A standard account-based pension is allowed to offer members the opportunity to take commutations – a lump sum now in exchange for lower income stream payments in the future. But why do we care whether they are partial or full commutations?
There are several key differences between a partial commutation and a full commutation that make distinguishing between the two extremely important.
Firstly, when a pension is fully commuted, the law requires the member to draw at least a prorated minimum payment first. If instead the pension is only partially commuted (that is, a balance remains in the pension account after the commutation), there is no requirement to take this pension payment upfront.
Rather, the requirement for a partial commutation is that the amount left over after the commutation is enough to allow the pensioner to meet the full year’s minimum payment requirements. For example, if the pensioner had already drawn half the year’s minimum payments, the amount remaining after the partial commutation would need to be at least enough to cover the remaining half.
Secondly, if the pension is only partially commuted, the trustee must ensure a full year’s minimum pension is paid even though the balance remaining may be much smaller. If this is not done, the pension will fail the minimum payment requirements.
Depending on the size of the shortfall and whether the fund has used a special rule to overlook small shortfalls in the past, the pension might lose its tax exemption on investment income for the whole year and open itself up to a range of other consequences. This is not required if a pension is fully commuted as the obligations to make payments end with the pension – hence the requirement, described above, to make a prorated minimum payment first.
In fact, this is one of the reasons a full commutation can sometimes be preferred – it can result in a lower amount being withdrawn from superannuation over the full year if the commuted amount will end up back in another pension.
For example: Kris has $1 million in his account-based pension on 1 July 2020. His minimum drawdown for the year is $25,000 (taking into account the half minimums for 2020/21). He decides to roll over to another fund, but has heard partial commutations are the way to go instead of fully commuting his pension. As such, he rolls over just $970,000 on 1 October 2020 (leaving enough to draw down the minimum for 2020/21 with a little left over). The minimum for his new pension in 2020/21 is $18,140. In total, then, Kris will be required to draw $43,140 ($25,000 + $18,140) from his superannuation in 2020/21.
If instead he had fully commuted the pension on 1 October 2020, he would need to withdraw around $6300 from his first pension (to pay it up to date) and then $18,580 from his new one. The combined amount would be close to the original $25,000. The partial commutation in this case effectively meant Kris was withdrawing minimum payments twice from most of his superannuation.
Finally, when a pension is fully commuted, it ends for exempt current pension income (ECPI) purposes as soon as:
- the member makes a valid request to commute, and
- the trustee agrees to do so.
By definition this will be before the payment is made.
This can have some extremely important consequences for ECPI in a fund entirely in pension phase and using the segregated method to claim its exemption. A full commutation will mean the fund stops being entirely in pension phase and has a short period, potentially only days, where the actuarial method applies for determining ECPI. When the commutation involves an in specie transfer, this will occur precisely when the capital gains are realised.
For example, Ted and Tia each have a $1 million account-based pension (with a 70 per cent tax-free component) and Tia has a second account-based pension of $500,000 (with a nil tax-free component). They want to transfer a property out of their fund in specie and it is worth $600,000.
They decide to do so by:
- fully commuting Tia’s second pension after making the required prorated minimum payment first (let’s say this is $25,000), and
- partially commuting Tia’s first pension.
However, fully commuting Tia’s pension means that for a short while the fund has $475,000 in accumulation phase in a fund worth nearly $2.5 million. And it’s at that time the capital gain on disposing of the property is realised.
Hence at least some of the capital gain will be subject to tax.
A partial commutation is entirely different. It does not cause the pension to end and in fact the payment itself is specifically defined as being a superannuation income stream benefit (a pension payment) exclusively for ECPI purposes. If Ted and Tia had treated the in specie transfer of the property as two partial commutations (one from each of Tia’s pensions), the fund would remain segregated throughout the year and the capital gain would be entirely disregarded.
Both partial and full commutations have their place, but it’s important to know the difference and choose the right one.
Meg Heffron is managing director of Heffron.
