Unfinished business with legacy pensions
Will 2023 will be the year that resolves the unfinished business with legacy pensions?
The proposal to allow individuals to exit legacy pensions, together with associated reserves, was announced back on 11 May 2021 in the 2021–22 federal budget, however it remains in limbo as it did not feature in the new government’s 2022–23 federal budget in October 2022.
Why is it important for this two-year amnesty provision to be reconsidered by government? Legacy pensions are complex. These pensions are not easily maintained within the current retirement framework primarily designed for account-based type income streams with complex rules for how the pensions are treated under the transfer balance cap, and how to access the remaining capital on death whilst minimising potentially significant tax implications.
Until such a time as members may have the opportunity to exit their legacy pensions, SMSF members need to be aware of what happens when the pension comes to an end, including when the pension recipient dies.
What is a legacy pension?
Legacy pensions refer to certain types of pensions that have not been able to be commenced by an SMSF member since 31 December 2005. Consequently, as time marches on they are becoming fewer in numbers, but are still out there, requiring attention and consideration of the options available to deal with them, particularly prior to the death of a member.
Legacy pensions fall into two categories:
- Defined benefit pensions
- Market-linked pensions
Defined benefit (DB) pensions
DB pensions are a type of legacy pension where a member exchanged a purchase price for a series of regular payments from their SMSF. The main features that distinguish defined benefit pensions from account-based pensions are:
- Pension payments pre-defined and must be paid every year
- The pension payments are not linked to investment performance of the underlying assets
- Other than the promised pension payments, the pensioner has no rights to the assets supporting the defined benefit pension
- Not all assets supporting the defined benefit pension earn tax free income
Existing defined benefit pensions can be categorised as follows:
Complying defined benefit pensions
- Complying lifetime
- Complying life-expectancy (fixed term)
Commutable defined benefit pensions (Flexi pensions)
- Commutable lifetime
- Commutable life-expectancy (fixed term)
Assets supporting a complying defined benefit pension may be exempt from the Centrelink Assets Test for the purposes of Social Security:
- 100% Assets Test exempt if started on or before 19 September 2004
- 50% Assets Test exempt if started 20 September 2004 to 31 December 2005
Defined benefit pensions are subjected to an annual solvency test performed by an actuary.
Market linked pensions (MLP)
MLP are a type of complying income stream, however, like with DB legacy pensions, an SMSF member has not been able to commence a MLP since 31 December 2005. An exception to this rule is where the MLP is commenced with the capital from a complying DB pension or MLP. This exception is very helpful with the restructuring options available to SMSF members with a legacy pension, as we’ll see later in this article.
The name ‘market linked’ refers to the way in which the pension interest is linked to the market value of the assets at any date. Market linked pensions are therefore also a type of account-based pension. These pensions are also referred to as ‘term allocated pensions’ or ‘TAPs’ because the pensioner selects a fixed term at commencement over which the income stream payments are paid.
What are the issues with a legacy pension?
The main issue is that an individual with a legacy pension cannot withdraw the pension capital out of the superannuation system or stop the pension and transfer the remaining capital back to their accumulation account. Why is this a problem? A couple of reasons:
- The pensioner only has access to the amount of pension paid each financial year, that is, they can’t ask for more, nor can they take additional lump sums; and
- If their death is pending and they have no dependents (as defined for tax purposes), they cannot withdraw their benefits out of the superannuation system, avoiding tax being imposed on the amount paid to a non-tax dependent. For a retired SMSF member with superannuation benefits held in accumulation or an account-based pensions, they could be withdrawn prior to death and then passed onto dependents, generally tax-free.
However, there’s another even bigger issue that applies to a DB legacy pension.
When a member with a DB legacy pension dies, the remaining capital supporting that pension is generally retained by the fund in a reserve. It does not form part of the deceased member’s benefits that can be paid out to their estate or dependents. If the DB legacy pension was set up as reversionary it can continue, but the issues will still arise on the death of the reversionary beneficiary.
Contribution caps restrict the amount that can be allocated from a reserve to other SMSF members without such an allocation be subject to tax. Further, there can be little to no estate planning strategies that can be implemented for these types of pensions as generally, any remaining pension capital does not belong to the deceased member. This can be an unpleasant surprise for family members, particularly those who were expecting (or relying on) an amount as a beneficiary of the deceased.
This is not such an issue for an SMSF member with an MLP. Firstly, the rules for a MLP are designed to ensure there is no pension capital remaining at the end of the term. Secondly, any capital at the time of a member’s death, prior to the term coming to an end (non-reversionary), can be paid out as superannuation death benefit.
My client has a SMSF DB legacy pension, what are the options?
As noted, generally, when an SMSF member with a DB legacy pension dies and it was not reversionary, any remaining capital that was supporting that DB legacy pension will remain in an unallocated reserve and cannot be paid to the deceased member’s dependents or their estate. (Note: where the DB legacy pension is a life expectancy pension there may be an option for some of the remaining capital to be paid to the deceased member’s estate or dependents).
An option, permitted by the law today, that can be considered by an SMSF member with a DB legacy pension is to effectively restructure the pension to an MLP. Whilst the capital supporting the MLP cannot be withdrawn prior to the end of its term or prior to the member’s death, any remaining capital at the time of death will be able to be paid out as a superannuation death benefit and not be retained by the fund in an unallocated reserve. It also allows for the member to implement estate planning strategies to deal with any remaining capital when they die.
Example: restructuring SMSF DB legacy pension
Alice is aged 79 and is a member of her SMSF. She is being paid a non-reversionary lifetime complying pension (LCP) of $90,500 per annum. At 30 June 2022 the capital backing Alice’s LCP is $1.3m and the actuary provided the following:
Best estimate valuation $920,000
High probability valuation $1,190,000
The best estimate valuation is required under the superannuation law. The capital backing the DB pension must be at least this amount to provide a 50% confidence level that the capital will be sufficient to pay the income stream to the pensioner for life. The high probability valuation is for Centrelink purposes where the LCP is an asset test exemption pension, this is the capital required to have 70% confidence the income stream could be paid for life. In this example, an additional $270,000 pension liability is required to provide the higher 70% confidence level.
In the event of Alice’s death any remaining capital which was held to support her pension liability would form part of an unallocated reserve in the SMSF and would not be available to pay a superannuation death benefit. In this example, if Alice had passed away on 1 July 2022 the whole $1.3 million of capital backing her LCP would form an unallocated reserve and there would be no death benefit to pay to Alice’s estate or dependents.
Allocations from an unallocated reserve to other SMSF members generally count towards their respective concessional cap. Further, such allocations would be subject to the preservation rules, meaning the member cannot access the amount allocated unless they have satisfied a condition of release.
However, Alice could decide to fully commute her LCP and use all the capital to commence a new MLP within the SMSF. There is no legislative prohibition on commencing a new MLP in an SMSF, provided the capital used to commence the new MLP is a result of the commutation of a ‘complying pension’, which includes 30/6/ the three previously mentioned legacy pensions. Importantly, the SMSF’s trust deed must permit the SMSF to pay a MLP to a member.
Alice will be required to set the terms of her MLP, including the period that the MLP will run, which would be a minimum of 12 years (based on her age and life expectancy) and a maximum of 21 years, being out to Alice’s 100th birthday. Where Alice wanted to maximise her annual pension payment, she could set the term to the shortest period, being 12 years providing a pension payment range in 2022–23 of $60,560 to $148,030. Using the maximum term of 21 years, she would have a first-year range of $39,800 to $97,280.
Alice could have used the lower best estimate or high probability valuation as the conversion amount; however, these would have left an amount in an unallocated reserve.
The main advantage of the conversion of Alice’s LCP to a MLP is that upon her death, the value of the MLP can be paid out of the SMSF as a superannuation death benefit, no amount will be caught in an unallocated reserve.
A similar approach could be applied where Alice had a life expectancy pension, however, there are commutation restriction rules that apply to this type of pension which is likely to result in a portion of the DB pension capital not being converted to the MLP and being held in an unallocated reserve.
A further advantage of restructuring to an MLP is that as it commenced on or after 1 July 2017, it is not a ‘capped defined benefit income stream’ (CDBIS). A CDBIS is subject to the ‘defined benefit income cap’, currently $106,250, which requires 50% of the pension amount in excess of this cap to be included in individual’s tax return as assessable income. Where Alice selected the minimum MLP term of 12 years and was paid the maximum pension amount of $148,030, none of the amount paid would be treated as assessable income as she is at least age 60 and the MLP is not a CDBIS. (Note an MLP that commences prior to 1 July 2017 is a CDBIS and the annual payment is subject to the defined benefit income cap. Consequently, a person with a pre-1 July 2017 MLP may consider restructuring to a post 30 June 2017 MLP as the new MLP will not be a CDBIS).
What about the transfer balance cap consequences?
A commutation of a DB pension and the commencement of a MLP are both transfer balance cap events that will give rise to transfer balance account (TBA) debits and credits. A technical issue that arose for many DB pension restructurings was that it resulted in the member having an excess TBA amount, which could not be reduced with the only pension they had was an MLP as the latter could not be commuted.
However, a legislative instrument was issued, with effect from 5 April 2022, that provides an exception to the non-commutability of an MLP. The legislative instrument will effectively allow the member to commute the MLP to the extent of the excess amount notified in a commutation authority issued by the ATO. The commuted amount can be paid out of the fund as a lump sum benefit or retained in the member’s accumulation interest. Depending on their TBC space, it could also be used to commence a new retirement phase account-based pension (ABP).
Do any of your clients have an SMSF legacy pension? Time to review!
SMSF members with DB legacy pensions should be reviewed and the options considered. This article has touched on some key issues, but each scenario is different (including potential Centrelink implications which we have not touched on here), and it would be prudent for professionals to encourage affected members to seek advice to be informed of the options to restructure under current law and the implications for their personal circumstances.
They key message is don’t just wait for the two-year exit measure that was proposed by the previous government to become law, it may simply be too late to help your clients! There may be options available to your SMSF members now which could assist in minimising issues down the track. Reaching out to your actuary is a great starting point to help you understand the options for your clients.
Melanie Dunn, principal and senior actuary, Accurium