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How COVID-19 could help the old legacy pension problem

Mar 31, 2020, 09:01 AM

By Mark Ellem


With the significant drop in markets over the last few months and possible continuing downturn, now maybe the time to consider the restructure of old legacy pensions within an SMSF.

Restructuring these types of pensions can solve a number of issues, such as dealing with the death of a member and solvency requirements. But remember, before embarking on any restructure of these types of pensions any applicable Centrelink ramifications must be considered.

The Transfer Balance Cap (TBC) can also be an issue, but again, this may be resolved where values have dropped.

The three common types of old legacy pensions that you’ll find in an SMSF are:

1. 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. It is a defined benefit pension, that is, the benefit (pension amount) is defined, but may be increased, for example by CPI;

2. Life expectancy pensions (also known as a Fixed Term pension) – these pensions are for a fixed term, normally based on the member’s life expectancy at the time of commencement. It’s also a defined benefit pension;

3. Market Linked pension (also known as a Term Allocated pension) – these pensions run for a set term, being generally a range from the life expectancy of the member at the time of commencement up to a when the member turns age 100.

The amount of the annual pension paid to the member is primarily determined by the balance of the pension at the start of the financial year and the remaining term. These pensions are not defined benefit pensions and consequently can be dealt with for estate planning purposes, similarly to an account-based pension.

Defined benefit pensions – the problems
The first two types of old legacy pensions present a number of challenges, including:

• Dealing with any residual capital after the death of the member or the term of the pension has ended. There can be difficulties with paying out any residual capital after the death of a member and potentially significant tax consequences;

• Compliance with the solvency requirements, which can present a problem where markets have had a significant downturn, for example the GFC and the current COVID-19 effect on asset values. Please refer to my separate blog article “Market movement causing potential solvency issues for certain SMSFs” for further discussion on this issue and potential solutions.

The Estate Planning solution – defined benefit pensions
One solution to deal with any residual capital of a defined benefit pension is to restructure the defined benefit pension to a market linked pension prior to the member’s death or if it’s a life expectancy pension, before the end of the term or member’s death, whichever occurs first.

Subject to any trust deed restrictions, this is permitted and is affected by the member requesting a full commutation of their defined benefit pension and the commuted amount to be used to immediately commence a market linked pension.

Sounds straight forward, but there are some issues to consider:

Issue 1 – the commuted amount

This depends on whether the defined benefit pension is either a lifetime complying pension or a life expectancy pension.

For a lifetime complying pension, it is generally accepted that the commuted amount can be a value ranging from an actuarially determined amount up to all of the capital that is backing the lifetime complying pension. Generally, the total capital backing the lifetime complying pension is used as the commuted amount and used to commence the market linked pension as this means there is no residual capital left in a reserve. 

For a life expectancy pension, there are rules in relation to the commuted amount. Unfortunately, there are two sets of commutation rules and it is not totally clear which one applies. Consequently, it would be prudent to engage an actuary to provide advice as to the commuted amount. However, generally there will be an amount left in the reserve, after the full commutation of the life expectancy pension and the calculated commuted amount is used to commence a market linked pension.

Issue 2 – Concessional cap

Capital set aside by a superannuation fund to meet defined benefit pension liabilities is a reserve, for taxation purposes. Consequently, when an amount is paid from the pension reserve, it is an allocation from the reserve and will be assessed against the member’s concessional cap, unless one of the exceptions applies.

Defined benefit pension payments, from a pension reserve, is one of the exceptions. The other exception is where the defined benefit pension is fully commuted, and the commuted amount is used to commence another ‘complying pension’.

Such pensions, from an SMSF perspective, includes a market linked pension. Without going into details, reference should be made to ATO ID 2015/22 in relation to the concessional cap consequences of the commutation of a lifetime complying pension and commencement of a market linked pension.

Issue 3 – Transfer Balance Cap (TBC)

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 are classified as ‘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. In relation to this new ‘special debit value’ calculation, refer to my blog article “Proposed 'special debit fix' far cry from original intent”.

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. The post 30 June 2017 market linked pension is not a CDBIS and consequently the special TBA rule for a CDBIS does not apply.

So, if the TBA balance exceeds the member’s TBC, there will be an excess that the member will be required to commute.

However, whilst the post 30 June 2017 market linked pension is not a CDBIS, it is still a non-commutable pension. Further, without going into detail, the commutable amount for excess TBA purposes, for a non-commutable pension is actually zero.

So, any excess TBA determination issued by the ATO will include an amount to commute of zero, which the SMSF can easily comply with.

This still leaves the member with an excess TBA account. What happens next? Will there be excess TBA notional earnings assessed for which the member has to be tax on? If so, would the tax rate applicable to notional earnings increase from 15% to 30% in year two? Well, we simply don’t know.

This issue has remained unresolved since 1 July 2017 and is the main reason why members with these old legacy pensions, with large capital amounts backing them, have not restructured to a post 30 June 2017 market linked pension – we have no certainty of the personal tax outcome for the member.

This also presents an ongoing estate planning issue for members with these pensions. In short, from an estate planning and tax perspective, if you have a defined benefit pension in an SMSF, the worst thing you can do (for you and your family) is to die!

Drop in market values may resolve TBC problem

With the significant drop in market values across asset classes, particularly shares and property, the numbers may simply work with a restructure of an old lifetime complying pension to a market linked pension.

For a lifetime complying pension, where it is the only retirement phase pension that the member has, the full commutation of the pension will result in the member’s TBA being reduced back to zero. Provided the capital that was backing that lifetime complying pension is no more than $1.6m, which it may be now, (unfortunately) due to the drop in asset values, the unresolved TBC issue for post 30 June 2017 market linked pensions will not arise.

This could also be the case for the restructure of a pre-1 July 2017 market linked pension, which is a CDBIS, to a post 30 June 2017 market linked pension, which is not a CDBIS.

However, as previously noted, we are still awaiting the passage of the revised special debit rule (which has its own problems – again, refer to my blog article “Proposed 'special debit fix' far cry from original intent”), so take care with any potential pension restructure.

Restructure before death (you’ve got that marked in your diary, right?)

As morbid as it sounds, a strategy to have clarity, from a personal tax perspective, for a person’s estate plan, is where they have a defined benefit pension and the capital backing that pension is more than the TBC, restructure to a market linked pension just prior to death. 

Say, a member has a lifetime complying pension and they restructure to a market liked pension, but the commencement value of the market linked pension is greater than the TBC and consequently, they have an excess TBA balance and whilst the ATO is working out how to deal with the excess, the member dies. Under the rules, when a member dies, their TBA is extinguished – problem solved! Of course, the variable, the tricky bit, is knowing when the member will die.

Is it time for an amnesty?

As noted in my blog article on solvency issues for SMSFs with defined benefit pensions, 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 the current economic circumstances and the unresolved TBC issues that exist, is it time now to allow these old legacy pensions to be restructured to a 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’s also noted that the SMSF Association and the Tax Institute have called on the Government to reform these pensions.