Dealing with legacy pensions – do you have time to wait for the 2-year exit measure?

This article was first published in selfmanaged super magazine issue 036

The number of SMSFs with a member being paid an old legacy pensions continues to fall and with the budget announcement of a two period for SMSF members with these old pension to exit, there may not be many, if any, left in five years. However, is the strategy for SMSFs with these pension as simple as waiting for the start of the two year exit period? Given the fact that the life expectancy tables are not that kind for such members, putting aside these SMSF members until the start of two year exit measure to deal with those pensions may turn out to be quite costly. 

What are “legacy pensions”?

 The pensions to focus on are those that will be eligible for the proposed 2-year exit measure, as we understand it:

  • SIS reg 1.06(2) lifetime complying pension
  • SIS reg 1.06(7) lifetime expectancy pension (also known as a fixed term pension)
  • SIS reg 1.06(8) market linked pension (also known as a term allocated pension) 

The first two pensions are defined benefit pensions, whereas a market linked pension is not. 

The issue with legacy pensions

All these pensions cannot be commuted, except in limited circumstances. Also, an SMSF member cannot affect a transfer of the pension capital back to their accumulation account, unlike an account based pension. 

Since 1 July 2007, the bigger issue is dealing with any left over pension capital after the pension has expired, either as a consequence of the pension term ceasing, or the member has died. The contribution caps that applied from 1 July 2007, present a challenge for dealing with these left over reserves. Further, there can be little to no estate planning strategies that can be implemented for these types of pensions as generally, any residual capital does not belong to the deceased member. 

Pension capital left over, after the (non-reversionary) pension term has expired or the member died, is not as big an issue for a market linked pension. Firstly, the rules for a market linked pension 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. 

What happens when an SMSF member with a defined benefit pension dies?

What needs to be at the forefront of mind for SMSF members and their advisors are the adverse estate planning and tax consequences that the death of a member with a defined benefit pension (DBP) has and the importance of considering the options available prior to the member’s death. I continue to get phone calls and emails from advisors that start off with “I have an SMSF client who has died. They had a defined benefit pension; how do we pay out the death benefit?”. How I wish I got that contact prior to the member’s death.

Generally, when a member is receiving a (non-reversionary) lifetime complying pension, then upon their death, the capital supporting the pension will remain in an unallocated reserve and cannot be paid to the deceased member’s dependants or their estate.  

This unallocated reserve belongs to the SMSF and is controlled by the Trustee. The Trustee of the fund could allocate money from the reserve to the other members in the fund but it is important to take note of the taxation treatment of those distributions as outlined in regulation 291-25.01 Income Tax Assessment (1997 Act) Regulations 2021.  

If the member is receiving a complying life-expectancy (fixed term) pension, then on death of the primary beneficiary where the term of the pension was not based on the spouse, the remaining pension payments until the end of the term of the pension or a lump sum equivalent of the remaining pension payments, can be paid to the estate. However, if the term of the pension was set based on the spouse’s life expectancy, the pension must continue to the spouse. The commutation value of a life-expectancy pension into a lump sum is also restricted by regulation 1.08 of the SIS Regulations. This provision imposes a limit on the maximum amount that can be commuted to a lump sum. 

If the capital supporting the life-expectancy pension exceed the amount that can be commuted to a lump sum, then the surplus capital will remain in an unallocated reserve. Again, reference should be made to the previously mentioned income tax regulation for the potential adverse tax consequences of allocations from a reserve. 

Given the low concessional contribution cap, allocating a large amount left over from an expired defined benefit pension could take a number of years, particularly where the objective is to avoid any excess concessional contributions and associated potential tax implications. This can be a disappointing revelation to surviving family members who may have been anticipating receiving a significant amount of capital as a superannuation death benefit payment, either directly from the SMSF or via the deceased member’s estate. 

Waiting for the start of the 2-year legacy pension measure to act could see this situation arise – an amount of capital retained inside of superannuation with restrictions to access and/or significant tax consequences applying to enable immediate withdrawal from superannuation. 

Dealing with a DB pension before the member’s death 

To remove the risk of potential estate and tax consequences where the member with a DB pension dies prior to being able to exit it under the 2-year budget measure, consideration should be given to restructuring the DB pension to a pension for which any capital remaining upon the member’s death can be dealt with, similar to a market linked or account based pension, that is, paid to a dependent or estate. 

The restructure of a DB pension requires it to be commuted. There are limited instances when a member can commute a complying defined benefit pension and one such occasion is when the proceeds are used to commence another complying income stream. There are only two types of complying income streams now available to members wishing to commute their complying defined benefit pensions. The two complying income streams are: 

  1. Complying market linked pensions
  2. Retail complying annuities

Where the relevant member wishes to retain capital inside the SMSF, which could be due to the type of assets held by the SMSF, a restructure to a market linked pension will be the only option. 

Example – restructuring a lifetime complying pension to a market linked pension 

Rosie, aged 75 has a non-reversionary lifetime complying pension (LCP) in her SMSF. The pension commenced on 1 October 2003 with an annual pension amount of $20,000, which is not indexed. 

At 30 June 2021 the capital backing Rosie’s LCP was $498,000. The actuarial review of the pension showed:

Rosie’s LCPBest estimate valuation – SIS purposesHigh probability valuation – SSA purposes
Capital supporting DB pension$498,000$498,000
DB pension liability$210,000$272,000

The higher probability valuation is for Centrelink purposes where the LCP is an asset test exemption pension. The additional $62,000 pension liability is required to provide the higher 70% confidence level.  

If Rosie was to die, for example prior to any 2-year exit measure commencing, the capital supporting her LCP, say it was still $498,000, could not be used to pay a superannuation death benefit. It would form part of an unallocated reserve within the SMSF. This can pose a challenge to distribute the amount to Rosie’s beneficiaries, particularly if there are no other members of the SMSF. 

However, Rosie could decide to fully commute her LCP and use all the capital to commence a new market linked pension (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 ‘complying pension’, which included the three previously mentioned legacy pensions. Importantly, the SMSF’s trust deed must permit the SMSF to pay a MLP to a member. 

Based on the ATO’s interpretive decision (ID) 2015/22, Rosie can use the value of the capital backing the LCP to commence the new MLP. Rosie will be required to set the terms of the MLP, including the term, which could be out to Rosie’s 100th birthday. Note, Rosie could have used the best estimate or high probability valuation as the conversion amount, however, these would have left an amount in an unallocated fund reserve. 

The main advantage of the conversion of Rosie’s LCP to a MLP is that upon her death, where it occurred prior her being able to exit the LCP under the 2-year exit measure, 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 Rosie had a life expectancy pension, however, as noted, the commutation restriction rules that apply to this type of pension 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.

The transfer balance cap issue 

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. One of the main reasons pre 1 July 2017 legacy DB pensions have not been restructured to a MLP is that the member ends up with an excess TBA, that cannot be rectified. The Federal Government announced as part of its December 2020 Mid-Year Economic and Fiscal Outlook (MYEFO) that it would amend the law to ensure that in such a scenario an affected member would be able to undertake the necessary partial commutation. Like the 2-year proposed exit measure, we are yet to see any draft legislation for this measure. 

However, given that section 294-45 ITAA 1997 states that an individual’s TBA ceases upon death, it effectively removes the issue of an excess TBA balance where it is known that a member is soon to, unfortunately, die. Harsh as this may sound, it does mean that capital can be paid out as a superannuation death benefit, rather than being retained in an unallocated reserve.

Centrelink considerations

There will also be Centrelink considerations for any conversion of an asset test exempt pension, both under the rules that apply today and any future 2-year exit measure. 

Why not just wait for the 2-year exit measure to commence? 

Based on our understanding of the 2-year legacy pension exit measure, referring back to the example of Rosie, she would still be entitled to apply the measure. The conversion of her LCP to a MLP would not take a way her opportunity to use the exit measure. However, it does remove the issue of dealing with an unallocated reserve in the situation where she dies prior to being able to use the exit measure. Further, depending on the draft legislation, the conversion from the LCP to the MLP is likely to have removed the assessable ‘commuted reserve’, but this will depend on how this term is defined. 

This would not be expected to be the case where Rosie had a life expectancy pension where a conversion to a MLP resulted in their being an amount retained in an unallocated reserve. It is not expected that general reserves can apply the proposed exit measure, as there’s no pension to be exited.  

SMSFs with defined benefit legacy pensions should be reviewed and the options considered. It would be prudent for affected members to be informed of the options to restructure, both under current law and the 2-year proposed exit measure and the potential estate planning consequences tax implications of both scenarios. 

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