No exit: The status of legacy pensions

A dictionary definition for legacy indicates a gift, especially of money or personal property, but also of something received or carried over from the past. Often these historical oddities are no longer fit for purpose and this is very much the case for legacy pensions. selfmanagedsuper senior journalist Jason Spits writes the looming prospect of the Division 296 tax means it is more urgent than ever to find a way to leave the past behind.

In 2007, Apple released the first version of the iPhone, hastening the movement of smartphones from the hands of the tech savvy into those of the mass consumer market.

If you used an earlier phone, it is unlikely today you would still want to do so, let alone be forced to do so because of some restriction under law that prevented you from moving on.

Yet for some superannuation fund members, including those with SMSFs, that’s the situation they find themselves in when it comes to the retirement income stream derived from their fund. They are locked into legacy pensions (see Pensions Ain’t Pensions below) that are hard to exit in some circumstances and still require regulatory intervention to allow them to move into another product or out of the income stream altogether.

The federal government is not unaware of the issue, with successive ministers being briefed on the matter and making noises something will be done, but despite assurances a fix is on the way, the only place a solution can be found is on the wish list of the SMSF sector.

One of the reasons for this is perhaps the government has other superannuation matters it wants to pursue, such as the introduction of the non-arm’s-length expenditure provisions and the proposed Division 296 tax. Alternatively, it may be the cohort of people affected, estimated at 8000, is too inconsequential for it to be a priority, despite only requiring simple changes to super and social security laws.

However, the clock is now ticking because the implementation of the Division 296 tax will add a further layer of complexity to using these pensions and exiting them in the future, while placing more pressure on recipients and advisers to act.

History repeating

Accurium head of SMSF education Mark Ellem says the issues facing legacy pensions are not new and stem from the Simplified Super changes introduced in 2007, which effectively ended the need for them.

“SMSFs have not been able to start a new defined benefit pension, such as a lifetime and life expectancy pension, since 1 January 2006 and since 20 September 2007, they could not start a market-linked pension (MLP) from a member’s accumulation interest,” Ellem notes.

“Where they could start a new MLP after that date was if the pension was commenced as a result of a commutation of a complying pension, which includes lifetime pensions, life expectancy pensions and pre-2007 MLPs.”

While this transfer between these income streams sounds relatively simple, it was made more complex by the introduction of the $1.6 million transfer balance cap (TBC) for pensions in 2017, leading to issues every time an SMSF member looks to exit an older pension.

“The issue with the TBC is since the older-style MLPs are non-commutable, where someone has more than $1.6 million in that pension it is not possible to roll back the excess to get back under the TBC and the excess becomes taxable,” Ellem explains.

He adds, however, an older MLP could be commuted if a new one is started because, since 1 July 2017, it would not be treated as a capped defined benefit income stream. It means any payments from the new income stream will not be taxed under the defined benefit income cap and the pension itself will be assessed for TBC purposes under the account-based pension (ABP) rules, so any balances at commencement will be subject to excess transfer balance tax.

Opening the door

Thankfully this is mostly history now as regulatory changes effective from 5 April 2022 have removed these barriers by allowing legacy pension holders to exit them by starting a replacement MLP.

Heffron SMSF technical and education services director Leigh Mansell says the change allows people to make the transition from a legacy pension and all of its money, including reserves, can be moved to the new MLP without triggering any concessional contributions, while any TBC excess can be commuted back to accumulation mode within the fund. However, Mansell points out the treatment of the excess has some issues.

“The downside of restructuring is the creation of the excess, which is taxed as earnings as soon as the member exceeds the TBC figure of $1.6 million, and that excess can’t be commuted in any way until a commutation authority is issued by the ATO,” she explains.

“This currently takes three to four months and the whole time the excess is attracting a general interest charge, which at present is 11.36 per cent per annum, and is applied at a daily compounding rate.

“With this long wait, the tax on the excess might look big, but legacy pension holders should view it in light of their pension level and what they hope to take out of the old income stream.”

The other flaw is if a legacy pension does not exceed the TBC, it can only be rolled over into a new MLP, which is still noncommutable during the lifetime of the holder.

“It all comes down to the fact you can get out if you can create an excess. How do you do that? Sometimes by restructuring what you’ve got or by adding an account-based pension to the mix, but to do so you need to have accumulation money and not all legacy pension holders do.”

Left in reserve

The April 2022 changes also don’t address what happens to reserves used to fund a legacy pension and Ellem acknowledges there are very few options on the table.

“If a legacy pension can’t be commuted inside the SMSF, it can be commuted to a retail product, but there are limited options available. For MLPs there is only one term allocated pension option and if there is only one product, that’s not an option. If it’s a lifetime pension, they have to be rolled over to a complying annuity and there are no retail products available,” he says.

This may not be of concern to some legacy pension holders, Mansell adds, as the reserves were created in the days of reasonable benefit limit compressions and exiting the pension would expose those SMSFs to tax. Alternatively, pensions drawn from the reserves may have some form of asset test exemption they might want to retain. These arrangements though may be fine during the life of the pension recipient, but the fate of reserves after their death becomes very complicated.

“The problem is the reserves are not a member benefit and they become locked in the fund after death. It means you need to approach the ATO for a ruling to get them out as part of a member’s balance. In doing so, they will be treated as a concessional contribution and if the reserves are large they can blow the cap and will be taxed to the hilt,” Mansell warns.

“However, if the reserves can be removed from the legacy pension while the member is alive, then at death they are treated with the other SMSF assets as a death benefit and only taxed at 15 per cent.”

The Division 296 deadline

While the SMSF sector has been pushing for wider changes to allow any person to exit any legacy pension without penalty, the pressing task has been making holders of these income streams, most of whom are estimated to be in their 80s, aware of their options and what it means in the present and for their estate planning.

However, the proposed introduction of the Division 296 tax, which will add an additional 15 per cent tax to the earnings of total super balances (TSB) above $3 million, has created a finite timeframe to act, according to MLC TechConnect senior technical services manager Julie Steed.

Steed highlights that legacy pensions are included in the TSB definition used to calculate the impost in a different way than ABPs currently in use by SMSFs.

“For pension holders who have rolled over to an MLP, calculating the account balance for the Division 296 tax will be simple as only its withdrawal value will be considered,” she says.

“Valuations for ongoing legacy pensions will need an actuary to be involved as they will be based on the pension credit for the 2017/18 financial year and revalued at 30 June each year for Division 296 purposes using family law split factors.”

While this is likely to create added cost and complexity, Ellem adds any exit from a legacy pension under the Division 296 regime may also push a fund member past the $3 million threshold.

“Legacy pension holders will need to consider the effect of any restructuring from 2025/26 onwards because if they start a financial year with an older income stream and move it to a new MLP, there could be a large difference in TSB,” he explains.

“This may occur because the movement of reserves out of a legacy pension will be treated as earnings for TSB purposes and the Division 296 tax could apply.

“Where the member has a noncommutable pension, they will not have the option to move at all, even if they are over 65, and may also be hit with the new tax.”

Taking it all

The favoured solution to the problems with legacy pensions is to allow an amnesty for those who hold them to not only exit them, including the associated reserves, but to do so without any further taxes being imposed on the way out.

SMSF Association chief executive Peter Burgess says this has been a request of the sector for a number of years and the closest it has come to being delivered were plans contained in the 2021 budget that were not enacted.

“When the plans for an amnesty were contained in the 2021 budget, legacy pension reserves were going to be treated as a contribution. Our preference is to allow legacy pensions to exit without any tax at all,” Burgess confirms.

“The pension holders have not broken any laws and entered into those arrangements for good reasons under the legislation in operation at the time. As such, we shouldn’t be taxing reserves or legacy pension balances, but allowing them to be converted to a newer income stream.”

He recognises a fixed-length amnesty may not deal with all legacy pensions though because some people may choose to continue with them due to the associated benefits, which will result in an even smaller cohort trapped at the end of the amnesty.

“We would not be in favour of forcing people out of a legacy pension, but the government can make it attractive enough for people to want to move out. They could create incentives such as removing any grey areas about what happens to reserves on the death of the member,” he says.

“We have flagged with Treasury the run-up to the introduction of the Division 296 tax would be a good opportunity for an amnesty and they are open to it, as well as how to deal with reserves. So we are confident it will be in place before the proposed tax applies.”

Time to choose

Steed believes sooner rather than later should be the timetable adopted for announcing any amnesty, even though the critical date for when the first Division 296 tax calculations will take place is 30 June 2026.

“The government does not need to announce an amnesty before the new tax regime starts on 1 July 2025, but it would be good to have it by then because these types of changes take planning and the way the Division 296 tax formula works some people may want to commute before that date,” she says.

While the clock is ticking, she doesn’t advocate a “get out while you can” approach due to the differing circumstances of each individual.

“Look at your clients and whether they should wait for an amnesty or is the April 2022 MLP approach suitable for them now?” she says.

Mansell also sees the need to act now, but not in haste and stresses being fully aware of all of the issues at hand is imperative.

“If a client needs to restructure, leave enough time to do it because while June 2026 seems a long time away, it is not if you have to restructure these funds,” she adds.

“No client will be the same and if they move out of a legacy pension, where will they go and what will the tax cost of that move be? If there is no amnesty, can you generate an excess to roll out of that pension?

“There are fewer people who understand legacy pensions now, so more time will be needed to address any changes. It is going to be hard for some pension holders due to their lack of knowledge and the same may apply to the advisers assisting them.”