Expert SMSF insights
Market movement causing potential solvency issues for certain SMSFs
By Mark Ellem
- The problem of insolvent defined benefit pensions
- Options if solvency is a problem
- Is it time for Amnesty?
Market movement may lead to solvency issues for SMSFs with defined benefit pension members
With the volatility of share markets in the second half of the 2019/20 financial year and the talk of GFC type conditions, where values end up at 30 June 2020 could present solvency issues for SMSFs running old legacy defined benefit pensions. Further, where a member’s defined benefit pension is a 100 per cent Asset Test Exempt (ATE) pension for Centrelink purposes, an adverse solvency certificate could have a knock-on detrimental financial affect if no action is taken within the required time period.
Whilst the number of SMSFs with these old legacy pensions is dwindling (since 31 December 2005, SMSFs have been prohibited from commencing new defined benefit pensions), accountants, advisers and SMSF trustees should be prepared and be able to consider what options are available, in situations where the actuary is unable to provide a solvency certificate.
Planning should start now to ensure that any SMSFs that have defined benefit pensions, particularly those that are 100 per cent ATE pensions, will have their 2019/20 annual financial statements prepared as soon as possible after 30 June 2020 so that the actuary can ascertain solvency well before any Centrelink deadline approaches. Generally, solvency reports need to be obtained and submitted to Centrelink before your office closes for the Christmas/New Year break. Where an adverse solvency certificate is issued, there is a short and strict time frame to respond and act.
The problem of an insolvent defined benefit pension
There are basically two categories of defined benefit pensions affected by the solvency requirements that have a flow on effect for Centrelink entitlements:
- Lifetime complying pension – this is a pension that is paid for the life of the member and if reversionary, the life of the reversionary beneficiary;
- Life expectancy pensions (also known as Fixed Term pensions) – these pensions are for a fixed term, normally based on the member’s life expectancy at the time of commencement.
For both types of pensions, effectively the member gives up their right to a lump sum of money in return for a right to an income stream, based on the terms of the pension. The pension is set and may be increased within allowable limits, e.g. CPI increases, but essentially the member no longer is concerned with the value of assets that are backing the pension as the superannuation fund trustee is contracted to pay the pension, per the defined terms - hence the name defined benefit pensions. The movement in value of the assets backing the pension is now the concern of the superannuation fund trustee. However, in an SMSF, this is usually one or the same person, so, market value movement of fund assets backing these pensions are of great concern to SMSF clients and their advisers.
From a regulatory perspective, there are two solvency requirements. One is what the superannuation law requires and the other is what Centrelink requires. In both cases there is a requirement for an actuary to provide an annual opinion on the solvency of the defined benefit pension and whether a particular level of certainty (70 per cent) can be provided in relation to the solvency status of the defined benefit pension. Where the actuary is of the opinion that the defined benefit pension does not meet the required level of certainty for solvency, the pension will fail the superannuation law requirements as well as the Centrelink requirement and consequently can lose it's asset test exemption status, which can result in the loss of Centrelink benefits, e.g. Age Pension.
Options if solvency is a problem
Firstly, the SMSF’s actuary will be a great starting point where the defined benefit pension has a solvency issue. Importantly, review the pension information that has been supplied to the actuary – is it correct? Can you reference the information back to the original pension documentation and the initial actuarial solvency certificate? Can you actually find them?
Remember, the actuary will base their investigations on the information provided, so it’s important that such information supplied, usually by the SMSF’s accountant or administrator, is correct. For example, a defined benefit pension that is reversionary to a younger spouse will generally require more capital backing the pension than if it was non-reversionary. Similarly, a pension that has guaranteed increases will generally require more capital than one that is not increased. Further, has the correct long term investment strategy been advised to the actuary? A ‘high growth’ long term investment strategy appears to have a more positive effect on solvency than a ‘conservative’ long term strategy, for the same fund.
Once the pension and SMSF information has been reviewed and confirmed, but there still is a solvency issue, then the following options can be considered.
Retention of 100 per cent ATE
Where the member’s defined benefit pension has a 100 per cent ATE exemption status and their number one priority is to retain this 100 per cent ATE status, then the only option is to rollover the capital backing the defined benefit pension to a retail complying annuity. Advice should be obtained in relation to:
- The specific retail annuity to be selected and the terms. Such advice should be obtained from an appropriately qualified licensed financial advisor;
- The commutable value of the defined benefit pension to ensure compliance with the relevant commutation rules and also to ensure compliance with Centrelink rules;
- Whether the new retail complying annuity will be treated as a 100 per cent ATE pension – this should be sought from Centrelink, prior to the proposed commutation and rollover being implemented.
Of course, there is also the requirement to document the commutation of the pension and rollover of benefits. The solvency issue and the commutation of the defined benefit pension may also lead to the wind up of the SMSF.
Conversion to a Market Linked Pension (loss of 100 per cent ATE status)
Where Centrelink benefits are not a priority for the SMSF member, consideration can be given to commuting the defined benefit pension and using the commuted amount to commence a market linked pension. Whilst a new market linked pension cannot be commenced from 20 September 2007, using a member’s accumulation benefits, it can be commenced as a consequence of the commutation of a previous ‘complying pension’, which includes:
- SIS reg 1.06(2) Lifetime complying pension;
- SIS reg 1.06(7) Life expectancy pension;
- SIS reg 1.06(8) Market linked pension.
As a market linked pension can be provided by an SMSF, the SMSF member has the option to commence the market linked pension in the SMSF or rollover over their benefit and commence a retail market linked pension. Commencing the market linked pension in the SMSF would not necessitate the liquidation of fund assets, which could be an important consideration.
Once again, appropriate advice should be sought from qualified and licensed advisers and actuaries, as well as from Centrelink to ensure that there will be no financial debt resulting from the contemplated commutation of the defined benefit pension.
Just a quick note, certain pensions commenced from 20 September 2004 up to 31 December 2005 may be 50 per cent ATE for Centrelink purposes. There is an option to commute these pensions, commence a market linked pension and retain the 50 per cent ATE status. However, advice should be sought prior to such a pension restructure to ensure the 50 per cent ATE status is retained.
Pension commutations and commencements are both Transfer Balance Account (TBA) events and are reportable by the relevant superannuation fund. All old legacy defined benefit pensions in an SMSF will be ‘capped defined benefit income streams’ as well as pre 1 July 2017 market linked pensions. Where the defined benefit pension is a lifetime complying pension and is fully commuted, effectively a TBA debit will arise equal to the previous TBA credit for the defined benefit pension. For a Life expectancy pension or a pre-1 July 2017 market linked pension, there remains the issue of how the debit is calculated, noting that a Bill proposing a new way to calculate a TBA debit for these pensions has passed the lower house and currently sits in the Senate.
There is also an unresolved TBC issue where a post 30 June 2017 market linked pension is commenced, and the commencement value is more than $1.6m. Consequently, in addition to seeking the above mentioned advice, advice on the TBC consequences should also be sought and considered.
Further information on this issue can be found in my previous blog articles “Proposed 'special debit fix' far cry from original intent” and “Houston, we have a problem. The issue with market-linked pension commutations”.
Is it time for an amnesty?
The major changes to the superannuation law in 2007, known as “Simple Super” or “Better Super” and the recent 2017 Super Reforms simply do not cater for the old legacy pensions, particularly the defined benefit pensions. Given that there are many predications that we are headed for another economic period similar to the GFC, the solvency issues that is may cause, and the unresolved TBC issues that exist, is it time now to allow these old legacy pensions to be restructured as modern day account based pension? Yes, there will be a need to sort some aspects, like the Centrelink consequences, but surely dealing with them now is better than simply playing the waiting game and hoping they’ll just go away.
The Institute of Actuaries have recently made a submission to Treasury outlining the legislative and regulatory issues with these old legacy pensions and calling for a consideration of reforms, including allowing affected pension recipients to restructure their retirement savings into a simpler, modern income stream. You can read their full submission by clicking here. It also noted that the SMSF Association and the Tax Institute have called on the Government to reform these pensions.
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