed any time.
(e) The pension will be impacted in case of any unforeseen contingency before completion of 15 years.
(f) Liquidity, and wealth creation options will remain restricted to available funds.
(g) The retiree not commuting pension is not challenged with the requirement of generating adequate returns from the commuted corpus. This makes retired life financially simple.
Option B- Full Commutation
(a) The Present Value (PV) as indicated in the chart above for all age profiles is more as compared to the option of not commuting.
(b) Commutation amount being tax free, Significant tax advantage on the commutation amount received. Income from investments continues to be taxable. And therefore one can argue that it cancels out the tax relief effect. One must note that unlike salary, the tax treatment of income from other sources like property, debt and equity is different. This gives the investor an option to minimize tax outgo. By careful planning, one can reduce this tax outgo to zero.
(c) By commuting pension, we can shield our dependents from adverse financial effects of any unforeseen contingency before completion of the pension restoration period which is 15 years.
(d) The commutation corpus provides adequate liquidity to cater for outstanding liabilities as well as to explore investment options.
(e) There is a requirement to ensure regeneration of lost pension amount. For every one Rupee of pension commuted, one needs to earn it back in the same time frame.
Returns Required from Commutation Amount
(a) One can observe that one critical factor affecting total commutation amount is the age of the retiree. For two individuals drawing same pay and retiring on the same date, the younger retiree would receive more commutation amount than the older one. This implies that to regenerate the one Rupee of pension commuted, the returns required for both the retirees would be different. The graph below indicates the required rate of return for retirees at different ages due to different commutation factors.
(b) The earliest age at which one could possible retire with pension is 41. And normally the latest would be 60. The required rate when retiring at age 41 is 7.35%, at 45 – 7.49%, at 50- 7.76%, at 54- 8.08% and at 60 it is 8.85%.
(c) The calculation does not factor inflation. As inflation would impact the self-generated income, or that received as pension in the same manner. The calculations have been based on a single Rupee to equalize effect for different pay scales.
(d) It can be seen that with falling interest rates and limited avenues of earning tax free income, achieving the hurdle rate shown by the graph above would not be easy. It would require lot of careful planning, involving part deployment in investments which might not be risk free.
Benefits of Commutation
(a) Commutation provides a lump sum payment which is tax free. Tax savings alone for 15 yrs would amount to approximately Rs 20 lakhs.
(b) It is possible that one is carrying some unpaid loans at the time of retirement. Some of these might be costlier than then the opportunity cost and can be retired earlier. To understand the cost of loan vis a vis opportunity cost, you may read – “ You have Idle Cash- Should You Pay off the Loan”
(c) The financial stress on dependants, esp. surviving spouse, can be overwhelming in case of untimely demise of retiree. This corpus can act as a robust cushion against such a contingency.
(d) The present-day technology and financial services offer plethora of opportunities to create wealth by balancing risk and reward. The commuted corpus provides an opportunity to generate better returns.
Utilization of Commutation Amount
(a) The commuted amount should be deployed in diversified asset classes. The portfolio should ensure generation of annualized returns more than the applicable hurdle rate for various retiree ages as given above.
(b) Retiree can use part of the corpus to pay off costly loans as discussed earlier.
(c) A robust liquidity status would facilitate an enhanced quality of retired life.
What Not to Do
(a) It is very important to retain financial importance and relevance till late in life. One should therefore not part with the corpus prematurely under social pressures.
(b) Lump sum amount might be tempting to indulge in extravagance. Improved quality of life should not be stretched to unaffordable extravagance.
(c) One should not fall for any Ponzi Scheme in eagerness to make quick profits, thereby risking hard earned money.
Who Should Commute?
(a) Anyone with dependants whose financial well-being might get adversely affected in case of any unforeseen contingency, should certainly commute. This in my view is the single most important reason to take full commutation amount.
(b) Anyone who is comfortable with part investment in risk carrying investments, and can generate annualized returns equal to or more than the hurdle rate applicable to him, should go for commutation.
(c) Someone who is carrying a costly liability should commute, and use the corpus to cater for the liability.
(d) Anyone who wants to enjoy his earned wealth till such time his age and health permits him after retirement, should commute. This will help him live his well deserved comfortable retired life.
Who Should Not Commute?
(a) The present risk-free interest rates are less than the required rate of return. Therefore, it would be necessary to invest a part of the commutation corpus in investment categories bearing some risk. Anyone who is not comfortable with risk bearing investments, should reconsider his decision to commute on financial grounds.
(b) If all dependents are financially comfortable, and all liabilities have been catered for, the retiree might be better off by not commuting. Or the retiree might commute a lesser portion as per liquidity requirements.
Recommendations
Money in hand today is always better than money in hand tomorrow. However, there is actuarial discounting done by the Govt when paying commutation. This creates an investment challenge for the retiree to ensure minimum required returns from subsequent investments. There is however the overwhelming uncertainty of life which can impact the financial well being of dependents. This in my opinion, is the most compelling reason in favor of commutation. Most of the retirees entitled to commutation shall certainly benefit from commuting. There may however be some with peculiar circumstances as discussed above, who might be better off by not commuting. In either case, one needs to take considered view in individual context, and not under peer or advisory pressure.