The two-year amnesty dilemma

The federal government’s decision to apply a two-year moratorium allowing superannuants with legacy pensions to deal with the adverse issues stemming from these income streams was welcomed by the sector. But with no indication of when the two-year period will commence, some individuals in this situation may not be able wait. Mark Ellem, head of education at Accurium, explores the implications for them and the potential remedies available.

The number of SMSFs with a member being paid an old legacy pension continues to fall and with the 2021 budget announcement of a two-year period for 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 pensions as simple as waiting for the start of the two-year exit period? Given the fact the life expectancy tables are not that kind for such members, putting these individuals aside until the start of a two-year exit period to deal with those pensions may turn out to be quite costly.

What are legacy pensions?

The pensions in focus are those that will be eligible for the proposed two-year exit measure being as we understand it:

• Superannuation Industry (Supervision) (SIS) regulation 1.06(2) lifetime complying pensions,

• SIS regulation 1.06(7) lifetime expectancy pensions, also known as a fixed-term pension, and

• SIS regulation 1.06(8) market-linked pensions (MLP), also known as term-allocated pensions.

The first two pensions are defined benefit pensions (DBP), whereas an MLP is not.

The issue with legacy pensions

All these pensions cannot be commuted, except in limited circumstances. That is, generally an SMSF member cannot effect a transfer of the pension capital back to their accumulation account, unlike an accountbased pension.

One of the biggest issues with DBPs is dealing with any leftover pension capital after the income stream has expired, either as a consequence of the pension term ceasing or the member dying. There can be few 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. The contribution caps that applied from 1 July 2007 present a challenge for dealing with these leftover reserves.

Pension capital left over, after its (nonreversionary) term has expired or the member has died, is not as big an issue for an MLP. Firstly, the rules for an MLP 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 a superannuation death benefit.

Defined benefit pension upon death

What needs to be at the forefront of SMSF members’ minds and their advisers’ minds are the adverse estate planning and tax consequences the death of a member with a DBP have and the importance of considering the options available prior to that individual’s death. I continue to get phone calls and emails from advisers that start 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 before doing so it is important to consider the taxation treatment of those distributions as outlined in regulation 291-25.01 of the Income Tax Assessment Act 1997 (ITAA) and 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 income stream was not based on the spouse, the remaining pension payments until expiry 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 SIS regulation 1.08. 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 exceeds 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 DBP 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 two-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 super.

Dealing with a DBP before the member’s death

To remove the risk of potential estate and tax consequences where the member with a DBP dies prior to being able to exit it under the two-year budget measure, consideration should be given to restructuring the DBP 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 dependant or estate.

The restructure of a DBP requires it to be commuted. There are limited instances when a member can commute a complying DBP 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 DBP. These are:

• complying MLP, and

• retail complying annuities.

Unfortunately, we understand there are currently no providers in the market offering 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 fund, a restructure to an MLP will be the only option.

Example – restructuring a lifetime complying pension to an MLP

Rosie, aged 75, has a non-reversionary lifetime complying pension (LCP) in her SMSF. It 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 is shown in Table 1 (below).

Rosie's LCP Best estimate valuation High probability valuation

– SIS purposes – social security purposes

Capital supporting DBP $498,000 $498,000

DBP liability $210,000 $272,000

surplus/(deficit) $288,000 $226,000

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

If Rosie was to die, for example, prior to any two-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 distributing 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 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 income stream is a result of the commutation of a complying pension, which includes the three previously mentioned legacy pensions. Importantly, the SMSF’s trust deed must permit the fund to pay an MLP to a member.

Based on the ATO’s Interpretive Decision 2015/22, Rosie can use the value of the capital backing of the LCP to commence the new MLP. She will be required to set the terms of the MLP, including how long it will be paid for, which could stretch out to her 100th birthday. Note, she 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 an MLP is that upon her death, where it occurred prior to her being able to exit the LCP under the two-year exit measure, the value of the MLP can be paid out of the SMSF as a superannuation death benefit and 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 income stream are likely to result in a portion of the DBP capital not being converted to the MLP and being held in an unallocated reserve.

The transfer balance cap issue

A commutation of a DBP and the commencement of an MLP are both transfer balance cap events that will give rise to transfer balance account (TBA) debits and credits. One reason pre-1 July 2017 legacy DBPs have not been restructured to an MLP is that the member may end 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 that it would amend the law to ensure in such a scenario an affected member would be able to undertake the necessary partial commutation. Like the two-year proposed exit measure, we are yet to see any draft legislation for this measure.

However, given that section 294-45 of the ITAA states that an individual’s TBA ceases upon death, it effectively removes the issue of an excess TBA balance where it is known a member will soon die. Harsh as this may sound, it does mean 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 two-year exit measure. Restructuring asset test exempt pensions can result in clients suffering lower age pension entitlements.

Why not just wait for the two-year measure to start?

Based on our understanding of the two-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 an MLP would not take away 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 may remove the assessable commuted reserve, but this will depend on how this term is defined.

This would not be expected to happen if Rosie had a life expectancy pension where a conversion to an MLP resulted in there being an amount retained in an unallocated reserve. It is not expected the proposed exit measure will apply to general reserves, 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 two-year proposed exit measure and the potential estate planning consequences and tax implications of both scenarios.