A guide for choosing which pension to commute
Is there a general rule of thumb for determining which account-based pensions should be rolled back into accumulation?
In the lead-up to 30 June 2017, fund members with more than one account-based pension (ABP) and total pension capital greater than $1.6 million will need to make a decision about which ABP to fully or partially commute to avoid an excess transfer balance arising on 1 July 2017.
Accordingly, the question must be asked – Is there any general rule of thumb that can be applied by fund members or advisers in determining which ABPs should be kept on foot and which rolled back into accumulation phase?
We take the view in this article that the following rule of thumb applies. In choosing between one or more pensions to commute and roll back into accumulation phase, the pension with the higher proportion of taxable component should generally be commuted, provided that the anticipated pension payments from all remaining pensions are lower than the fund’s overall growth.
This article only covers ABPs and not other types of pensions such as defined benefit pensions that are subject to special rules under the super reforms.
Fund growth and the proportioning rule
In most cases, different pension accounts will have different taxable and tax-free components. In some cases, these differences can be quite dramatic. For example, where a fund member has made large non-concessional contributions.
Such differences matter due to the way that earnings and growth are added to accumulation interests versus pension interests.
The starting point under the income tax laws is that the taxable component of a superannuation interest is a balancing figure i.e. the taxable component is the total value of the interest, less the tax-free component.
Broadly, this means that to the extent that a fund is in accumulation phase, the relevant proportion of earnings and growth in the fund will be added to the taxable component of the accumulation interest. This means that the taxable component of an accumulation account is always fluctuating based on how the investments supporting the superannuation interest perform over time.
In contrast, for pension interests, effectively earnings and growth will be added to the pension in proportion to the taxable and tax-free components of the pension on its commencement due to the proportioning rule. This is an oversimplification of how the law operates, as the proportioning rule actually operates on a point of time basis e.g. when benefits are cashed or commuted. However, this is the effective outcome of how the law works.
This means that the tax-free component of a pension will be proportionately increased by earnings and growth (assuming that the tax-free component is not zero), provided that pension payments and other outgoings don’t eliminate such growth, whereas the tax-free component of an accumulation interest is unaffected by earnings and growth.
Accordingly, on the assumption that having more tax-free component is always a good thing, fund members might choose pensions that have with the lowest tax-free component when making adjustments to stay within their transfer balance cap, retaining pensions with the highest tax-free component, to ensure that fund earnings and growth will be added proportionately to the tax-free component. Again, this is subject to the anticipated pension payments from all remaining pensions being lower than the fund’s overall growth.
The above commentary is best illustrated with the following example:
John is 62 years old and retired. The trustee of John’s SMSF is paying him two ABPs. He has no accumulation balance. As at 30 June 2017, the account balances of the ABPs will be as follows:
- ABP 1 – $1.6 million comprising 50 per cent tax-free component and 50 per cent taxable component; and
- ABP 2 – $1.6 million comprising 100 per cent taxable component.
John knows he needs to fully commute one of his ABPs, or partially commute both, to avoid an excess transfer balance. John also conservatively expects that due to savvy investment decisions, the fund will grow by 10 per cent overall in FY2018 after outgoings are taken into account.
If John rolls back ABP 1 into accumulation phase, the balance of his accumulation account (i.e. $1.6 million) will grow in FY2018. However, only the taxable component of the accumulation interest will be added to in respect of the fund’s 10 per cent growth.
If John partially commutes both ABPs, a similar outcome will occur, as the proportion of tax-free component in retirement phase will be reduced, and tax-free component of the accumulation interest (i.e. $400,000) will not be added to by earnings and growth.
Accordingly, John should fully commute ABP 2, as the earnings and growth in the fund attributable to ABP 1 will add to the tax-free component of ABP 1 maximising the tax-free component of John’s overall benefits.
Fund members with more than one ABP and pension capital greater than $1.6 million who will be rolling back excess amounts to stay within the transfer balance cap might consider commuting the pensions that have the highest taxable component and retaining the pensions with the highest tax-free component. This will ensure that growth and earnings in the fund can be added to the tax-free component of their benefits. Naturally, this analysis depends on there being overall growth in the fund.
Please note that the above is a general rule of thumb for rolling back ABPs and there may be other relevant reasons for commuting one ABP over another, including succession planning reasons. Expert advice should be obtained if there is any doubt.
William Fettes, senior associate and Bryce Figot, special counsel, DBA Lawyers