For a number of years now, if you came across a client who had an entitlement to a defined benefit pension, you may have thought, “What a lucky client!”. They would have been entitled to a regular income stream, which may even be subject to indexation. And the client didn’t bear the risk of market movements.
And if you had clients who were given the choice of taking a defined benefit pension or a lump sum at retirement, in most cases the answer would have been to take the defined benefit pension because of the certainty it provided during recent times of volatility and lower levels of return.
But with the introduction of the new super rules from 1 July 2017 and the implications under the transfer balance cap assessment, and personal tax treatment, for some clients the use of a defined benefit arrangement may have some adverse, unintended, and arguably unfair, outcomes.
First, let’s look at the impacts under the transfer balance cap. In order to try and provide a level of fairness and equity across both defined benefit arrangements and standard accumulation funds, rules that provide a formula for determining the value of a defined benefit pension have been introduced.
The credit to a member’s transfer balance cap is a factor of the first-year annualised payment or for the year commencing 1 July 2017 for pre-existing defined benefit pensions, multiplied by a factor. For fixed-term pensions, the factor is the term of the pension or term remaining from 1 July 2017 for existing arrangements. For a lifetime pension, the multiplication factor is 16.
It would be very difficult to come up with a calculation methodology that is not only simple but one that does not unduly disadvantage or advantage any particular member or arrangement. To this end, the simplicity of the formula to try and drive some form of equality should be applauded.
Using the remaining term makes logical sense and is certainly easy or easier to explain to clients. But the use of a factor of 16 for lifetime pensions is more difficult. A few years ago, when the life expectancy for a 65-year-old male was just over 16 years, the use of a factor 16 could have been explained – but only if you happened to be a 65-year-old male at the time with only 16 years to live.
If you were lucky enough to be able to commence a lifetime defined benefit income stream today, a factor of 16 may give you a good outcome as you would use the first-year payment amount (before any indexation has kicked in) and you would probably hope to live more than 16 years. If the answer took you above the maximum $1.6 million transfer balance cap, then so be it and it wouldn’t matter how far above. But you may also be in a position that because you are receiving less than $100,000 as income in the first year, you have some of your cap available still.
Compare this to someone who has been in receipt of a defined benefit pension for some years now. Indexation of their benefit could have taken them above a $100,000 annual payment. But more importantly, we could be talking about someone who is, say, in their 80s with less than 16 years expected to live, yet the impact for them is still calculated by reference to a factor of 16.
The inequity of the formula for lifetime pensions is that it takes into account time that has essentially already elapsed, unlike a fixed-term pension which is only forward looking. Of course, taking an approach of different factors for different ages arguably has an outcome that disadvantages, on a comparative basis, those only about to commence a pension now compared to those who had such income streams in place for a number of years. And introducing a range of factors would also add further complexity of what, for many, is already a difficult concept to understand and explain.
The second impact for consideration is how the defined benefit income is to be assessed, particularly where the recipient is over aged 60. There are differences depending on the source of the pension and whether it is coming from a taxed or untaxed source.
Many advisers would be aware that there is differing tax treatment where the defined benefit pension income exceeds $100,000 per year. But what is important to remember is that we are not focused only on what would otherwise be assessable income – any tax-free component returned as part of a pension payment is taken into account and dealt with first.
With most traditional defined benefit pensions, there may not be a tax-free component, as any non-concessional contributions a member has made throughout their working life has often been segregated to a separate, standard accumulation-style account. However, it may be necessary to consider this impact for clients that have market-linked income streams or to use older terminology, term allocated pensions (TAP).
A TAP may have been purchased a number of years ago with non-concessional or undeducted contributions as part of the purchase price. These pensions may have been set up for old reasonable benefit limit management purposes or for preferential treatment for age pension eligibility, of which neither reason exists today. Yet, these monies are locked away in a non-commutable income stream.
If a client was to receive a payment of, say, $200,000 from their TAP and the payment may be high if they are approaching the end of the term of the TAP, and let’s just assume half or $100,000 of the payment represented a tax-free component, it wouldn’t be a surprise that many take the view that this client has no issue as you can ignore the tax-free component and deal with what is left over, which in this case is $100,000 and it’s within the defined benefit income cap.
While understandable, this is wrong. The tax-free component is assessed to the defined benefit cap also and, in fact, takes priority. Therefore, in this example, the $100,000 of tax-free component completely exhausts the defined benefit income cap, meaning the remaining $100,000 taxable component is deemed to be excessive defined benefit income. Under the pre-1 July 2017 tax rules, if the client was over 60, that taxable component was tax free to the recipient, as they would have paid no tax on the taxed element of a super benefit. From 1 July 2017, however, 50 per cent of this excessive amount will now be taxed. The client would be taxed at their marginal rates on $50,000 of income.
While there has been some focus on how the new rules apply to defined benefit pensions from both a transfer balance cap and personal tax perspective, much of this has been concentrated on traditional defined benefit arrangements. But it is important to understand that some other forms of income streams, such as TAPs and complying pensions under the old RBL regime, may still exist and be impacted.
And for clients with SMSFs that run these pensions, the changes need to be understood not only at a personal level for the member, but also how the earnings to support these older-style arrangements are taxed with the fund, given we have defined benefit pensions paid from an accumulation-style super fund.
By Bryan Ashenden, head of financial literacy and advocacy, BT Financial Group