Child death benefit pension considerations

Including children in death benefit allocations is not straightforward. Julie Steed, senior technical services manager at Australian Executor Trustees, identifies the complexities regarding child death benefit pensions.

When considering the benefits of a child death benefit pension, there are a number of important considerations to take into account, including the transfer balance cap (TBC). In this article we review the rules surrounding child death benefit pensions and some of the traps involved.

Child death benefits

A death benefit can only be paid in the form of a pension to the child of a deceased member if the child is:

• under age 18,

• age 18 or over and either:

− is financially dependent on the member and under age 25, or

− has a disability described in section 8(1) of the Disability Services Act 1986.

For a child to meet the disability definition, the child must have a permanent physical or intellectual disability that results in a substantially reduced capacity of the child for communication, learning or mobility and means they need ongoing support services.

Child cap increment

Where a death benefit is paid as a pension to a child, a special TBC amount comes into play – the child cap increment.

For child death benefit pensions that were commenced prior to 1 July 2017, the child cap increment is $1.6 million for all pensions. Any amount above $1.6 million was an excess and had to be removed from the super system.

Since 1 July 2017, the amount of the child cap increment depends upon whether or not the deceased had a transfer balance account (TBA) at the date of death.

Importantly, the test is whether the deceased has a TBA at the date of death, that is, whether they had ever commenced a retirement-phase pension, rather than whether the deceased had a retirementphase pension at the date of death.

If the deceased did not have a TBA, then the child cap increment is a prorated amount of the general TBC at the time the child receives the pension, based on the child’s proportion of the deceased’s total death benefit.

If the deceased had a TBA at any time, the child cap increment is a prorated value of the pension account/s as at the date of death, based on the child’s proportion of the deceased’s total death benefits.

A child death benefit pension above the general TBC may also be possible without having an excess transfer balance amount. This could occur if the parent’s pension increases above the general TBC as a result of investment returns.

Investment returns from the date of death until the date the child pension commences are included in the pension account balance and therefore count towards the child cap increment.

In addition, a child can have multiple child cap increments if multiple parents die.

It is not an everyday occurrence for a member receiving a retirement-phase pension to have a minor child, however, they will occur for older clients with younger spouses (think Mick Jagger having a child at age 73). In addition, clients with young children may be in receipt of a disability income stream, and adult children with disabilities will often live with their parent well into the parent’s 70s or 80s.

Case study

Mick held $1.6 million in an account-based pension on 1 July 2017 and did not have an excess transfer balance amount. He dies at age 68 in August 2021 with a pension account balance of $2.2 million, which is to be paid to his only child, Ollie, who is 16.

Because Mick had a TBA, Ollie’s child cap increment is his share of Mick’s pension account/s, which is 100 per cent of $2.2 million. Ollie can commence a death benefit pension of $2.2 million and does not have an excess transfer balance amount, even though his pension is commenced for an amount greater than the general TBC of $1.7 million.

If a death benefit is payable from both accumulation and pension benefits, then the child is still constrained by the child cap increment, which results in all accumulation balances having to leave the super system.

Case study

Rachael is a 45-year-old single parent who is diagnosed with a debilitating degenerative disease, however, she has a life expectancy of over 10 years. Rachael’s beneficiaries are her two children, aged 10 and 12. She has $300,000 in an accumulation account that has a $1 million insurance policy under which Rachael is claiming a total and permanent disability benefit.

Rachael understands the benefits of tax-free investment returns on pensions and her fund is satisfied she has met a disability condition of release. She commences a pension with $300,000 while awaiting the outcome of her insurance claim.

Unfortunately, Rachael dies before her insurance claim is finalised. The insurance proceeds are received a few weeks after she dies.

Rachael had a TBA at the date of her death, so her children’s child cap increment is their share of Rachael’s pension account, which is 50 per cent of $300,000 each (or $150,000). The insurance proceeds that are received into her accumulation account cannot be paid as a death benefit pension and must leave the super system.

If Rachael had not commenced a pension and had died with $1.3 million in an accumulation account, each of her children could have received a death benefit pension of $650,000.

End of a child death benefit pension

A child death benefit pension must be commuted by age 25 unless the child has a disability. The pension may end earlier if assets backing the pension are exhausted.

The benefit may also be commuted when the child reaches 18 and requests a commutation, unless the fund’s trust deed restricts access to an age up to 25. An SMSF or a small Australian Prudential Regulation Authority (APRA) fund would be likely to offer this flexibility, however, it is unlikely in a large APRA-regulated fund.

When the child death benefit pension ends, the child’s TBA is deleted. The child will then be eligible for the general TBC when they retire.

Excess transfer balance amount

If the parent had an excess transfer balance at the time of their death, the child death benefit pension is reduced by their proportionate share of the parent’s excess transfer balance.

Insurance

Where an accumulation account includes insurance proceeds, the insurance proceeds form part of the accumulated balance and are included in the child cap increment amounts.

However, if an insurance policy is held in a retirement-phase pension, none of the insurance proceeds can be used to start a death benefit pension paid to a child as all the insurance proceeds must be paid as a lump sum.

Conversely, if an insurance policy is held in a reversionary retirement-phase pension that will be paid to a spouse, the insurance proceeds are treated as investment returns and can be retained in the spouse’s death benefit pension.

Indexation of a child death benefit pension

A child death benefit pension is not eligible for any indexation. The amount able to be paid as a pension is determined at the time of commencement and cannot be added to (unless by another child cap increment if another parent dies).

SMSFs and child members

Paying death benefit pensions to children can create difficulties in SMSFs. A person who receives a pension from an SMSF is defined as being a member of the SMSF. To meet the definition of an SMSF, a child in receipt of a death benefit pension must also be a trustee.

Where the child is under 18, this is relatively simple; the child’s surviving parent or guardian is the trustee for the child. However, when the child turns 18, they are required to be appointed as trustee and assume all trustee responsibilities.

For an adult disabled child, it is not so straightforward. If the adult child has a power of attorney, the attorney can be the trustee for the child. However, most disabled child death benefit pensions are paid to adult children with long-standing intellectual disabilities that have prevented them from completing a power of attorney document. The alternative is to have a court-appointed guardian, which is rarely done if the parents are caring for the adult child as it is generally an arduous and unpleasant process.

A possibility is to convert an SMSF to a small APRA fund that has a professional licensed trustee. This may be beneficial where the SMSF has unique assets.

Fortunately, since 1 July 2017 a death benefit pension can be rolled over to another fund. The SMSF could therefore roll a child’s death benefit pension to a retail fund.

Planning opportunities

Not all parents are thrilled at the idea of their 18-year-old children having access to commute significant amounts of death benefit pensions. In an SMSF, the terms of the trust deed may restrict the child’s access to age 25, by which time parents may be more comfortable with the decisions their children may make regarding appropriate uses for the death benefit proceeds.

An often overlooked alternative in an SMSF is to have a non-binding nomination that allows a surviving spouse to allocate death benefit proceeds between themselves and children, maximising the amount that is retained as superannuation death benefit pensions. This also means binding nominations don’t have to be updated as circumstances (and account balances) change.

In a retail or industry fund there may be less confidence in the trustee’s decisions for non-binding nominations, however, a similar outcome may be achieved by assessing the best outcome annually and making binding nominations to that effect.

For clients who have retirement-phase pensions and accumulation accounts, it may be appropriate to leave all the pension benefits to the children equally and all the accumulation accounts to the surviving spouse.

In many instances, parents will be far more concerned about control than the potential tax benefits of retaining death benefit pensions in the super environment. Clients may look to commence child death benefit pensions that are expected to have a zero balance by the time the child is 18. Each year they may work with the adviser to estimate the amount required to support the child’s lifestyle needs until they turn 18. The balance can be directed to testamentary trusts or to a surviving spouse. Of course, the estimates will never be perfect, but will greatly reduce the likelihood of the child having access to large sums of money at 18.

In an SMSF this can also be achieved by using non-binding nominations. In a retail fund, binding nominations could be updated annually.

Conclusion

Understanding how child death benefit pensions interact with the TBC can assist practitioners in providing appropriate advice to clients, particularly clients with young or disabled children.