Background – pre-2007
Originally, SMSFs were able to commence paying members “defined benefit pensions”. Basically, a defined benefit pension means a pension where, upon commencement, the member’s benefit was paid as a fixed annual amount as indexed with limited flexibility to commute to another type of pension (typically to a market-linked pension). Invariably, reserves were associated with these pensions.
There were three main types of defined benefit pensions:
- lifetime pensions – i.e. pensions paid under reg 1.06(2) of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (SISR)
- fixed-term pensions – i.e. pensions paid under reg 1.06(7) of the SISR
- flexi-pensions – i.e. pensions paid under reg 1.06(6)
These three types of pension could have had positive implications under the reasonable benefit limit (RBL) regime that existed at the time. Similarly, lifetime and fixed-term pensions could also have had positive implications in respect of social security benefits (e.g. eligibility for the Age Pension etc).
Also, from 20 September 2004, SMSFs could commence paying market-linked pensions. Market-linked pensions differ from defined benefit pensions because they typically do not have reserves. However, market-linked pensions are similar to lifetime and fixed-term pensions due to their limited flexibility to commute (typically to a new market-linked pension with a different term).
Market-linked pensions also could have had positive social security and reasonable benefit limit regime implications.
Background – from 2007 until present
The RBL regime was abolished with effect from mid-2007. This removed the reason for many to want to have defined benefit pensions or market-linked pensions.
However, due to the commutation restrictions, these pensions generally had to be continued. Further, significant money was in reserves. Generally, any allocation from reserves constitutes a concessional contribution subject to limited exceptions, such as the less than 5 per cent allocation rule in reg 291-25.01(4) of the Income Tax Assessment Regulations 1997 (Cth). Effectively, this means a significant tax bill could result if reserves are transferred to a member’s account or paid out as a lump sum.
Naturally, this causes many issues, including potential succession planning issues!
Budget announcements
On 11 May 2021, the federal budget announced that it will “allow individuals to exit a specified range of legacy retirement products, together with any associated reserves, for a two-year period” and that “[t]he allocations and the commuted reserves will be taxed as an assessable contribution”.
On its face, this is great news and presumably many members with legacy pensions will wish to take advantage of this.
Not all pensions covered
The announcement does not cover all pensions. Importantly, flexi-pensions do not appear to be covered.
Our experience has often revealed that when we review the SMSF deed and pension documents, the type of pension in existence is not clear and we need to first seek to establish what type of pension we are advising on. Thus, it is worthwhile ensuring each pension is appropriately documented with supporting evidence.
What if a pension has been ‘reset’?
Over the years, many lifetime, fixed-term and market-linked pensions were “reset” (e.g. with the pension commuted and a new market-linked pension commenced in its place). Indeed, many were reset around mid-2017 due to the introduction of the transfer balance cap regime. This begs the question of whether the announcement also applies to such restructured market-linked pensions. A relevant factsheet from the government states:
Market-linked, life-expectancy and lifetime products which were first commenced prior to 20 September 2007 from any provider, including self-managed superannuation funds (SMSFs). [Emphasis added]
The words “first commenced prior to 20 September 2007” mean it is unclear if “reset” pensions will be eligible. Presumably, the detailed legislation will answer this question.
Loss of existing grandfathering
The budget paper states “[s]ocial security and taxation treatment will not be grandfathered for any new products commenced with commuted funds”. Therefore, extreme care will be needed before taking advantage of this relief. Advisers will also need to ensure they respect their limits on what advice they can provide depending on whether they have an Australian financial services licence.
What if one person has already died?
It is unclear if the relief will apply in respect of any reserves associated with a legacy pension covered by the relief that remain in the fund upon the death a member. Again, presumably the detailed legislation will answer this question.
Who can the reserves be allocated to?
The factsheet states:
Retirees with these products who choose to will be able to completely exit these products by fully commuting the product and transferring the underlying capital, including any reserves, back into a superannuation fund account in the accumulation phase. [Emphasis added]
The factsheet does not specify that the accumulation account needs be in the name of the pensioner. Common sense would suggest that the accumulation account will need to be in the name of the pensioner. However, if there are multiple pensioners (e.g. mum and dad both in receipt of a lifetime pension supported by a single pension reserve in an SMSF), it could be that the legislation will need to have some flexibility in how allocations may occur. Again, presumably the detailed legislation will answer this question.
Limited window of opportunity
The government will only allow individuals to exit for a two-year period. It is anticipated that this period will finalised at the earliest for the period of 1 July 2022 to 30 June 2024.
Given the advanced age of many now receiving market-linked, lifetime and fixed-term pensions, it will probably be important to start alerting relevant clients ASAP so that — if it is appropriate for them — they can act as soon as possible when the legislation is finalised. If a person dies before exiting a market-linked, lifetime and fixed-term pensions, the negative taxation implications can be significant.
Date of effect
Again, the relief will probably only take effect from 1 July 2022. If a pensioner dies before that time, it might be too late for them to take advantage of the relief.
Taxation on commutation
The budget states that “commuted reserves will be taxed as an assessable contribution”. Accordingly, an SMSF with $1 million of reserves exiting a market-linked, lifetime and fixed-term pension, could generate an immediate $150,000 income tax liability as part of accessing the relief.
Will reserves constitute the taxable component?
When reserves are allocated to a member, it is unclear whether these reserves will constitute the taxable or tax-free component. It is entirely possible (dare we say probable) that they will constitute the taxable component. The succession planning implications of an increase in taxable component must therefore be considered.
Social security treatment
If social security benefits are important for a client, there might be merit in retaining the existing pension if it attracts a more concessional treatment under relevant eligibility rules (e.g. for the Age Pension or Commonwealth Seniors Health Card etc) as social security benefits will not be grandfathered for any new products commenced with commuted amounts accessed under the proposed relief.
This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.
Bryce Figot, special counsel (bfigot@dbalawyers.com.au), Daniel Butler, director (dbutler@dbalawyers.com.au), and William Fettes, senior associate (wfettes@dbalawyers.com.au), DBA Lawyers
