A welcomed announcement out of this year’s budget was the proposed measure to allow those with certain legacy pensions to effectively cease them during a two-year period, which is expected to commence on 1 July 2022. Whilst the measure provides an escape route for those with these pensions which are generally non-commutable, there may be some traps along the way, as well as some being left behind. Let’s consider how this measure may be implemented and what traps could be encountered along the way.
The proposed measure
The Government will allow individuals to exit a specified range of legacy retirement products, together with any associated reserves, for a two-year period. The measure will include market-linked, life-expectancy and lifetime products, but not flexi-pension products or a lifetime product in a large APRA-regulated or public sector defined benefit scheme.
The two-year period will commence on 1 July following the enabling legislation receiving Royal Assent. It is generally accepted that this will most likely mean a start date of the two-year period on 1 July 2022.
SMSF members with an eligible legacy pension should consider the option to effectively convert the pension back to accumulation and further consider whether or not to commence a new, more flexible, account-based pension. Commencement of a new account-based pension will be dependent on the transfer balance cap space available to the SMSF member.
There is a small proportion of SMSFs that have members with legacy pensions, particular those that are defined benefit pensions, that is, lifetime and life expectancy pensions. An SMSF has been unable to commence a new defined benefit pension since 1 January 2006 and consequently many defined benefit pensions have ceased, either due to the member dying or the term of the pension coming to an end.
Based on Accurium actuarial statistics for 2018-19, we estimate that there would be around 1,000 SMSFs that are paying a defined benefit pension.
The more common type of legacy pension, that has been included in the cohort that can be converted, is the market linked pension (also known as a term allocated pension). Whilst an SMSF could not commence a new market linked pension from a member’s accumulation interest since 20 September 2007, a new market linked pension can be commenced, since that date, where it is commenced as a result of a commutation of a ‘complying pension’. A ‘complying pension’ includes a lifetime complying pensions; a life expectancy complying pension and a market linked pension. Consequently, a market linked pension would be expected to be the more common type of legacy pension in an SMSF.
The conversion consequences
Currently, these legacy pension products can only be converted into another like product and limits apply to the allocation of any associated reserves without counting towards an individual’s contribution caps. This measure will permit access to the legacy pension product’s underlying capital, including any reserves, and allow individuals to potentially shift to more contemporary retirement products, for example an account-based pension paid from their SMSF.
Based on the budget papers and factsheet, the consequences of such a conversion would be:
- The commutation of the legacy pension will give rise to a transfer balance account (TBA) debit and will require a Transfer Balance Account Report (TBAR) to be lodged with the ATO.
- For a lifetime complying pension paid from an SMSF, the TBA debit value will generally be equal to the value of the TBA credit that arose in relation to the existing pension on 1 July 2017.
- For a life expectancy or pre 1 July 2017 market linked pension, the TBA debit value will be calculated in accordance with the revised TBA debit formula. For more information refer to the ATO’s website and search using Quick Code (QC) 63523.
- For a market linked pension commenced on or after 1 July 2017, the TBA debit value will be equal to the account balance of the market linked pension at the time of commutation. This is the same treatment as a commutation of an account-based pension.
- The commuted amount will be transferred to the member’s accumulation interest.
- The member can then choose to commence a new retirement phase pension, for example an account-based pension. This will give rise to a TBA credit and require the SMSF to prepare and lodge a TBAR. The value of the credit will be equal to the commencement value of the account-based pension. The member will need to consider their available transfer balance cap space when commencing a new retirement phase pension.
- Any existing social security treatment that applies to the legacy pension will not transition over for those who elect to take advantage of the conversion measure. However, exiting a product will not cause re-assessment of the social security treatment of the legacy pension for the period before conversion.
- An amount, yet to be defined, referred to in the Budget papers as ‘commuted reserves’; will be taxed as an assessable contribution.
- Where the legacy pension was a defined benefit pension, the SMSF trustee will no longer be required to obtain an actuarial solvency certificate in subsequent income years.
- SMSF members will be able to deal with the capital converted from an existing defined benefit legacy pension for estate planning purposes. Generally, any residual capital of a defined benefit pensions after the member dies is not available to be paid as a death benefit to dependants.
The (potential) traps!
The first thing to keep in mind is that effectively exiting an eligible legacy pension under the proposed measure is optional. There is no requirement to take advantage of the measure, however, it is only open for a period of two years, so there is a defined period for affected SMSF members to take into consideration their personal circumstances, get specialist advice and decide.
Let’s consider some of the potential the traps…..
The 20 September 2007 trap
Included in the budget fact sheet for this measure, but not in the budget papers, was the following:
- 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).
- Flexi-pension products offered by any provider, and lifetime products offered by a large APRA-regulated defined benefit schemes or public sector defined benefit schemes, will not be included.”
There have been many of these legacy pensions that have been commuted since 20 September 2007 where the commuted amount has been used to either:
- Commence a new market linked pension within the SMSF – this was generally done to allow the member to retain assets within the SMSF, as a market linked pension is the only type of ‘complying pension’ that can be commenced in an SMSF. Further, a common strategy was to commute a pre 1 July legacy pension and use the commuted amount to commence a new post 30 June 2017 market linked pension, with the new market linked pension not being a ‘capped defined benefit income stream’ and therefore not subject to the ‘defined benefit income cap’; or
- Rollover to a life insurance company to commence a retail complying annuity – this was generally done where retaining the Asset Test Exempt (ATE) status of the pension was a key priority for the SMSF member.
This gives rise to a number of questions:
- Will the cohort of eligible legacy pensions include those commenced on or after 20 September 2007?
- Where an eligible pre 20 September 2007 legacy pension reverts to an eligible beneficiary, e.g. a surviving spouse, on or after 20 September 2007, will the reverted legacy pension be eligible for the two-year conversion option?
- Where an eligible defined benefit legacy pension had been commuted, but due to commutation restrictions there was residual pension capital that defaulted to a general reserve, will there be an opportunity to allocate the reserve to the member without it counting towards the member’s concessional cap, other than the existing exemptions?
- Where an eligible defined benefit legacy pension ceased, either due to the death of the member or the term of the pension coming to an end, will any residual capital that was supporting the defined benefit pension, now sitting in a reserve, be available to be allocated to a member, again, without it counting towards the member’s concessional cap, other than the existing exemptions?
It appears that question 1 has been addressed. It was recently reported by the SMSF Association that they had clarified with Treasury that the measure “will apply to the specified range of legacy pensions commenced prior to 20 September 2007, even if the pension has subsequently been restructured as a Market-linked Income Stream, or if it was a Market-linked income that has been commuted and restarted as a new Market-linked income stream on or after 20 September 2007”.
It would also be logical that where a pre 20 September 2007 legacy pension reverts to an eligible beneficiary after that date, it would be considered a pre 20 September 2007 pension. This would also be in line with the ATO’s view in Taxation Ruling (TR) 2013/5.
In relation to questions 3 and 4, it appears likely that these scenarios would not be included in the two-year conversion period. Consequently, any allocation from these reserves would count towards the member’s concessional contribution cap, unless an exception applied, for example, the less than 5% rule exception.
Commutation restriction trap
For defined benefit pensions, a restriction may apply to the commutation amount. Commutation means (notionally) converting a right to an income stream to a lump sum. Consequently, the SMSF trustee needs to determine an appropriate factor to convert a pension to lump sum. The options for the factors that can be used to convert are:
- Based on an actuarial value of liabilities – this would range between a best estimate or high probability valuation and was the common approach up until the ATO issued their interpretative decision (ATO ID) 2012/84, later replaced with ATO ID 2015/22.
- Based on value of all of the capital supporting the defined benefit pension, that is, the whole defined benefit pension reserve. The ATO appears comfortable with using a commutation factor that uses up all the capital (refer ATO ID 2015/22). Further, where the defined benefit pension was also an Asset Test Exempt (ATE) pension for Centrelink purposes, one requirement of the relevant social security rules is that all of the capital supporting the defined benefit pension must be transferred to the new pension in order to retain the pension’s ATE status.
For a defined benefit pension that is a life expectancy pension, there are additional restrictions on commutation factors in the SIS regulations, being:
- Reg 1.06(7)(i) – “the commuted amount cannot exceed the benefit that was payable immediately before the commutation”; and
- Reg 1.08 – caps the commutation factor to those found in Schedule 1B. These factors are based on age rather than remaining term of the pension.
Any capital, that was supporting the pension, remaining after commutation is left in unallocated (general) reserve.
The budget factsheet states that where a person chooses, they “….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”. Clarification is required as to whether commutation restrictions will be relaxed to allow all of the capital supporting the defined benefit pension to be effectively transferred to the member’s accumulation interest.
Assessable ‘commuted reserve’ trap
An aspect of the proposed legacy pension conversion measure that could be a detraction from taking it up is the income tax consequence of the conversion. The budget papers note that “the commuted reserves will be taxed as an assessable contribution”. Further, the budget factsheet states that “Any commuted reserves………will be taxed as an assessable contribution of the fund (with a 15 per cent tax rate), recognizing the prior concessional tax treated received when the reserve was accumulated and held to pay a pension”.
It will be interesting to read any expanded explanation from Treasury on what ‘prior concessional tax treatment’ such reserves have received to justify an amount being included as assessable income of the fund. Income generated from a reserve, where a reserve is regarded as an amount in excess of the actuarially determine capital needed to support the defined benefit pension, was subject to the same tax rules as other income of the fund – income earned in relation to a reserve representing the amount above the actuarily determined amount of capital required to support the defined benefit pension cannot be claimed as exempt current pension income (ECPI). It seems inconsistent for an amount to be included as assessable income purely as a consequence of the commutation of a pension.
That issue aside, the definition of the ‘commuted reserve’ will be an important factor in the member’s deliberations as it may result in a tax imposition and may be considered akin to an early exit penalty. This could be a significant amount, again, depending on what a ‘commuted reserve’ is defined to be.
Possible definitions for the ‘commuted reserve’ might include:
- Any capital supporting the pension that exceeds some defined commutation value. Possibilities here include:
- Actuarial ‘best estimate’ approach – the ‘commuted reserve’ is equal to the amount above the ‘best estimate’ valuation of pension liabilities;
- Actuarial ‘high probability’ approach – the ‘commuted reserve’ is equal to the amount above the ‘high probability’ valuation of pension liabilities. This is the valuation approach required for Centrelink solvency requirements so the pension retains its asset test exemption status; or
- All the capital supporting the pension. The ATO’s regulatory bulletin on the use of reserves by SMSFs (SMSF RB 2018/1) states that all of the capital supporting a defined benefit pension is considered a reserve for income tax purposes. This would result in the entire amount commuted from the legacy defined benefit pension being included as an assessable contribution in the SMSF’s annual return.
We would not expect the concept of an assessable ‘commuted reserve’ to be an issue for a legacy pension that is a market linked pension as these pensions are based on an account balance and consequently have no associated reserve. However, this does raise the question of the equity and fairness of this measure. That is, why is there a tax cost for conversion for those with defined benefit legacy pensions, but not for those with a market linked pension?
This could also lead to some inconsistencies in how the tax on the ‘commuted reserve’ is applied. For example, let’s consider the following:
- an SMSF member currently has a lifetime complying pension supported by $1.2m of capital. The member currently has no access to the capital supporting the pension except for pension payments in accordance with the pension terms and conditions;
- as part of a review of future retirement income needs and estate planning considerations, the member requests a full commutation of their lifetime complying pension and for the commuted amount to be used to immediately commence a market linked pension in the SMSF (note: in this particular scenario, the relevant TBA debits and credits do not cause the member to exceed their personal transfer balance cap);
- at the time of commutation of the lifetime complying pension, an actuary determined that the ‘best estimate’ valuation of pension liabilities is $900,000, leaving a surplus above this of $300,000. For tax purposes, no ECPI is claimed on income earned on this surplus amount;
- after the two-year period commences for legacy pension conversions, the member elects to fully commute their market linked pension back to accumulation.
Based on current rules and our understanding of the legacy pension conversion measure:
- The ATO will accept that all of the capital supporting the lifetime complying pension can be used to commence the market linked pension, that is, the $900,000 ‘best estimate’ valuation plus the $300,000 surplus;
- The amount commuted in respect of the lifetime complying pension, which for tax purposes is wholly considered a reserve, will not count towards the member’s concessional cap (refer ATO ID 2015/22);
- The commutation of the market linked pension back to accumulation, during the two year legacy pension conversion period, would not be expected to give rise to an assessable ‘commuted reserve’, as there is no reserve associated with a market linked pension.
Now let’s compare that to a slightly alternative scenario……
Rather than commuting the lifetime complying pension and commencing a market linked pension, the SMSF member waits until the commencement of the two-year legacy pension conversion period and elects to fully commute their lifetime complying pension back to accumulation under the measure. At the time the value of the capital supporting the lifetime complying pension is now $1,225,000; the actuary’s ‘best estimate’ valuation is $895,000; leaving a surplus of $330,000.
If the surplus capital in excess of the pension liabilities is treated as a ‘commuted reserve’ under this measure, then the tax treatment would be quite different:
- There will be a transfer balance account (TBA) debit for the commutation of the lifetime complying pension. This would be equal to the TBA credit that arose on 1 July 2017 in relation to lifetime complying pension;
- As the pension commuted under the legacy pension conversion measure was a defined benefit pension it may be deemed to have a ‘commuted reserve’ which would be included as an assessable contribution for the SMSF and subject to 15% tax;
- The amount of the ‘commuted reserve’ is yet to be defined, however, let’s say the draft legislation takes the actuarial ‘best estimate’ view and that it is the amount above the ‘best estimate’ valuation. So, in this scenario the ‘commuted reserve’ would be $330,000, resulting in a potential tax cost of the conversion of $49,500. However, if the draft legislation defined the ‘commuted reserve’ as all of the capital commuted from the legacy pension, this would result in an assessable amount of $1,225,000 and a gross tax impost of $183,750. Taxing all of the capital commuted from the legacy pension would appear to be unreasonable. Further, it could potentially include the commuted amount from a market linked pension; a pension that does not have a reserve or surplus amount.
Given the differences above, it will be interesting to see how the draft legislation defines ‘commuted reserve’ and whether any further clarity is provided on what commutation factors should be used when commuting defined benefit pensions. The interaction of the conversion legislation with the commutation restrictions, particularly for a life expectancy pension will also be important.
To fully understand the tax effect of the conversion measure on a ‘commuted reserve’ assessable amount, we will need to understand whether:
- it can be claimed as exempt current pension income (ECPI);
- the tax on the assessable amount can be offset by fund imputation credits.
In relation to claiming ECPI against the assessable ‘commuted reserve’, our expectation is that it will not be allowed. The budget papers and the factsheet both refer to the ‘commuted reserve’ being treated as an ‘assessable contribution’. Where a fund claims ECPI, either using the segregated or proportionate method, excluded from being claimed as exempt are amounts included in assessable income under Subdivision 295-C ITAA1997. Consequently, where ‘commuted reserve’ is defined under this subdivision as a form of assessable contribution, no part would be able to be claimed as ECPI.
Residual reserves trap
As noted above, there are a number of scenarios where an SMSF could have a general reserve that is a consequence of the cessation of legacy defined benefit pensions that were being paid to members. For example, such a reserve could have arisen where a lifetime complying pension was fully commuted to commence a market linked pension and the commutation amount was restricted to the actuary’s ‘best estimate’ valuation, with the capital above this amount being retained in a general reserve. This is not an uncommon scenario where the commutation occurred prior to the ATO issuing their interpretive decision ATO ID 2012/84, which outlined their acceptance of all the capital supporting the lifetime complying pension being used to commence the market linked pension.
It appears unlikely that the two-year legacy pension conversion measure will incorporate reserves that are not supporting an existing defined benefit pension. Consequently, assuming this is the outcome, SMSF trustees with such reserves will need to deal with them using current rules. However, it would be appreciated if dealing with these reserves under the two-year conversion period were considered during any consultation period.
No decision to exit the legacy defined benefit pension
As noted, it is proposed that the two-year legacy pension conversion measure is a choice, it’s not compulsory. However, it would be not surprising if this two-year window of opportunity was a one off, once in a lifetime (no pun intended) opportunity. Where a member with a legacy pension does not choose to convert it back to accumulation during the conversion period, management of the pension and any residual capital or reserves will be subject to the existing rules. This will require planning and obtaining specialist advice. Where you have clients with legacy pensions, both those eligible for the conversion and those which are not, it would be prudent to obtain specialist advice on the options, implications and consequences of choosing to apply or not apply the conversion measure or advice on how to deal with a legacy pension that is not eligible for the conversion measure.
You can read about defined benefit pension and the current options available from the Accurium website here. We are always happy to assist with technical advice on the options available for legacy pensions.
We expect there will be more to come and say on this topic……..