Rather than paying a level monthly benefit throughout retirement, a commuted pension pays a single lump sum based on the beneficiary's age and length of employment. There are several risks associated with taking the commuted value of your pension.
Most traditional pension plans offer inflation protection in the form of annual benefit increases. If you opt to receive a lump sum payment under a commuted pension, you will not receive annual increases based on inflation, because a commuted pension does not have periodic payments. How you invest your lump sum payment will determine whether your funds keep pace with inflation. Gauging future inflation is not easy. If you elect to take a lump sum payment, you should speak with a financial professional about investing the funds to ensure your lump sum can keep pace with inflation.
The commuted value of the pension, in theory, should support the pensioner until he dies. However, the pension bases the lump sum payment on the average life expectancy as determined by a mortality table. If you outlive the commuted pension’s average life expectancy calculation, the lump sum may not sufficiently support you until your death. Of course, if you pass away before the funds from the lump sum are exhausted, your beneficiaries will receive funds from the lump sum paid out by your estate. Thus, from an economic standpoint, taking a commuted pension is justified if you die before the average life expectancy, which is difficult to predict if you're in reasonably good health.
Pensions typically invest funds in safe and secure investments, such as government bonds that have a reliable but low return. When you take a commuted pension, you assume the risk of the investment choices you make. If you invest your lump sum wisely and take risks through a diversified portfolio, you may achieve greater returns on your investments than those realized by a typical pension fund. However, investing always entails risk, so if you make poor investment decisions, you can lose your commuted pension payout.
Your retirement age should have the greatest impact on deciding whether to consider a commuted pension. According to “Fundamentals of Private Pensions,” if you collect your pension at an age at which you still plan to work, you can benefit by electing to take a commuted pension. For example, you could use the funds from the lump sum to open your own business or start a new career. On the other hand, if you do not plan to continue to work, taking the commuted pension becomes a riskier option.