It's the time of the year when many of our country's brave soldiers will be faced with a key question regarding whether to commute their pensions or not. This is an important decision - one that will go on to affect their financial lives for the next decade and a half. If you're one of them, and are caught in this all too familiar quandary, read on.
The two options at hand
You've got two options at hand: do not commute your pension, and receive a tax free monthly income for the next 14 years - or commute a tax-free lump sum of money, and receive a reduced pension for the same time duration.
In the second scenario, you'll be able to invest the lump sum as you like. You may choose to purchase physical assets such as real estate or gold, or invest the funds into financial assets such as stocks, bonds and mutual funds.
As an illustrative example, let's consider the decision that needs to be taken by Col. Gupta (name changed). He could either commute Rs. 42.05 Lakhs of his pension and receive a monthly income of Rs. 70,451, or not commute anything, and receive a monthly income of Rs. 111,265 instead. In both scenarios, the tax-free income will continue for 14 years, and will grow at a fixed rate of 5% per annum. How can he decide which option is the most rewarding?
Using Net Present Value (NPV) to arrive at a decision
The decision to commute or not can be simplified using NPV (Net Present Value). Put simply, the NPV of s series of cash flows equates the value of those cash flows to their 'present value'. By shifting both scenarios to a common frame of reference - that is, 'today'.
The NPV of a series of cash flows can be calculated using a simple excel sheet, or using a financial calculator. A qualified Financial Planner will be able to assist you with this calculation.
While calculating the NPV for both scenarios, two things must be taken into account. One - the expected portfolio return that you expect to earn from your investments, and two - the need to generate supplemental income from the portfolio itself. Both will material impact your decision.
The NPV for the commutation scenario will be directly proportional to your expected portfolio return, and inversely proportional to the quantum of drawings that you need to make from it. In order to set up a decision framework, Col. Gupta may take 12% as a reasonable annualised return expectation, from a balanced portfolio of financial assets.
How the NPV for both scenarios stack up
As it turns out, the NPV of the commutation scenario with the lower monthly income works out to 1.9 Crores, versus 1.65 Crores for the commutation scenario - assuming an average inflation rate of 6%. What this means is this: if Col. Gupta plans to not draw any income from his commuted pension, the decision is a cut and dried one - commute the pension, and invest the received moneys in a balanced portfolio that can be expected to earn him 12% per annum or so. However, the need for generating income from his investments may alter Col. Gupta's decision.
How the decision to periodically draw upon the lump sum affects the NPV
Intuitively, it follows that redeeming money from your commuted pension will reduce the NPV for the commutation scenario, as your money will not be allowed to compound and grow. Consider this - in Col. Gupta's case, 42.05 lakhs, compounding at 12% per annum for 14 years, would grow to a sizeable 2.06 Crores by 2032. If, however, he was to redeem the inflation adjusted equivalent of Rs. 30,000/month from his portfolio as income for the next 14 years, the portfolio value in 2032 would be a mere 29 lakhs! In fact, doing so would bring the NPV's for both scenarios exactly at par (1.65 Crores). Even then, it would make sense for Col. Gupta to commute the Rs. 42.05 lakhs, as he would have access to a larger amount of capital for medical emergencies or leisure expenditures.
End Note - to commute or not to commute
To conclude, here's an end note 'formula' to simplify your decision. If you do not plan to draw upon your commuted pension and can invest it for the next 14 years (barring the odd withdrawal here and there), commute it. If you plan to draw upon more than 9% of the starting value your pension each year (inflation adjusted) to fulfil your monthly income requirements, you're better off not commuting it and choosing the higher income option instead. If you plan to draw upon 8-8.5% of the starting value of your pension as annual income, the two scenarios are almost exactly the same from a purely financial standpoint. However, you still ought to commute the available money, as it's always a good idea to have a higher access to capital.