Commutation of Pension (Personal Finance and Investments)

Commutation of pension is one of the most crucial decisions for the officers/ pensioners proceeding on superannuation or on Premature retirement(PMR). The decision taken on commutation firstly, has major financial implications. Secondly, the factors that need to be considered are not only financial but many intangibles factors too.
Though, there can not be any straight answer to this question, here is our attempt to simplify the commutation decision matrix on whether to commute or not commute the pension.

1. Financial Factors: For calculation purposes only, let’s take the details of an officer of 45 yrs proceeding for premature retirement after 24 years of service to the Indian Armed Forces and as on date his pay is:
Basic Pay: ₹165400
MSP: ₹15500
DA is 34%

Calculations for Pension:
Basic pension=50% of (Basic Pay + MSP)=(₹165400+₹15500)/2 = ₹180900/2= ₹90450
Basic Pension will be ₹90,450

Monthly Pension
Retiring Pension= ₹90,450
DA @ 34% = ₹30753
Monthly Pension=₹90,450 + ₹30753=₹121203

Commutation Factor: From the available table
Applicable Commutation factor at age of 45 Years from the table will be 8.996.
If 50% pension is commuted:
Commuted portion of pension= ₹45225
Commutation Corpus received will be = ₹(45225 X 8.996 X 12) = ₹48,82,129.

Monthly Pension after commutation will be: ₹121203-₹45225=₹75978
Note: The pensioner will continue to receive Dearness Allowance/Dearness Relief, even on the commuted portion.

Assumptions:
DA/DR is 34%.
Annual rate of increase in DA/DR for the next 15 years will be 6%.
Pensioner opts for the new tax regime, and current income tax rates have been applied.

Inferences from the above cash flow table explained in YouTube video:
When a Pension is Taxable: The shortfall in the monthly pension for 15 years due to commutation can be completely fulfilled by the investment of the commuted corpus for just 3% annual post-tax returns.
When Pension is Tax-Free: For breakeven, the Commuted Corpus needs to be invested for 7.2% annual post tax returns.
Note: If cess and other charges as applicable to income tax on monthly full pension received are added to above calculations. Then the breakeven rate of return will further come down to even below 3% & 7.2%.

Other factors influencing Commutation decisions could be:
If you have any major liability that needs to be paid off, you must commute.
If you are likely to pick up a job or have a source of regular income from any business etc. to fill up the gap created in regular monthly pension due to commutation, you must commute.
PMR and officers retiring at younger ages should prefer to commute, unless commutation of pension is ruled out for other more compelling reasons.
The commuted corpus comes as tax-free and in an unfortunate demise of the pensioner. The pension to the spouse gets restored/ reverted to full pension.
The available commuted corpus at hand provides chances of availing opportunity cost.
In case of demise of pensioner the pension to family is restored to full pension.

Conclusion: Based on the financial factors alone, pensioners should always prefer to commute their pension. Why? For a simple reason which is that, the required breakeven rate of return of 3% is possible even with the Fixed Deposits offered by banks such as SBI (current SBI FD rates are 6% pre-tax and 4.2% post-tax).