Traps in establishing an account-based pension

An “auto reversionary pension” is an account-based pension that continues to the nominated beneficiary and does not cease on the death of the member.

Most often, it seems common for pension documents to be difficult to locate and many clients or their advisers are unaware whether they have elected, as part of the establishment of an account-based pension, for that pension to be made auto reversionary.

Typically, if a client has a domestic partner or spouse, a pension is usually made auto reversionary because there are significant tax benefits if the pension is paid or continues to be paid to the spouse on the death of the member.

Making a death benefit nomination before starting an account-based pension

The bear trap arises in this scenario. Usually around the time when a client establishes an SMSF, they are invited to complete a death benefit nomination. If the client has a spouse or partner, they will usually want their superannuation benefits to pass to that person when they pass away and thereafter to their estate.

Later on, the client will establish an account-based pension as they get closer to retirement. When they complete the pension documents, the pension is usually made auto reversionary, to a spouse or domestic partner.

Subject to the provisions of the deed, there is at present a high degree of uncertainty as to whether a reversionary pension election prevails over the Death Benefit Nomination. The issue has not been tested in the courts and many commentators argue that if a pension is made reversionary, the assets that create the pension are not subject to the Death Benefit Nomination.

While the Death Benefit Nomination and the reversionary pension may both favour the same individual, the risk is that if the spouse predeceases the member or, for example, both the member and his or her spouse pass away together, there is no valid Death Benefit Nomination and whoever gets control of the fund would determine how the death benefit is paid, providing it is paid to a dependant of the deceased member. This is highly problematic where children are in conflict and where one child is appointed as executor of the member’s will.

A greater problem emerges if there is a discrepancy between the beneficiary under a reversionary pension and a beneficiary under a death benefit nomination.

If a member starts an SMSF and completes a death benefit nomination before the fund goes into pension mode, it is most likely they will favour their partner at the time or, if they’re not in a relationship, will direct the super to their estate to be divided among children or other beneficiaries. Later on, when they retire, they may start an account-based pension which could be made auto reversionary and therefore nullify the earlier Death Benefit Nomination with different outcomes, particularly if their Death Benefit Nomination split the super between their current spouse and children from a formal relationship. This division could only be achieved by a Death Benefit Nomination which would be overwritten if the pension is made reversionary at the time the pension is commenced.

Problems with account based pensions commenced after divorce

Because of the uncertainty between a reversionary pension and Death Benefit Nomination, other problems can arise. For example, we have seen people who go through a divorce, usually make a will in favour of their new spouse or partner. The law automatically invalidates a bequest in a will in favour of an earlier spouse where there has been a divorce. Similarly, the superannuation laws exclude an ex-spouse from the definition of “dependants” and therefore ineligible to receive a superannuation benefit. However, there is a loophole in the system. Ex-spouses qualify as being a tax dependant (referred to as a “death benefit dependant”) even though they’re not a superannuation dependant. This means they can receive a pension income stream from a superannuation interest but not a lump sum death benefit.

We have seen people in their 60s who have separated but who started an earlier account-based pension made reversionary to the ex-spouse unbeknown to the client or perhaps the advisor at the time. Years later, the client re-partners and via a new Death Benefit Nomination, even one that is made binding, directs that their super is paid to their new spouse or partner. In these circumstances, it is likely that the pension death benefits would be paid to the former spouse and would trump the provisions of the Binding Death Benefit Nomination, with disastrous results and liability risks to the adviser who wrote the nomination.

We have also seen pension documents made in circumstances where the client was married, subsequently divorced but had not re-partnered, with their earlier account based pension made reversionary to the ex-partner. Subsequently they made a binding Death Benefit Nomination with the intention of directing the super to the estate where the will would distribute the superannuation benefits among the children. Again for the reasons above, such a nomination is likely to fail particularly as most SMSF trust deeds don’t address this discrepancy.

It is most important that before completing a Death Benefit Nomination, you review the terms and conditions of any account based pension if it is existing at the time as well as any change in your relationships. Similarly, you should consider, before starting an account based pension, how this will impact on your Death Benefit Nomination as the two may be in conflict, particularly where there is a change in your family circumstances. If there is an account-based pension that has been made reversionary to a former spouse, it will be necessary to roll that pension back and start a new pension to fix the problem unless the trust deed addresses conflicts of this nature. If you are uncertain about these issues, please do not hesitate to contact us.

Chris Hill, senior lawyer and principal, Hill Legal Lawyers and Consultants