Having a defined benefit pension within an SMSF has been problematic for some time, but the introduction of the transfer balance cap means the situation is now even worse, writes Tim Miller.
Do you have SMSF clients who are paying themselves a defined benefit pension from their SMSF? Have you considered an end game for these pensions? If there is one category of SMSF trustees who are caught between a rock and a hard place, particularly with the impending transfer balance cap introduction contained in the superannuation reforms, it would be those trustees paying a defined benefit pension from an SMSF.
While there are many factors why this is the case, there are two that appear to be obvious. Firstly, their very reason for existence has been compromised by significant regulatory change to superannuation, taxation and social security law, and secondly, their diminishing relevance has resulted in an industry that by and large doesn’t fully comprehend their operation and some trustees who can’t remember why they have them. This may be a situation where one was set up and left to a surviving spouse or where the ramifications of having one was never fully explained upon establishment.
It should be noted that a reference to diminishing relevance is specifically a comment targeted at the inability to establish one in over a decade. This means only a small number of SMSFs would be paying a defined benefit pension and by my estimation that would easily be less than 2 per cent, but perhaps even less than 1 per cent.
However, these pensions are of high relevance to those who have one and those who administer or advise on them.
What are we talking about?
Just to be clear, what we are discussing here are pensions that, prior to 20 September 2007, met the definition of Superannuation Industry (Supervision) (SIS) Regulations 1.06(2), (6) and (7), commonly referred to as:
- complying lifetime pensions – 1.06(2),
- non-complying lifetime pensions – 1.06(6), and
- complying life expectancy (fixed term) pensions – 1.06(7).
These pensions, when payable from an SMSF, must have been set up prior to 1 January 2006 and were only applicable to members of an SMSF if they were a member on 11 May 2004 and met other conditions. These conditions are set out in the ATO’s Superannuation Determination “SD 2004/1 Superannuation: can a self managed superannuation fund provide a defined benefit pension?”
Troubled past and trouble ahead
Defined benefit pensions inside SMSFs have always been troubling, but if ever there was a year for great concern, it is 2017. There are only two questions people have to ask themselves about these pensions, but it’s the answers, or non-answers in some instances, that are worrying. They are:
- What happens if I don’t stop my defined benefit pension?
- What happens if I want to stop my defined benefit pension?
- We can explore these questions shortly.
Some will argue clients in receipt of a defined benefit pension have benefited from the tax or social security concessions associated with the pension, so should accept their predicament. You could, however, argue that those who set these pensions up for reasonable benefit limit (RBL) purposes, prior to their abolition, have received little or potentially no benefit as they forewent their access to capital in exchange for a 15 per cent tax rebate on their personal income, however, their fund has paid tax, at 15 per cent, on the reserves supporting the pension in most instances.
By comparison, those who elected to commence allocated pensions (prior to 1 July 2007) over and above their RBL, forewent the 15 per cent rebate on their income drawn from the non-commutable pension, but received the full tax exemption on the income supporting the pension. In addition, they suffered no consequence on implementation of the 2007 superannuation reform, but rather were rewarded with a 100 per cent tax concession inside and out.
The 2007 reform may have been more palatable for defined benefit pension recipients, largely the RBL-driven clients, if the concessional contribution rules hadn’t been so restrictive on allocations from reserves, but more on this below.
Likewise, there is no questioning that the use of these pensions for asset test exemption has provided social security benefits to many clients, but they will come at a cost to many of these same clients as their pension nears the end of its term or the fund goes through another financial market meltdown. If we are to assume that many of these clients didn’t have significant assets in the first place – yes, there were exceptions – and were only using these types of income streams to enhance their modest retirement savings, then the potential ramifications could outweigh the benefits for some.
Of course, the elephant in the room is the introduction of the transfer balance cap, which means for many they have less than six months to make a decision – one that may already have been made for them, but they just don’t know it yet.
What happens if I don’t stop my defined benefit pension?
This question and the next need to be looked at from multiple angles and the scope of this article is not to provide all things to all people, but to highlight the road ahead.
Immediate concern
As stated above, the transfer balance cap is effective from 1 July 2017 and we know for sure that anyone in receipt of a ‘non-commutable’ defined benefit income stream, such as a 1.06(2) lifetime pension or a 1.06(7) life-expectancy (term) pension, knows their pension will count towards their personal transfer balance cap of $1.6 million, either represented as 16 times the annual income for lifetime pensions or an amount that represents the term remaining as a multiple of the annualised income. What is not so clear, at the time of writing, is the final treatment of a 1.06(6) commutable lifetime pension. As pure speculation we could suggest these pensions will be treated no differently to other lifetime pensions and have the factor of 16 applied to them or perhaps they will require a more technically correct calculation to determine their actual lump sum valuation, via the SIS pension factors, and have that amount attributable to the personal transfer balance cap. Watch this space as the Income Tax Regulations will prescribe which other income streams the rules apply to.
So with regard to the immediate concerns, clients will be able to forecast the impact an existing defined benefit pension will have on their personal transfer balance cap and make a decision, based on options available, about what to do.
Future concern
Beyond 1 July, the concern returns to the same concerns that have been faced since 2007, primarily what happens when a client passes away or the term comes to an end?
In some instances, and based on legislative positioning, death seems to be the logical solution, particularly for lifetime pensions. Given its inevitability, the best advice may be no advice. But don’t be deceived by this statement as it doesn’t contemplate death of a primary beneficiary with a reversion. These clients will still be faced with the reversion of the transfer balance cap with what would appear as less opportunity to rectify it if they themselves have a complying lifetime pension. There are additional income tax consequences based on an individual’s defined benefit income cap.
Fixed term pensions introduce a range of additional issues, which on one hand is linked to the introduction of the transfer balance cap, but in a more urgent sense is the term they are based on. Investor confidence began to rise in 2002 after the tech-stock crash and the use of ‘asset test exempt’ pensions became more widespread, often as 15-year term pensions for those at age pension age.
Those same clients, now nearing or in their 80s, will soon be facing unallocated fully taxable reserves, something none of them nor their advisers envisaged 15 or so years ago in a pre-concessional cap world. Similarly, many are confronting the death of a spouse, which is transitioning them from a Centrelink couple to a Centrelink single, so many of the benefits they have received will be reduced or removed sooner rather than later. Fixed term pensions are no doubt more problematic based solely on the lack of supporting evidence about what can be done with them and the consequences of any activity.
What happens if I stop my defined benefit pension?
Stopping a defined benefit pension is not a simple task and also needs to be contemplated in light of the transfer balance cap and concessional contribution tax assessments.Complying lifetime pensions are the easiest to consider as the ATO, via interpretative decision ID 2015/22 and numerous private binding rulings, has identified that so long as the entire amount supporting the pension is used to commence a market-linked pension, there is no concessional contribution tax assessment. This amount is regularly referred to as the reserve, but incorporates the capital value as determined by an actuary, the solvency reserve and any excess reserves.
Therefore, determining whether to commute a lifetime pension could be determined now by performing a simple calculation: income x 16 versus balance supporting the pension. If one is greater than the personal transfer balance cap and the other isn’t, that may provide your solution. Let’s assume anyone contemplating Centrelink isn’t contemplating the transfer balance cap, but we can’t forget the Centrelink ramifications of commuting an asset test exempt pension.
Fixed term pensions and commutable lifetime pensions are more complex as their ‘commutable’ value is factor driven and they don’t have the guarantee provided by the abovementioned ID of concessional contribution cap exclusion. Individually the best option may be to investigate personal circumstances via a private ATO ruling as some have provided the desired relief.
If your clients’ only concerns are the concessional contribution treatment, then once again death may be the only option.
A solution or a pipe dream
One solution I can see, albeit a rather hypothetical and somewhat ideological one, is for SMSFs to be provided with an all-inclusive tax, social security and operating standards amnesty. All we need is an undertaking from the ATO and Centrelink (Department of Veterans’ Affairs) that any breaches or deviations away from the rules around SIS Regulations 1.06(2), (6) or (7), and particularly their associated commutation rules, all done within a certain time frame, will go unpunished.Further, by extension any allocation from a reserve supporting such a pension will also go unpunished and, while we are at it, these actions, which will result in a re-assessment for Centrelink clients, will not result in a debt being raised by the government if it is determined that these clients should not be eligible for or entitled to a reduction in the age pension. Of course, any commutation would incorporate a 100 per cent move to an appropriate account-based pension.
One thing is for sure, amnesty or not, if you have defined benefit pensions within an SMSF, you should be looking at them pretty soon as you only get one crack at the transfer balance cap for existing pensions.
