What commutation factor makes giving up DB pension for cash worthwhile?

01 What the factor is telling you

A commutation factor of 12:1 means the scheme pays £12 of cash for every £1 of annual pension you give up permanently. The implicit annuity rate is the inverse: 1/12, or 8.3% a year. That sounds generous against a market annuity rate until you notice what the scheme pension includes that the market rate does not.

The pension you surrender rises with inflation under the scheme's escalation rules and typically pays a survivor's pension after your death. An index-linked, joint-life income for life costs far more than 12 times its annual amount to buy on the open market. On a like-for-like basis, factors below about 20:1 are usually a discount to what the benefit is worth.

Factors are set by the scheme, reviewed periodically, and are not negotiable. Public service schemes have historically clustered around 12:1; private schemes vary more widely and some are considerably more generous.

Source: Pension types and how they work

02 Why tax changes the answer

The lump sum is paid free of Income Tax; the pension is taxed at your marginal rate every year. For a basic-rate taxpayer, £5,600 of pension is £4,480 net, so a £67,200 lump sum is buying up fifteen years of net income rather than twelve years of gross. For a higher-rate taxpayer in retirement the effect is stronger still.

That is the honest argument for commuting at a mediocre factor, and it is the one most scheme literature does not make. It does not rescue a genuinely bad factor, but it moves the break-even by several years, and for anyone who expects to be a taxpayer throughout retirement it should be in the calculation.

The counterweight is that the pension keeps rising and the lump sum does not. Thirty years of escalation on £5,600 is a great deal more than thirty years of nothing on £67,200, unless the cash is invested — and investing it reintroduces exactly the risk the scheme was carrying.

On the defaults above, the worked example shows 15.0 years. A factor of 12.0:1. After 20% tax the pension is £4,480 a year, so the cash covers 15.0 years of it — before any inflation increases.

Source: Income Tax rates and Personal Allowances

03 The survivor's pension question

Commuting reduces your pension, and in most schemes the survivor's pension is calculated on the pension before commutation — but not in all of them. Where it is calculated after, commuting takes money away from a spouse who may live a decade beyond you, and that consequence does not appear in the factor at all.

This is the single most important thing to establish from the scheme booklet before deciding, and it is a yes-or-no question the administrator can answer in a sentence. A couple where one partner has a substantial survivor's entitlement and the other has little pension of their own should treat a post-commutation calculation as close to disqualifying.

Source: Pension types and how they work

04 When commuting is the right call anyway

Three cases justify a poor factor. Clearing an expensive debt: paying off a mortgage at 5.5% with tax-free cash beats keeping a taxed pension income, arithmetically and in peace of mind. Poor health: a shortened life expectancy inverts the whole calculation, because the cash is certain and the pension is not.

And liquidity: a household with a guaranteed income already sufficient for its essential spending can rationally take cash for the flexible part of retirement, because the marginal pound of guaranteed income is worth less than the marginal pound of accessible capital.

Outside those, taking less than the maximum is often the answer nobody offers. Commutation is not all-or-nothing in most schemes — you can take the cash you have a use for and keep the rest as pension.

There is a fourth case that is really the first three in disguise: a scheme whose factor is genuinely generous. Some private schemes commute at 20:1 or better, and at that level the arithmetic stops being a concession and starts being a fair price for the benefit surrendered. The only way to know which camp your scheme is in is to divide the quoted lump sum by the pension given up, because schemes do not publish the factor as a factor.

Source: Plan your retirement income

05 How to run the decision

Get three numbers from the scheme: the maximum lump sum, the pension given up to reach it, and whether the survivor's pension is based on the pre- or post-commutation figure. Those three settle most of it.

Then divide the lump sum by the pension surrendered to get the factor, and compare it against what an inflation-linked joint-life annuity would cost for the same income. If the gap is wide, commute only what you have a specific use for. If you have no specific use for the cash, the default should be to keep the pension — a lump sum with no purpose is a taxable investment problem you did not previously have.

One practical warning about the paperwork. The retirement quotation usually presents the maximum lump sum as the headline option, with the full-pension alternative below it, and the maximum is not a recommendation. Ask for a quotation at two or three different commutation levels before choosing, because seeing the pension you keep alongside the cash you take is what makes the trade visible.

Source: MoneyHelper: guaranteed retirement income (annuities)