Market-linked pension mire

The presence of a market-linked pension makes the process of winding up an SMSF difficult. SuperCentral executive consultant Michael Hallinan lays out the options available to trustees when faced with this situation.

There is often a point in time when an SMSF trustee feels running their own super fund is no longer viable. However, if the fund is supporting a market-linked pension (MLP), winding up the SMSF is not a simple process and there are several courses of action the trustee must consider to achieve their objective. The following example illustrates the difficulty associated with the process and the options available to the trustee in these situations.

Tarquin is the sole member of an SMSF. While the SMSF has been an effective vehicle for his superannuation for the past 30 years, he has decided this type of retirement savings vehicle is no longer appropriate for him. The fund has only one superannuation interest, which supports an MLP with a current balance of $50,000 and a remaining term of 12 years. Tarquin wishes to wind up the SMSF as the cost to keep running the fund is disproportionate given the sole pension interest. Clearly the continuance of the SMSF is not in his best interest.

Tarquin commenced the MLP on 1 July 2005 when he retired at age 60 in order to target the pension reasonable benefit limit. The term selected was 29 years. Tarquin’s then super balance excluded him from the age pension. His MLP did not and still does not qualify as an assets test exempt pension. Unfortunately, only two years later, the reasonable benefit regime was replaced by the contributions cap regime introduced by then Treasurer Peter Costello’s super changes of 2007. Doubly unfortunately, these amendments did not permit MLPs to be restructured as account-based pensions. So what can be done?

It all began on 11 May 2004

On this date, the government announced SMSFs and small Australian Prudential Regulation Authority funds could no longer issue new defined benefit income streams. This change was subject to a grandfathered grace period in which new defined benefit pensions could be commenced subject to certain conditions, which in this case do not apply to Tarquin. This grace period ceased on 31 December 2005.

To fill the gap created by the 11 May 2004 changes, a new form of pension was introduced with effect from 20 September 2004. This new form of pension was structured as an account-based pension that was not a defined benefit pension and was not supported by reserves, yet permitted the targeting of the pension reasonable benefit limit, which was twice the size of the lump sum reasonable benefit limit. This new kind of pension was payable for a specified term and could not be cashed out. This new kind of pension was called a marketlinked pension and was introduced by the Superannuation Industry (Supervision) (SIS) Amendment Regulations 2004 (No 4) F2005B00167.

Budget 2021

The May 2021 federal budget, unexpectedly, contained a proposal to allow legacy pensions, including MLPs, to be commuted at the pension recipient’s option and have the commutation amount either cashed out, again at the pension recipient’s option, or used to commence replacement accountbased pensions subject to transfer balance cap space. Additionally, the adverse social security treatment that would normally arise on the commutation of an assets-test-exempt pension was to be removed. However, any replacement account-based pension would not be assets-test exempt and would not qualify for the grandfathered return of capital method of incomes test assessment for age pension and Commonwealth Seniors Health Card entitlement.

The implementation of this proposal would have required amendments to various acts and regulations, but principally the Income Tax Assessment Act 1997 (ITAA), Social Security Act 1991 and the SIS Regulations. Unfortunately, the coalition government at the time could not enact the necessary enabling legislation before the May 2022 election. Now the current status of this proposal under the new government is unknown. Curiously, in the October 2022 budget, the government listed various previously announced but unacted upon proposals and whether they were to proceed or be dropped. The legacy pension proposal was neither on the proceed list nor the dropped list. Consequently, the current status of the legacy pension proposal is unknown.

What could have been

The simple solution to taking advantage of the budget proposal, when enacted, by cashing out the MLP through commutation of the pension and paying the resulting lump sum as a superannuation member benefit seems to have disappeared.

Applying this development to Tarquin’s situation it means he must go back to the drawing board. So what can be done?

Tarquin is thinking of four options:

• option 1 – restructure the term of the of the MLP,

• option 2 – roll over his superannuation benefits into a large fund and recommence an MLP,

• option 3 – simply commute the MLP and cash it out, or

• option 4 – seek a modification of the SIS rules preventing the implementation of option 4.

After some thought, Tarquin dismisses options 1 and 2. Option 3 permits him to wind up the SMSF and is therefore effective. Option 4 enables him to wind up the SMSF and get the cash so is better than options 1, 2 and 3, but does come with some downsides.

Assessing each option

Option 1 – restructure pension

This option is the restructure of the MLP into one with a shorter term. Tarquin will be 77 on 1 July 2022. While MLPs cannot generally be commuted, one exception to the general rule is where the lump sum resulting from the commutation is immediately applied in the purchase of another MLP. The SMSF is also able to issue an MLP after 1 July 2007 if the purchase price of the pension arises entirely from the commutation of a previously existing MLP. Additionally, since the new MLP will be issued after 1 July 2007, it must also comply with the account-based pension drawdown rules. Unfortunately, the minimum term of any new MLP for Tarquin is 12 years, meaning this course of action offers no improvement. So option 1 is out.

Option 2 – rollover to another fund

This option involves commuting the current MLP, rolling over the commutation lump sum to another superannuation fund and the immediate issue by that fund of a new replacement MLP. Essentially, this option is the same as option 1 with the difference being the replacement MLP will be issued by the trustee of another super fund. The commutation proceeds will be treated as a rollover superannuation benefit, which contains no untaxed element, and not included in the assessable income of the receiving fund. The rollover superannuation benefit will be treated as forming part of the contributions segment and so will form part of the tax-free component.

As the original MLP commenced before 1 July 2017, it will, for transfer balance cap purposes, be treated as a capped defined benefit income stream and so the credit to Tarquin’s transfer balance account will be the special value of the MLP as at 1 July 2017. Commuting the pension as at 1 July 2022 will generate a transfer balance account debit equal to the original credit value less the total pension payments made since 1 July 2017, as per section 294-145 of the ITAA. The new credit to the transfer balance account arising by reason of the issue of the replacement MLP will be the value of the rollover superannuation benefit and not a special value as the new replacement MLP will not be a capped defined benefit income stream as it commenced after 1 July 2017.

While there is a mix of special values and actual pension balances in determining the transfer balance account, as a general statement, the special value at 1 July 2017 will be in excess of the actual pension account balance at that date. As such, the debit will be the 1 July 2017 special value reduced by the aggregate of pension payments since 1 July 2017 and before the commutation and the credit arising upon the issue of the replacement pension will be the actual balance as at 1 July 2017 reduced by the aggregate pension payments plus or minus any associated earnings since 1 July 2017. To be otherwise would require the pension account earnings since 1 July 2017 being greater than the total of the pension withdrawals and the excess of the special value as at 1 July 2017 over the actual pension account balance at that date.

The fundamental problem with option 2 is to find a retail or industry fund willing to issue an MLP. They are under no legal obligation to issue such products and the relatively small account balance involved may discourage them from doing so.

Option 3 – simply commute the MLP

This option involves the member requesting, and the trustee acceding to the request, to simply commute the pension and cash out the account balance.

The commutation of the pension would constitute a breach of SIS regulation 6.17C. This breach would clearly be an intentional breach of an operational standard and therefore the trustee, or each director of the corporate trustee, would be subject to a fine not exceeding 100 penalty units, currently $222 per unit but proposed to increase to $275 per unit. As the contravention is an intentional one, it would empower the ATO to review the compliance status of the fund and, if thought fit, revoke the compliance status of the fund.

If the pro-rata minimum pension has not been paid prior to the commutation, there would also be an intentional breach of SIS regulation 1.07C, again with a chance for a second fine of up to 100 penalty units and another ground warranting the ATO to review the compliance status of the fund. Also there would be an intentional breach of SIS regulation 6.17 – benefit cashing standards.

Additionally, the pension would be taken to have ceased to be in retirement phase from the start of the financial year in which the commutation arose. Given the other consequences and the small balance, this is not significant.

If the ATO revokes the compliance status of the SMSF, the fund will be taxed at 45 per cent on its assessable income for the financial year in which the commutation occurred and the total value of the SMSF immediately before the start of that financial year, less the contributions segment, will be included in assessable income of the fund.

The commutation payment will taxed under Division 304 of the ITAA at marginal rates subject to the discretion of the ATO to exclude all or part of the payment.

Given these adverse financial consequences, option 3 is not viable and not recommended.

Option 4 – request exercise of modification powers

This option is to request the ATO, as the regulator of SMSFs, to exercise its statutory power of modification of the SIS provisions, which preclude the cashing-out option.

Part 29 of the SIS Act (sections 326 to 336) confers power on the ATO to “grant exemptions from, and make modifications of, certain provisions of this act and the regulations”. In particular, part 29 confers power on the ATO to modify any regulation made for the purposes of part 3, which includes section 31, which is the authority for the making of operating standards.

Significantly, the ATO has no statutory power to modify the SIS Regulations, which do not constitute operating standards.

The cashing-out option is currently precluded by SIS regulation 1.06(8) and SIS regulation 6.17C. There are flow-on consequences under section 42A of the SIS Act and the ITAA. The key issue is whether both SIS regulations 1.06(8) and 6.17C constitute operating standards. Unfortunately this is unclear. SIS regulation 1.06(8) is simply a definition of a certain kind of pension. SIS regulation 6.17C is simply a probation on the trustee paying or commuting a pension in a manner not consistent with the mandatory pension terms.

While SIS regulation 6.17 is expressed to be made for the purposes of section 31(1) of the SIS Act, a modification of that regulation may not be sufficient to protect a trustee from the consequences arsing breaching or intentionally breaching SIS regulation 6.17C.