9 minute read
The case for non-reversionary pensions
MEG HEFFRON is managing director of Heffron.
Making a pension reversionary is a popular estate planning strategy for many SMSF members. However, having a non-reversionary pension can be beneficial as well, Meg Heffron writes.
Back in the day when reasonable benefit limits still existed, I was an advocate of reversionary pensions. The decision had a huge impact on the tax treatment of any ongoing pension for the recipient and in some cases made the difference between leaving money inherited from a spouse in superannuation as opposed to withdrawing it.
All that changed when superannuation was simplified in 2007 and making a pension reversionary suddenly became less critical.
Changes to the income test for the Commonwealth Seniors Health Card (CSHC) in 2015 and the next major round of superannuation tax changes in 2017 swung the pendulum back the other way, but even today there are some circumstances where making a pension non-reversionary can be very beneficial.
Why are we even asking the question?
There are well-known benefits to making a pension reversionary when it comes to transfer balance caps.
Critically, when a person dies and their pension reverts to someone else, let’s assume their spouse as is usually the case, the spouse gets two important benefits:
• even though they start receiving the reversionary pension immediately, nothing counts towards their transfer balance cap until 12 months later, and
• the amount that counts is the value of the pension account on death, not 12 months later.
(We are assuming a standard account-based pension here rather than a capped defined benefit pension).
On the latter point, there are actually two benefits – one is the certainty of the amount upfront and the second is the fact it won’t reflect any growth in the pension account after death.
So in many cases this is good news.
What is the counterview?
However, there are some good reasons a client might still choose a non-reversionary pension. The top five I would nominate are as follows.
The fixed time frame
A 12-month delay sounds great until it’s not quite enough. Put another way, when a pension is reversionary, the one thing that is happening for sure is the value of the pension at death will be added to the reversionary beneficiary’s transfer balance account 12 months later. That’s fine if they are well prepared and have taken steps such as rolling back their own pension. If they haven’t done so, it can be a problem. Remember in particular that sometimes the surviving spouse doesn’t have a pension big enough to roll back the amount they need to clear transfer balance cap space for the reversionary pension.
Take this situation as an example. Jill has an account-based pension. It started on 1 July 2017 at $1.6 million, but over the years she’s taken a little more than the minimum, markets have dropped and it’s now worth $1.5 million. Her husband, Tony, also has an account-based pension that he started more recently than Jill. Its value when set up on 1 July 2019 was $1.6 million, but it is now worth $1.7 million. Tony dies and his pension automatically reverts to Jill.
Even if Jill rolls back her entire pension of $1.5 million, her transfer balance account will only reduce to $100,000. In 12 months’ time, $1.7 million will be added to her transfer balance account from Tony’s pension. Between now and then, she will need to make sure she has taken a commutation of at least $200,000 from the reversionary pension. This is a hard deadline and it requires a physical transaction – she can’t just put paperwork in place to roll it back to accumulation phase.
It rules out a payment to the estate
Sometimes, even when the spouse is receiving the superannuation, making it payable as a pension, there are benefits in having superannuation money paid to the estate. Perhaps the superannuation was predominantly tax-free and the family wanted the freedom to distribute the money via a testamentary trust. Perhaps, like Jill above, not all of the money can remain in superannuation anyway.
If the pension is reversionary, any commutation ‘belongs’ to the member who owns the pension at the time. In the example above, Jill would have to take the $200,000 directly; she couldn’t put that amount into Tony’s estate.
By contrast, if the pension was non-reversionary and the trustee could pay some of the death benefit to the estate, in other words there was no binding death benefit nomination saying it all had to be paid to Jill, the trustee could choose to pay $200,000 to the estate and only put the remaining $1.5 million into a new death benefit pension for Jill.
It’s not important for exempt current pension income
There was a time when making a pension reversionary was beneficial for maximising exempt current pension income. This is because the tax exemption ceased when a pension ended on death. These days the exemption continues until the death benefit has been dealt with.
In Jill’s case, for example, even if Tony’s pension was non-reversionary, it would continue to contribute to the fund’s actuarial percentage until the entire balance was either converted to a pension, paid out as a lump sum or a combination of the two.
Of course, the same applies if the pension is reversionary, but the key is this doesn’t have to be the case to continue the tax exemption.
It is included in the reversionary beneficiary’s TSB immediately
Remember that the total superannuation balance (TSB) is relevant for many things – a number of which revolve around contributions.
In the Jill example above, her current balance is $1.5 million. That means it’s conceivable her account could be slightly less than this amount at 30 June 2021. If she’s still young enough to contribute to superannuation and use the bring-forward rules, that gives her scope to make up to $200,000 in non-concessional contributions in 2021/22 (assuming no change to the general transfer balance cap or concessional contribution cap amounts).
If, however, Tony’s pension is reversionary to her, the value of his pension account will be included in her TSB immediately. That won’t impact on her ability to make contributions in 2020/21, as this is based on her TSB at 30 June 2020, but it will definitely rule her out of further non-concessional contributions in 2021/22.
Not everyone cares about this. Jill might not be concerned if she’s too old to make non-concessional contributions or if she’s young enough but had no plans to do so. If it’s the latter, though, don’t forget she’s going to have to take some of Tony’s superannuation out of her fund. This might be exactly the time when being able to put large amounts back in could become useful.
The pension payments don’t need to continue
When a pension is reversionary, the usual minimum payment is required in the year of death. In Jill and Tony’s case above, the fund would need to make the normal minimum payments for both Jill and Tony’s pensions in 2020/21 if Tony died but the pension reverted automatically to Jill.
On the other hand, if the pension was not reversionary, there is no minimum pension required from Tony’s pension in 2020/21. This is even true if he dies in June 2021 and hasn’t drawn any pensions at all during the year.
Of course, Jill may actually need the money and want her pension payments to continue. If so, she has a few options:
• keep the payments running, but treat them as coming from her own pension – it will mean she meets her minimum earlier, but buys her time to decide what to do with Tony’s superannuation, or
• quickly start a pension with some or all of Tony’s super – there’s nothing to prevent the trustee from doing this very quickly, or
• take a lump sum payment from Tony’s super balance. It’s worth remembering, though, that a maximum of two superannuation lump sums can be taken from Tony’s pension account.
But there are things to watch out for when pensions are not reversionary.
SIS Act requires death benefits to be dealt with
A neat side benefit of a reversionary pension is that the trustee automatically meets the Superannuation Industry (Supervision) (SIS) Act requirement to cash a death benefit if it is paid as a reversionary pension.
Normally this is something that needs to be done as soon as practicable after the member dies. If the deceased had a non-reversionary pension or an accumulation account, the trustee must take specific action to demonstrate the death benefit has been dealt with, either by starting a new pension, or paying a lump sum in cash, or by transferring assets.
Even though the benefit won’t be added to the beneficiary’s transfer balance account for another 12 months, and they may in fact commute part or all of the pension, making a pension reversionary means the trustee will have at least ticked one task off the to-do list and met the SIS Act requirement to cash the death benefit.
Watch the CSHC implications
Remember that account-based pensions started before 1 January 2015 have some handy grandfathering for the purposes of the CSHC. Basically the pension is completely ignored for the income test that applies to this card.
If the pension is reversionary, this grandfathering will continue to the beneficiary when they inherit it. Sometimes this is really important and can be reason enough to tip the balance in favour of making the pension reversionary. However, it might not be. Take, for example, cases where:
• the couple had other income and have already lost the CSHC. The special grandfathering is lost forever if they ever lose the card, and
• the widow/widower will have income from other sources and will fail the income test in any case once the income from a combined portfolio is assessed for this card.
One final point – legacy pensions should be handled with care
In an SMSF it’s too late for the pensioner to change their mind about whether a lifetime or life expectancy pension should be reversionary. The terms were set at the outset and changing them now is something that might require them to profoundly change the pension, for example, convert it to a market-linked pension. At the very least it is something to handle with a great deal of care.
However, some market-linked pensions can be changed from reversionary to non-reversionary or vice versa.
If the term of the market-linked pension was set based only on the original pensioner’s particulars, such as age and sex, the pensioner can choose whether or not the income stream is reversionary. And they can even change their mind now if they want, as long as their governing rules allow it. The opposite applies if Tony had a market-linked pension for which he had deliberately made Jill the reversionary beneficiary because it allowed him to choose a longer term. In this case, Tony has no choice and the pension must be reversionary to Jill.
So would it be better if the marketlinked pension was reversionary? Maybe – it depends.
Making it reversionary would mean it can keep running after the original pensioner dies, assuming the pension hasn’t reached the end of its term yet. It will also keep its status as a ‘capped defined benefit’, which allows people to have more than $1.6 million in a superannuation income stream without being forced to reduce it.
But that could be a blessing or a curse, depending on a great many factors.
This is exactly where the services of an accountant or financial adviser become crucial in making the call.
