What is a defined benefit pension and actuarial requirements | Accurium

What are defined benefit pensions

What is a defined benefit pension?

A defined pension is one where a purchase price was exchanged for a specific defined income stream. The member ceases to have an interest in the assets and the income stream is not linked to the account balance. Once the terms of the defined pension are set up they cannot be changed. For example, a lifetime pension of $10,000 per annum increasing by 2% guaranteed each 1 July with no reversion.

Defined benefit pensions are, as the name suggests, defined and the pension payment requirements do not depend on the account balance. The trustee must pay the specified pension amount as defined under the terms of the pension each financial year.

In an SMSF a defined benefit pension will generally be a Superannuation Industry (Supervision) Regulation (SISR) section 1.06(2) or 1.06(7) income stream. These are known as a lifetime defined benefit pension and a life-expectancy defined benefit pension respectively.

In the May 2004 budget it was announced that funds had to have at least 50 members in order to offer a defined benefit pension i.e. preventing SMSFs from offering this type of pension. After various extensions, this came into effect on1 January 2006.

Actuarial requirements for a defined benefit pension

Defined benefit pensions require an actuary’s statement of adequacy opinion each year. This opinion will state whether, in the actuary’s opinion, there are sufficient assets on an ‘average’ Best Estimate basis (50% probability) backing the defined benefit pension to meet all future liabilities. The actuary will also issue a ‘High Probability’ adequacy opinion for Centrelink purposes. This is a more conservative adequacy level, it determines whether there is a 70% likelihood that there are sufficient monies to meet all future liabilities.

Defined benefit pensions were either 100% asset test exempt for social security purposes or 50% assets test exempt depending upon the date they were commenced. Where a defined benefit pension does not meet the high probability adequacy level, and the member receives Centrelink benefits, the member may be required to commute the defined benefit pension. This will be required if they cannot, in conjunction with the actuary, determine that the defined benefit pension is adequate. Due to the large investment losses experienced during the global financial crisis many defined benefit pensions became inadequate, that is they failed the high probabilityy test of adequacy, and were commuted.

Where a retiree is not receiving Centrelink benefits it is still important that the defined benefit pension meets the Best Estimate solvency level. Falling below this level may cause the pension to breach the SISR requirements, and it may need to be commuted unless the trustees, in conjunction with the actuary, determine that the defined benefit pension is satisfactory.

Options for commutation

There are generally two alternatives for this commutation which are summarised below. This is a very complex area and we explore these in more detail in our article Commuting complying DB Pensions.

A defined benefit pension may be restructured by commuting the existing pension and commencing a new complying pension which is either:

  • a complying retail product, e.g. a life office annuity, which will need to be purchased outside of the SMSF.
  • a market-linked income stream within the SMSF or from a retail provider.

Whether the new complying income stream will continue to be assessed as asset-test exempt under will depend on whether the conditions for the retention of ATE in the Social Security Guide are met. Generally the conditions require that all of the assets supporting the income stream (including the pension reserves) be commuted into the new complying income stream.

Where the complying pension is a life expectancy defined benefit pension there is also a restriction on the commutation value equal to the value of the benefit as defined in SISR 1.06(7)(h)(i) that must be complied with. This may pose problems for life expectancy pensions with large reserves.

The introduction of the Transfer Balance Cap (TBC) on 1 July 2017 created further complications to the commutation of defined benefit pensions where the value of assets supporting the income stream are in excess of $1.6million. A new complying pension is not a capped defined benefit income stream for TBC purposes. Therefore starting a new complying pension will trigger an excess Transfer Balance Account for the member where the assets supporting the new income stream exceed $1.6million. The member however is unable to take any corrective action to reduce the excess because the income stream is non-commutable.  

Conclusion

It is important for professionals to understand if an SMSF they are dealing with is paying a complying pension. Where this is the case the SMSF will have additional actuarial requirements and it will be important to review with the fund trustee the estate planning and TBC implications of paying a complying pension. If the member is looking to commute the income stream remember there are restrictions and social security implications on the commutation of these income streams, and they cannot be commuted to an account-based pension.

Complying pensions are a complex area of superannuation and if you have questions please don’t hesitate to give us a call on 1800 203 123.