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| Commutation of Pension |
*Firstly, people don't understand it correctly.
*Secondly, the advantages and disadvantages of commutation are not clear to most of us.
*Thirdly and most importantly, whether to opt for it or not.
*Fourthly, how much should you commute.
Let's decipher it one by one:
What is Commutation of Pension?
A Government servant has an option to commute a portion of pension, not exceeding 50% of it, into a lump sum payment. Lump sum payable is calculated with reference to the Commutation Table. The monthly pension will stand reduced by the portion commuted and the commuted portion will be restored on the expiry of 15 years from the date of receipt of the commuted value of pension. Dearness Relief, however, will continue to be calculated on the basis of the original pension (i.e. without reduction of commuted portion).
While civilian government employees are allowed to commute a maximum of 40 per cent of their pension, defense personnel are allowed to commute upto 50 per cent of their pension.
A Government servant has an option to commute a portion of pension, not exceeding 50% of it, into a lump sum payment. Lump sum payable is calculated with reference to the Commutation Table. The monthly pension will stand reduced by the portion commuted and the commuted portion will be restored on the expiry of 15 years from the date of receipt of the commuted value of pension. Dearness Relief, however, will continue to be calculated on the basis of the original pension (i.e. without reduction of commuted portion).
While civilian government employees are allowed to commute a maximum of 40 per cent of their pension, defense personnel are allowed to commute upto 50 per cent of their pension.
What is Commutation Factor?
Commutation Factor is the No of years of Commuted pension that the govt will pay in advance out of the 15 years of commuted pension that is payable to you. For example, if your basic pay (incl MSP or NPA) on retirement is Rs 2.0 lakh, your monthly pension at 50%, works out to Rs 1.0 lakh. If you do not commute, the total pension payable to you over 15 years is approx (1.0x15x12)= Rs 1,80,00,000/- (approx 1.80 Cr). If you commute 50% of your pension, you will get Rs 90,00,000/-(approx Rs 90 lakhs) over a period of 15 years as your monthly pension. Out of the balance Rs 90 lakhs( 180-90) due to you, the govt will pay approx Rs 52 lakhs in advance on retirement (Commutation Factor of 8.627) and keep the remaining RS 48 LAKHS.
Why does the govt give you 8.627 years’ worth of commuted pension and retain the balance of nearly 6.373 years’ worth? There are two reasons for it.
*One is that the govt is giving you the lumpsum amount in advance, so there is an interest component to be recovered.
*The second reason, again not known to many of us, is that the govt deducts an insurance amount or a mortality factor. To put it simply, those who survive for 15 years, after their retirement, are compensating the govt for the loss suffered by the government when a pensioner dies before the commuted amount is recovered from him.
* Is the Govt overcharging it's employees? Commuted pension is fully recovered by the Govt, along with interest in about 11 years but the govt continues to recover it for an additional four years, bringing the total recovery period to 15 years. Logically, it may be correct. If you have taken a loan of Rs 52 Lakhs from any agency at 8.5% for 15 years in the normal course, you would have paid the lender a total of Rs 90 Lakhs, which is Rs 48 Lakhs extra. There is nothing extraordinary about it and normal loans do not come with the additional advantage of life insurance. The main reason projected by the Government for excess recovery is the ‘mortality risk factor’ since the balance recovery is waived in case of death. The fact remains that it is like any other advance/ loan, on which the issuer charges interest at market rate!
Advantages of Commutation:
* You get the lumpsum amount. It's an insured loan against death cover, govt is offering you at the best lending rates(around 8.5%).
* The pension is fully taxable while the commuted amount is fully tax-free. If this commuted amount is properly invested, just a fraction of the tax would need to be paid compared to the tax on uncommuted pension while getting the same net pension.
* In the unfortunate eventuality of death of an individual, the amount is not recovered by the govt. Family pension remains the same.
Disadvantages of Commutation:
* Commuted pension is fully recovered by the Govt, along with interest in about 11 years but the govt continues to recover it for an additional four years, bringing the total recovery period to 15 years.
* Most of the individuals are unfortunately not financially savvy to handle such large sums of personal income and will find it difficult to earn an ROI of 9% over the next 15 years, in a scenario where the interest rates are falling perpetually. Today Senior Citizen Saving Scheme offers the safest return of 8.3%. After 30% taxes, the scheme gives nearly 5.9% returns. MIS gives you only 5% post tax returns. FDs give you even less than 5% post tax returns.
So, finally whether to take commutation or not?
Most of the pensioners opt for this option. The huge amount received on commutation can be very handy. Earlier, it used to more simple to decide to commute or not to commute. The interest rates were high, so was the commutation factor. It was easy to earn the amount reduced from pension on account of commutation, just by putting it in FDs that earned nearly 9 to 10%. These days, the FDs give a return of only 6 to 7%. Thus, it becomes all the more difficult to replenish the commuted amount every month. Mind you, the Commutation Factor (CF) has also been reduced periodically, while keeping the restoration period at 15 years.
If you take the commutation amount and then invest it in tax-inefficient products like bank FDs, Post Office Monthly Income Scheme (PO MIS), Senior Citizen Savings Scheme (SCSS) etc, then it is better that you do not commute. The reason is that these three investment products will actually give you just 5%, 6.2% and 6.7% returns respectively if we assume all will be at least in the 20% tax bracket. And if you happen to be in 30% tax bracket, your returns further reduced to 4.5%, 5.5% and 5.8% respectively.
If you can to invest the commuted portion of pension in the financial instruments where you can generate more than 8% post tax returns, then your take home pension will be almost same even after commutation while still having this large commuted amount with you as an additional reserve. If you can do it you must opt for it.
Your ability to earn a reasonable Return on Investment (ROI) is a major factor to decide for commutation. A post tax return of around 8-9% is a safe bet to compensate the reduced pension. With wise investing without taking too much risks, you can generate same amount of pension vis-Ã -vis non-commutation and keeping the commutated amount with you for rest of your life.
But, it is not all that simple. Also, It is not only commutation amount that you get but also your gratuity, leave encashment, Group Insurance and provident fund. That sums up to very huge amount. Now it's a problem of plenty. So, it's not only 52 lakhs that you have to invest but at least 2 to 3 times of that amount depending upon your provident fund. I have seen most of individuals investing most of the amount in FDs/MIS/SCSS. You are going nowhere by investing your retirement benefits in tax-inefficient products. So, how to invest this huge corpus in tax efficient products which can give you at least 8% post tax returns. This is a topic in itself and I may take it separately. You can also consult any good and reliable financial advisor for an honest help and opinion. But remember, good financial advice will come for a price. Please do your home work and then choose a reliable and honest financial advisor.
To summarize, take commutation if you are ready to invest in a mix of debt and equity funds which can give you at least 8-9 % post tax returns to offset the reduced amount given by the govt. Please think once again before taking commutation if you are going to invest in tax-inefficient products like bank FDs, Post Office Monthly Income Scheme (PO MIS), Senior Citizen Savings Scheme (SCSS) etc. The only advantage you can think of is on the unfortunate eventuality of death of an individual, the amount is not taken back from your family and full family pension is given to the dependents.
DISCLAIMER
To write the article, the following websites have been studied:
outlookindia.com
pensionersportal.gov.in
gconnect.in
humfauji.com
doppw.gov.in
DISCLAIMER
To write the article, the following websites have been studied:
outlookindia.com
pensionersportal.gov.in
gconnect.in
humfauji.com
doppw.gov.in
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