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Home arrow Resettlement arrow Personal Finance arrow A Guide To Commutation And Inverse Commutation In AFPS 05 And AFPS 15
A Guide To Commutation And Inverse Commutation In AFPS 05 And AFPS 15 PDF Print E-mail

The Forces Pension Society look at what AFPS 05 and AFPS 15 have to offer in terms of commutation and inverse commutation…

Just so that we all know what we are talking about, commutation means that income is surrendered to generate a lump sum and inverse commutation means that some or all of a lump sum is surrendered to increase monthly income.

AFPS 15

Looking at AFPS 15, there are two relevant areas of flexibility to be considered relating to lump sums. First, the pension itself does not feature an automatic lump sum but the rules allow for pension to be surrendered to generate one. Second, those leaving at the Early Departure Payment (EDP) point are entitled to a lump sum but can give it up to improve their EDP income. Let’s look at each in turn.

Whilst AFPS 75 and AFPS 05 feature a lump sum of three times pension (this is called automatic commutation) which is worth approximately 13% of the value of the capitalised pension, AFPS 15 has no automatic lump sum. However, the scheme allows a tax free lump sum to be generated which is worth up to 25% of the value of the total pension. This 25% figure is the largest amount allowed by HMRC and is a bit tricky to calculate, as it is not a straight quarter of the pension. The actuary's formula for arriving at 25% of the value is to multiply by 20 and divide by 56, then multiply the product by 12.

The following example shows how the maximum lump sum would be calculated for an individual leaving with an AFPS 15 pension of £3,600/ year (index linked).

EXAMPLE:
  • Pension earned = £3,600
  • Maximum amount which may be surrendered = (£3,600 x 20/56) = £1,285.71
  • Lump sum generated = £1,285.71 x 12 = £15,428.52
  • Pension remaining = £3,600 - £1,285.71 = £2,314.29/ year (index linked)
For those who do not want to see their pension reduced by a large amount but would welcome a more modest lump sum, there is the opportunity of giving up smaller sums and the rule of thumb is that for every £1 of taxable pension surrendered a tax free lump sum of £12 is generated.

For AFPS 15 members, EDP benefits are payable when an individual leaves the Regular Armed Forces having given at least 20 years’ service and having reached the age of at least 40. Both criteria have to be met. So, if the individual joined at age 18, he would still have to serve until age 40 even though this would mean he had 22 years’ service. Equally, if someone joined at age 23, he would have to serve for 20 years to qualify even though this would mean he was 43 when he left.

EDP benefits comprise a tax free lump sum of 2.25 times the deferred pension earned and an income stream of at least 34% of the value of the deferred pension. The flexibility lies in the fact that individuals can opt to surrender the tax free lump sum – all or nothing – to improve their annual EDP income.

As we are in the very early days of AFPS 15, I will use a very modest example:
- If the EDP lump sum = £3,602.14
and
- EDP Income Stream = £544.32

By giving up the EDP lump sum, the Income Stream would rise by £211.68 to £756. Assuming that the individual left at age 60 and his State Pension Age is 67, that would add up to an extra £5,715.36 over the life of the EDP benefits. 

If you are thinking of doing this, it is worth having a chat with a financial adviser first as you need to take into account that the EDP lump sum is tax free and the income generated is taxable. It may be that the financial adviser can suggest a financial product which would pay out income whilst keeping some or all of your capital intact.

AFPS 05

Turning now to AFPS 05. AFPS 05 features an automatic tax free lump sum of three times pension. The rules allow members to give up some (in units of £100) or all of their pension lump sum to increase their taxable monthly pension. To give you an idea of cost, each £100 surrendered would buy £6.10 per year for a male or £5.20 per year for a female – the difference is due to the fact that women tend to live longer than men so the amount surrendered has to ‘stretch’ further.

Thus a male who opts to commute the whole of his preserved pension lump sum, which by the time he is age 65 (when his preserved pension is payable) is £63,560, would gain an additional £3,877.16 (£63,560 x 6.10/100) annual pension. Again, remember that the lump sum is tax free and the income is taxable. Therefore, it is good sense to consult a financial adviser as to your options.

Small Pension Commutation

Finally, a few words about ‘Small Pension Commutation’. All the Armed Forces pension schemes have a rule which allows the scheme administrators to offer the member or, if he or she is deceased, the adult dependant a lump sum which, effectively, buys out that particular scheme’s pension liability in respect of that individual. The reason the option exists is that some pensions are so small that the cost of administration is far greater than the value of the benefit. I mention Small Pension Commutation because, with some people being transferred to AFPS 15 for a very short period, there is every likelihood that more of you will come across it.

The issue has been raised several times at Financial Aspects of Resettlement briefings because people believe, quite wrongly, that this lump sum will be paid immediately on leaving the Armed Forces. The Finance Act 2004 made it an ‘unauthorised payment’ (subject to stringent tax implications) for a pension benefit to be paid to a member before age 55, save in the event of a medical retirement. That is why the lump sum cannot be paid immediately on discharge to most people. 

The amount below which Small Pension Commutation may be offered is set by HMRC and is periodically adjusted but, as it will be the best part of 20 years before the first AFPS 15 member will have to consider it (10 years if he or she wants to claim their deferred pension early with actuarial reductions), there is very little point in setting the figures out in this article.

Further Information

If you have questions about your Armed Forces Pension and you are a member of the Forces Pension Society, you can call the Society’s dedicated help line on 020 7735 0110 or find answers on its web site. If you are not yet a member, the cost is modest and benefits (in addition to the best available expert advice) include discounts on a range of useful products and services and the assurance that a dedicated organisation, independent of the Government, is there to help you get the most from your Armed Forces pension.

For more information, go to www.ForcesPensionSociety.org

 
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