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The defined benefit pension problem

Transfer balance cap and transfer balance account issues have arisen due to the ATO’s treatment of commutations involving defined benefit income streams, writes Melanie Dunn.

The ATO’s interpretation of defined benefit (DB) income stream commutations means legacy pensions may be double counted for transfer balance cap (TBC) purposes.

When an SMSF member partially or fully commutes an income stream, they are required to calculate and report the debit value that will apply to their transfer balance account (TBA). The purpose of this debit value is to increase the member’s remaining TBC by the value of the income stream that has been transferred out of retirement phase.

This becomes important where a member wants to restructure an income stream or transfer it to another provider. For example, an SMSF trustee might commute an existing account-based pension at 1 July and recommence a new income stream in order to move contributions made in the previous year into retirement phase while maintaining only one pension interest instead of two.

Another reason for commutations in an SMSF is where a member is restructuring their legacy pensions, including lifetime, life-expectancy and market-linked income streams. These are non-commutable income streams, meaning that, upon commutation, the balances cannot be left in accumulation phase and must be used to commence another complying income stream. This is generally in the form of a new market-linked income stream in the SMSF or a complying annuity with a life company. Where the pension commenced prior to 1 July 2018, it will be a capped DB income stream for the purposes of the TBC.

The debit a member of an SMSF receives against their TBA upon commutation for capped DB income streams is defined in section 294.145 of the Income Tax Assessment Act (ITAA) 1994. For a lifetime income stream, it is the original transfer balance credit that arose at 1 July 2017 less debits that have occurred since that time (apart from payment splits). For a market-linked or life-expectancy income stream, the debit value is the special value of the income stream at the time of commutation.

Issue with commutation debit value for market-linked or life-expectancy income streams

The ATO has confirmed with Accurium its interpretation of the legislation defining the special value of capped DB income streams means in certain cases the TBA debit on commutation will be $0.

This issue impacts on market-linked and life-expectancy income streams on full commutation and is caused by the requirement to recalculate the special value at the commutation date. The special value at commutation is the annual entitlement multiplied by the term remaining rounded up at that time.

To work out the annual entitlement, section 294.135 of the ITAA provides a method to annualise the “first superannuation income stream benefit you are entitled to receive from the income stream just after that time”.

You might think this means we look at the next income stream payment the trustee would have paid:

  • for a market-linked income stream the first payment in the next year, because the trustee needs to make a full annual payment prior to commutation, and
  • for a life-expectancy income stream it would be the next payment due.

However, we understand the ATO’s interpretation is that because the income stream will be commuted in full, the member has no entitlement to any future income stream benefit and so the annual entitlement is $0. Consequently the special value on commutation is also $0.

Why this is a problem

A special value of $0 effectively means the member will have their income stream double counted under the TBC when the member is restructuring these legacy income streams. The member does not receive a debit value equal to the ‘value’ of the income stream; instead there is a $0 debit value. This means the member’s TBA is not reduced in line with the value of the income stream that has been transferred out of retirement phase. However, when the member recommences a new income stream or annuity, this will raise a credit against their TBA equal to the market value of the assets supporting the new income stream (the purchase price).

The tax office has indicated that a fix to this issue requires a change in the legislation by Treasury.

The regulator’s interpretation means that, to avoid this double-counting issue, some retirees will not be able to restructure their legacy income streams to adjust terms such as reversionary beneficiaries or term of payment. It could also prevent them moving their income streams to a new provider or winding up the SMSF. If the income stream has a market value that would cause a member’s TBA to exceed their TBC if it was restructured, then the member’s hands are tied. Implementing the restructure would mean raising an excess transfer balance because the new income stream would not be a capped DB income stream.

We encourage professionals dealing with trustees who have market-linked or life-expectancy income streams to talk to the ATO about the implications for the member’s TBA prior to making decisions about these income streams and obtaining a private binding ruling where appropriate.

"The ATO has confirmed with Accurium its interpretation of the legislation defining the special value of capped DB income streams means in certain cases the TBA debit on commutation will be $0."

Melanie Dunn

Example: commuting a market-linked income stream

John is 75 and the sole member of his SMSF. His only interest in the fund is a market-linked pension with a balance at 20 June 2018 of $570,000.

His market-linked income stream had a remaining term of eight years and two months at 1 July 2017 and his annual pension payment for 2017/18 was $70,000. The special value of John’s income stream at 1 July 2017 will be 9 x 70,000 = $630,000.

He also has a non-commutable public sector DB pension and has received a statement from the fund identifying that this pension had a special value at 1 July 2017 of $770,000.

His total TBA at 1 July 2017 for both pensions was $1.4 million, meaning he has a remaining TBC of $200,000.

He is finding it more difficult to manage his SMSF and is looking to wind it up. Market-linked pensions are non-commutable except to commence a new complying income stream so the only option available is to transfer his income stream to a retail provider. The TBA credit on commencing the new income stream will be the value of the assets used to commence the pension at that date, that is, the rollover from John’s SMSF of $570,000.

Unfortunately, under the ATO’s interpretation, there would be no debit against his TBA when his market-linked pension is commuted because the special value calculated at the date of commutation is deemed to be zero. Rolling over his market-linked pension to a new provider would therefore result in an increase in his TBA of around $570,000, giving him an excess transfer balance of $370,000. The new income stream is not a capped DB income stream and the credit applied to John’s TBA is the purchase price of the income stream, not a special value.

As the market-linked pension is non-commutable, John would not be able to make a commutation to bring his balance under the cap and would have to pay penalties on this excess for the remainder of the term of his pension. He has the unenviable choice of either continuing to run his SMSF until the value of his market-linked income stream is below $200,000, despite the difficulties, or paying penalties on any new income stream he starts.

"A special value of $0 effectively means the member will have their income stream double counted under the TBC when the member is restructuring these legacy income streams."

Melanie Dunn

Example: expiring life-expectancy income streams

Max, 80, and his 78-year-old wife, Maureen, are members of the Pot of Gold SMSF. Maureen is being paid a 50 per cent asset test exempt (ATE) market-linked income stream with a balance of $210,000 and a term of seven years and three months remaining at 1 July 2017. Max is being paid an annual payment of $97,000 from a life-expectancy complying DB pension and also had an account-based income stream valued at $540,000. The life-expectancy income stream had two years and four months remaining on 1 July 2017 and there was $970,000 in assets supporting that income stream liability. Max’s life-expectancy income stream is 100 per cent ATE for Centrelink purposes. The couple are receiving a part age pension.

The special value of Max’s life-expectancy complying income stream at 1 July 2017 was 3 x 97,000 = $291,000. Max’s total TBA at 1 July 2017 for both pensions was $831,000, meaning he has a remaining TBC of $769,000.

Maureen’s market-linked income stream was valued at 8 x $14,400 = $115,200, meaning she has a remaining TBC of $1,484,800.

There are no adequacy issues with Max’s complying income stream, however, the value of the assets supporting it is significantly higher than is likely to be needed to meet the pension payments up to the end of the term. When the income stream expires, any remaining assets will fall into an unallocated reserve in the fund. Additionally, Max and Maureen are finding it difficult to continue running their fund and want to wind up the SMSF.

Maureen will commute her market-linked income stream, currently valued at around $205,000, to another market-linked income stream with a retail provider that can accept the 50 per cent ATE income stream. Although she will receive a $0 debit against her TBC, this will not impact on her ability to commence a new income stream at this time due to her low TBA. However, it will impact on her ability to receive future death benefits as an income stream.

Maureen’s new market-linked income stream is established as non-reversionary so that upon her death it can be paid as a death benefit pension or lump sum to Max rather than continue as a reversionary market-linked income stream, which could potentially raise a TBC issue for Max, depending on his balances at the time.

Max’s account-based pension will be rolled over to a retail provider and the debit of the current value of the pension of around $510,000 applied against his TBA will be the same as the credit reapplied when the new account-based income stream is commenced. In order to retain the 100 per cent ATE on his income stream, Max wishes to purchase a retail complying annuity with the value of his commuted life-expectancy complying pension. The value of the assets supporting this income stream liability is currently around $950,000.

The commutation value of a life-expectancy pension is limited by the factors set out in schedule 1B of the Superannuation Industry (Supervision) Regulations. However, in this case the value of the assets supporting the income stream is less than the maximum commutation value, meaning the entire value can be commuted.

Unfortunately, under the ATO’s interpretation, there would be no debit against Max’s TBA when this happens. The new income stream is not a capped DB income stream and the credit applied to Max’s TBA is the purchase price of the income stream, not a special value. Rolling the life-expectancy income stream to a retail complying annuity provider would therefore result in an increase in his TBA of around $950,000, giving him an excess transfer balance of $181,000.

Max would not be able to commute his life-expectancy income stream without raising an excess transfer balance. If he does so, he would have to pay penalties on this excess for the remainder of the term of his annuity. He has the unenviable choice of either continuing to run his SMSF despite his desire to wind up the fund, and let the life-expectancy income stream expire, leading to a very large unallocated reserve in the SMSF, or roll over the income stream and pay penalties on the resulting excess transfer balance for the rest of his life.

Conclusion

We understand industry participants are working on submissions to Treasury. If you have clients affected by this, we recommend you discuss it with your professional body.

In the meantime, if you are considering making changes to a complying income stream, or have done so already, we recommend you talk to the ATO as it is aware of this issue.

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