Beware the commutation catch in tax-free cash Employees considering taking tax-free lump sums from their pensions have been warned to beware of settlements that slash the value of their remaining retirement funds. The recent transfer of the UK Coal pension scheme to the Pension Protection Fund (PPF) highlighted the importance of "commutation ratios" for employees in defined benefit pension schemes, who accept reduced incomes in return for taking a lump sum. Commutation ratios determine the reduction in income after taking a lump sum. Matthew Demwell, partner in the financial strategy team at consultants Mercer, said annual income is typically reduced by £1 for every £14-£18 taken in tax-free cash. Yet to buy that level of income as an annuity would cost substantially more. Laith Khalaf, head of corporate research at financial advisers Hargreaves Lansdown, said that to buy £1,000 of annual, index-linked income for a 65-year-old man would require a capital sum of about £28,000. A 60-year-old would need a £34,600 lump sum - equivalent to a commutation ratio of £34.60, almost double the typical value. The PPF uses a "market neutral" rate considerably higher than the rate UK Coal itself was using. That means that UK Coal employees not yet in retirement could be better off in the PPF than they were before the company failed. There are no firm rules anywhere telling employers how commutation ratios are to be calculated. Taking one can reduce your pension in payment by more than 25 per cent, or less than that. It may affect the pension that your spouse receives after your death, or it may not. Advisers say that before opting for tax-free cash, employees should watch for commutation terms that offer poor value to them, but are advantageous to the scheme because they reduce its long-term liabilities. They warn that under almost no circumstances could an employee take the cash lump sum then use it to buy the pension income given up by extracting cash. For those whose post-retirement income is taxed at the basic rate, the wisdom of collecting a lump sum on such poor terms is even more questionable, although the ability to take tax-free cash is often touted as a major pension benefit. Mr Demwell said there may still be good reasons to take a tax-free lump sum. For example, people in poor health who may not live for decades will find it to their advantage. Those with an outstanding liability such as a mortgage might wish to wipe that out so that their retirement can be debt free. It can also be a way of extracting capital to pass to children without having to sell a primary residence; provided the parent lives another seven years, the sum gifted will not attract inheritance tax. There are some good reasons why companies use commutation factors that are well below economic value; one is that everyone understands the cash taken will be tax free whereas the income forfeited is taxable. Cash commutation terms are not reviewed frequently, but Mr Demwell said that could be changing. Now there is upward pressure on commutation factors - as annuity rates have gone up, there is a bigger gap. Several actuaries have expressed growing concern about certifying that the terms are "fair" or "balanced," a requirement set out in some scheme trust deeds.