Commutation
Taking a portion of a pension or annuity corpus as a lump sum at retirement instead of as income — typically up to one-third in superannuation funds and insurers' pension plans.
In plain language
A pension corpus is meant to become income. Commutation is the facility to take part of it in cash at the point of retirement, with the balance used to buy an annuity.
The workbook defines it in one line: commutation "refers to the exercise of the facility of taking a portion of the annuity corpus in a lump sum". It is a trade-off between liquidity now and income for life — every rupee commuted is a rupee that no longer generates pension.
The standard fraction the paper uses is one-third.
How it works
Superannuation funds (Chapter 6, section 6.1). On retirement the employee may take one third of the accumulation as commutation; the balance buys an annuity. Apart from LIC, life insurers allow customers to buy the annuity from any annuity provider. Payments received from an approved superannuation fund at retirement or death are exempt from tax.
Insurers' pension plans (Chapter 3, section 3.4.2). Pension plans of insurance companies allow commutation of up to 1/3 of the vesting amount, which is exempt from tax.
The NPS equivalent. The NPS does not call it commutation, but the lump sum on exit plays the same role at a much larger fraction:
| Scheme | Lump sum on normal exit | Tax on lump sum |
|---|---|---|
| Superannuation / insurer pension plan | Up to 1/3 | Exempt (as above) |
| NPS, Government sector | Up to 60% | Exempt up to 60% of the amount payable |
| NPS, Non-Government sector | Up to 80% | Exempt up to 60% of the amount payable |
The NPS figures are from Chapter 4, sections 4.2.4 and 4.5, for corpora above Rs 12 lakh.
What is not commutation. Gratuity is paid in a lump sum under the Payment of Gratuity Act — it is not a pension, and there is nothing to commute. The Chapter 6 sample question offers "1/3rd is commuted and the rest used to purchase an annuity" as a wrong answer for gratuity.
A worked example
Suresh retires with Rs 36,00,000 in his employer's approved superannuation fund.
Commuted (1/3) = 36,00,000 ÷ 3 = Rs 12,00,000 ← lump sum, tax exempt
Balance to annuity = 36,00,000 − 12,00,000 = Rs 24,00,000
What the Rs 12 lakh costs him. Take an annuity rate of 7 per cent purely as an illustration:
| Commute 1/3 | Commute nothing | |
|---|---|---|
| Cash at retirement | Rs 12,00,000 | nil |
| Annuity purchase price | Rs 24,00,000 | Rs 36,00,000 |
| Annual annuity at 7% | Rs 1,68,000 | Rs 2,52,000 |
He gives up Rs 84,000 a year for life in exchange for Rs 12 lakh today. At that rate the income forgone equals the lump sum in about 14.3 years (12,00,000 ÷ 84,000). If he lives past 74 on a 60 retirement, not commuting would have paid more in total — before counting what the Rs 12 lakh could have earned if invested, and before counting that the annuity income is taxable while the commuted sum is not.
That is why the workbook's distribution-stage advice limits annuities to essential expenses: the commuted lump sum can go to a medical corpus, debt repayment, or growth assets that the annuity cannot provide.
Why NISM asks about it
Chapter 6, section 6.1 (Mandatory Retirement Benefit Schemes), defines commutation under Superannuation Benefit. Chapter 3, section 3.4.2 (Plan for Retirement Income), cites the one-third tax-exempt commutation from insurers' pension plans when discussing tax at the withdrawal stage. The Chapter 6 sample questions use commutation as a distractor for how gratuity is paid. Expect recall of the one-third fraction and its tax exemption, and a question distinguishing commutation from gratuity.
Common exam traps
- One-third, not one-half and not 60 per cent. The 60 per cent figure belongs to the NPS lump sum, which the workbook does not call commutation.
- Gratuity is not commuted. It is paid in a lump sum. This is a sample question.
- The commuted portion is tax exempt; the annuity income is not. Annuity income is taxable in the annuitant's hands.
- Commuting reduces the pension permanently. The annuity is bought only with the balance.
- LIC is the exception on annuity choice. The workbook says that apart from LIC, insurers let customers buy the annuity from any provider.
- In the NPS the lump-sum limit and the tax-exempt limit are not the same number for Non-Government subscribers: up to 80 per cent may be withdrawn, but the exemption runs up to 60 per cent of the amount payable.
Where this is taught
Free preparation for NISM Series X-BRelated terms
- GratuityA lump sum an employer must pay under the Payment of Gratuity Act, 1972 on termination after at least five years of continuous service, a condition waived on death or disablement.
- National Pension SystemA PFRDA-regulated, defined-contribution retirement scheme in which the subscriber builds a market-linked corpus and must convert part of it into an annuity at exit; there is no guaranteed return.
- AnnuityAn insurance contract in which a corpus paid as a lump sum or in instalments buys a periodic payment from the insurer, at a rate fixed at purchase and guaranteed for life or the contracted term.
- Superannuation benefitAn employer-funded retirement scheme, on top of the mandatory PF, that pays one-third of the accumulated corpus as a lump sum and converts the rest into an annuity.
- SuperannuationAn organisational pension programme set up by an employer for its employees, funded through an irrevocable trust or a life insurer, typically paying annuities on retirement.