Options for defined benefit pensions in SMSFs

Doug McBirnie

Several years ago, defined benefit pensions were set up to comply with the rules governing retirement at the time. However, after several significant changes to the law, many SMSFs are looking to scrap these arrangements.Doug McBirnie details the options available to trustees wanting to make this move.

Over the past decade, there has been a progressive undoing of a number of tax and social security incentives previously used by governments to encourage the uptake of long-term income streams over lump sums at retirement.

Retirees were motivated to invest in complying income streams, such as defined benefit pensions, because the financial assets backing these pensions were sheltered from higher tax rates (in the case of the old reasonable benefit limits regulations) or were exempted from the age pension asset test, leading to higher age pension payments.

The ability to start a new defined benefit pension in an SMSF ceased at the end of 2005 and in September 2007 the last of the special treatments for other complying pensions were removed. Existing pensions were grandfathered under the rules in place at the time they commenced.

To be a complying income stream, a pension had to satisfy specific rules, including requiring fixed annual payments, except for indexation, being payable for a person’s lifetime or until their life expectancy. There was also a requirement that the income stream had no capital value on death or at the end of the term.

Despite these defined benefit arrangements requiring SMSF trustees to make guaranteed annual payments to members, there are limited restrictions on the type of assets trustees can invest in to back these pensions. Many trustees invest these assets in shares or other market-linked investments.

Both the Australian Taxation Office (ATO) and Centrelink therefore require an actuarial assessment each year of the SMSF’s ability to meet its defined benefit obligations, notwithstanding the movements in underlying asset markets. The consequences of failing to meet these solvency requirements can be severe, particularly where a retiree has been receiving the age pension.

From a Centrelink and Department of Veterans’ Affairs (DVA) perspective, complying defined benefit pensions are eligible for a 100 per cent asset test exemption (ATE) if they were commenced prior to 20 September 2004 or a 50 per cent ATE if commenced between 20 September 2004 and 1 January 2006. Note that it was possible to start a complying market-linked pension up to 20 September 2007 and still receive a 50 per cent ATE. The ATE means the value of the assets supporting the income stream are not assessed when applying means testing to determine Centrelink/DVA entitlements. Retaining the ATE is therefore an important consideration for those retirees receiving a part or full age pension.

A condition of retaining the ATE is that an actuarial certificate is obtained each year stating that, in the opinion of the actuary, there is a high probability (that is, greater than 70 per cent) that there are sufficient assets in the fund to be able to pay the required future benefits. Under the Social Security Act 1991, trustees are required to obtain these certificates by 29 December each year.

Note: the Superannuation Industry (Supervision) (SIS) Act requirements the fund must satisfy in respect of these pensions are less onerous and only require that the fund has a reasonable probability (that is, 50 per cent) of meeting its liabilities.

Changing circumstances

SMSFs with complying defined benefit pensions are now generally in the mature phase and we are increasingly seeing incidences of trustees seeking to either restructure or exit their SMSFs for a variety of reasons, including the inability to meet solvency provisions. In these situations, trustees are seeking advice on what options are available for dealing with this as well as the implications, particularly in relation to Centrelink benefits.

Since commencing a complying defined benefit pension in an SMSF, circumstances may have changed and trustees may find:

  • the value of the fund’s assets may have fallen to the point where they can no longer support the income guarantees (as per actuarial certification), or
  • they may no longer need the ATE, or
  • a life expectancy pension may be approaching the end of its term, or
  • they may no longer wish to operate a defined benefit pension or even the SMSF itself (for a variety of reasons, including age or incapacity of the trustee).

Importantly, complying defined benefit income streams are non-commutable except to roll over to another complying income stream (or in truly exceptional circumstances such as a divorce settlement payment).

Commuting part or all of a complying defined benefit pensions to a lump sum is therefore not an option as this is not allowed through the relevant legislation. Indeed, making a lump sum commutation could be disastrous in terms of the tax and Centrelink/ DVA consequences for the fund. Earnings within the fund would become taxable income to the SMSF and the fund might be deemed to be non-complying. The ATE would no longer apply and Centrelink/DVA benefits paid in previous years might be clawed back.

Options for exiting a defined benefit pension

So what are the main options available to trustees who find themselves in one of the above situations?

Option 1: Retaining the ATE.

If retaining the ATE is the key priority, the trustee could roll out of their defined benefit pension to purchase a complying annuity generally offered by a life insurance company. The assets supporting the pension are transferred out of the SMSF to the annuity provider in return for a guaranteed income stream. As the ATE is retained, this option will not have a significant impact on the trustee’s age pension entitlements.

A complying annuity provides a guaranteed income stream for a person’s lifetime or a fixed term and is held in the individual’s name outside the SMSF. To meet the requirements of being a complying pension, the annuity must be non-commutable. However, a benefit may be available on the death of the member (generally equal to the value of the remaining payments). This may also be an option for those older members in the pension phase who no longer want or are able to deal with the administrative complexity of running an SMSF.

Case study 1: Jim and Vera

Jim and Vera commenced a complying lifetime defined benefit pension in May 2003 using the $300,000 balance in their SMSF, when both were aged 65. A key reason for setting up this income stream was to maximise their Centrelink entitlements, given their defined benefit pension was 100 per cent ATE.

In January 2014, Jim passed away (and the pension reverted to Vera retaining the full 100 per cent ATE). Vera, now aged 76 and in good health, is having difficulty managing her SMSF as this was something she had always left to her husband, a retired accountant.

In order to retain the ATE, Vera commutes the value of her SMSF defined benefit pension, which is now worth $200,000, and rolls over the proceeds to purchase a complying lifetime annuity. Vera’s age pension payments are largely unaffected and she receives a guaranteed income stream from the annuity provider.

Option 2: Forgoing the ATE but continuing an SMSF.

This involves converting the complying defined benefit pension to a different type of complying income stream called a market-linked pension. This option may suit those pensioners who want to keep their SMSF intact and are either facing adequacy issues (that is, insufficient funds to meet prudential requirements for their defined pension) or find the cost of maintaining the ATE defined pension (via extra tax and actuarial reports) exceeds the benefit of the extra Centrelink benefits received.

Always consult closely with Centrelink/DVA before making changes to ATE income streams. There are heavy penalties for getting it wrong. The waiver-of-debt provision that became effective in August 2011 requires that the whole account balance of the 100 per cent ATE income stream be converted to a market-linked pension in order to avoid Centrelink clawing back previously paid age pension benefits.

The assets supporting the new pension will be fully asset tested and may result in a reduction in the trustee’s age pension entitlement. Centrelink/DVA will raise a nominal debt as a result of this commutation, but will waive it provided the new pension satisfies all the requirements of section 9BA (market-linked income streams) of the Social Security Act. Different rules apply to 50 per cent ATE defined pensions; the new market-linked pension might retain the 50 per cent ATE provided certain conditions are met.

Case study 2:  Barry and Joan

In July 2002, Barry and Joan commenced a complying life expectancy pension using $320,000 in their SMSF when they both retired from running their family business at age 70. At the time of commencement, their income stream qualified for a 100 per cent ATE. Recent poor performance of the underlying assets in their SMSF resulted in them being told their income stream does not meet the high probability requirements that would enable them to receive an actuarial certificate and thus retain their ATE.

Barry and Joan elect to convert their complying life expectancy pension to a market-linked pension within their SMSF. On conversion to the market-linked pension, they will lose their ATE, however, because they have moved the entire balance (now worth $112,000) into a market-linked pension, they will be able to take advantage of the waiver of debt provisions and not have previous Centrelink benefits paid to them clawed back. Their age pension may be reduced going forward, but Centrelink will not ask them to repay any benefits they have already received.


In many cases the circumstances of clients who have defined benefit complying income streams in their SMSFs have changed significantly since these were commenced. The annual actuarial certification process for these income streams provides a yearly catalyst for an assessment on the ongoing appropriateness of these for clients going forward.

When deciding whether to make any changes to a defined benefit pension, it is important to consider:

  • the impact on age pension entitlements,
  • the ongoing compliance costs of maintaining the pension,
  • the desire of the trustees to continue running their SMSF,
  • estate planning considerations, and
  • obtaining tax and financial advice from a qualified adviser.

A market-linked pension (sometimes known as a term-allocated pension or TAP) is a complying account-based pension that is payable for a fixed term. The term is chosen when the pension is started and cannot be varied except by commuting and starting a new pension. The term must be within limits based on the life expectancy of the primary pensioner or the life expectancy of a reversionary pensioner.

The nominal pension payable each financial year is determined by dividing the account balance at the start of that year by a payment factor set out in the SIS Regulations. The actual pension amount each year can be up to 10 per cent higher or lower than that nominal value. Importantly, it must also satisfy minimum pension standards. That is, the annual pension payments must be at least as much as would be paid from an account-based pension with the same account balance. (This requirement may impose an additional limit on the longest term that can be chosen.)

The Centrelink waiver-of-debt provisions came into effect on 15 August 2011 and enabled SMSF trustees to restructure their complying income streams in certain circumstances without triggering a requirement to repay benefits received (debts) to Centrelink. Prior to this provision, where a complying pension lost its ATE, Centrelink would treat the pension as though it had never had an ATE. It would then reassess all age pension benefits paid to the individual over the previous five years and claw back any overpaid benefits. This often resulted in significant debts levied on pensioners.

The waiver-of-debt provisions generally target only the defined pensions started before 20 September 2004, although there are provisions that also cover the 50 per cent ATE defined pensions. Very few defined pensions were started on or after 20 September 2004 because they were entitled to only 50 per cent ATE, which could instead be obtained from the more user-friendly market-linked pensions. The general rule regarding commutation is that an ATE pension can be commuted only to another complying pension that satisfies the same rules as applied at the time the original pension started. An ATE defined pension that started before 20 September 2004 cannot be commuted to a market-linked pension – but for the waiver-of-debt – because there were no market-linked pensions before 20 September 2004.

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