Self Managed Super: Issue 48

A free pass: The legacy pension amnesty

For the first time since 2006, the treatment of legacy pensions has undergone significant changes, opening the way for them to be fully commuted and closed. While this move has been welcomed, Jason Spits writes making an exit will require slow and careful deliberation.

After many years of requesting action from the government to allow SMSF members to exit legacy pensions, the green light to do so was given on 7 December when draft regulations, first released for consultation in September, were approved by the Governor-General and took effect immediately.

For the SMSF sector, this marks the end of a long campaign to enact change for legacy pension holders that appeared for many years to be unheeded by government and mainly left off any agenda for change.

That’s not to say legacy pensions were never considered by the government. The 2021/22 budget proposed a two-year commutation period during which any pension amounts would still be taxed and subject to the concessional contributions cap, but these plans under the previous government never eventuated.

Canberra has now granted a five-year amnesty to commute any existing legacy pensions. Further, no taxes will be imposed upon the cessation of these income streams nor on the allocation of any associated reserves. Also, the allocation of a legacy pension reserve to the income stream recipient will not count towards that member’s contributions caps.

Additionally, large allocations from nonpension reserves will be counted towards a fund member’s non-concessional contributions cap (see: What’s been approved).

A welcome reception

There is not much the sector does not like about the changes, with SMSF Association technical manager Fabian Bussoletti seeing it as the culmination of its activities in this area.

“We have been advocating for this type of amnesty for years as there has been a long-term

need to address these pensions, so it is very welcome. It is also more favourable than what was expected, given the last time we saw any proposal it was for a two-year window where taxes would still apply,” Bussoletti says.

Insignia Financial Group senior technical services manager Julie Steed adds the applause for the pension reforms is because they will benefit older SMSF members who have been trapped in products not offered for more than 17 years.

“I can’t think of any financial product that old being sustainable or viable for those using it,” Steed notes.

“These pensions were okay when people were in their 60s, but now they are in their 80s at least and many are holding onto their SMSF just because of a legacy pension and paying annual actuarial, audit and bookkeeping fees which are more than the actual pension payment.”

Another key issue is the reforms were uncoupled from the proposed Division 296 tax bill, which threatened to prevent any further progress taking place, with BDO private wealth senior consultant Peter Crump confirming the perception the two measures were linked together in the mind of government officials.

“In consultations with Treasury it was suggested the legacy pension reforms would help with tidying up Division 296, as reserve allocations would be added to the earnings calculations for that tax, and were contingent on the $3 million cap bill passing,” Crump says.

“Given that bill still remains under a cloud, if they had remained connected, we may not have seen these generous reforms get up.”

The uncoupling from the Division 296 proposals, however, does not take all the pressure off legacy pension holders, particularly those who may be subject to the

tax on earnings for total super balances over $3 million, to take action to deal with reserve allocations, Heffron SMSF technical and education services director Leigh Mansell points out.

“If Division 296 takes effect from 1 July 2025, as proposed, and someone held a legacy pension at that time, any allocation of reserves would be taxable and to avoid having it happen they would have limited time to exit the pension by the start of the next financial year,” Mansell says.

“If the pension reserve is illiquid, this could also create the potential for Division 296-related liquidity problems.”

Pieces still missing

Along with the Division 296 timing issues, some holes still remain in the finalised regulations that the industry had requested be addressed in regards to asset test exemptions and the uncertain fate of reserves unable to be allocated to members because they are deceased.

Super Central superannuation special counsel Michael Hallinan regards these gaps as issues related to the drafting of the regulations rather than intentional oversights, and feels, in the case of the assets test exemption, they can be easily fixed via another regulatory change.

Hallinan suggests one of the drivers behind commencing a legacy pension in the past was the asset test exempt status they were given where the capital value of the pension was not counted for Centrelink purposes.

“However, now if you use the pension reforms, it will undo the social security treatment and allow Centrelink to reassess any entitlements for the age pension for the last five years, creating a debt which would have to be repaid,” he explains.

“The Social Security Act does allow for discretion so this would not require complex change, but rather the adoption of a policy allowing any debt to be written off.”

However, Bussoletti notes the passing of the pension reforms without any related changes to the social security rules means all legacy pensions are currently open to Centrelink assessment.

“Legacy pensions were given full or 50 per cent asset test exemptions if they met a certain condition, being they would be non-commutable except under specific circumstances. The new regulations make all legacy pensions commutable so there is a risk they will all lose the exemption,” he says.

“These new regulations and the existing provisions of the Social Security Act are not talking to each other. Treasury will need to work with the Department of Social Services to resolve this because it affects all legacy pension holders.”

Another gap in the operation of the regulations relates to the treatment of reserve allocations where a pension recipient has died as the cap-free pathway available to living pension holders becomes invalid in this circumstance.

“The amended regulations don’t address this issue, but there was a genuine intent during the consultation that these reserve allocations would follow the same path as a death benefit pension,” Crump acknowledges.

“The only way to access them previously was to direct them to another member via a modest drip-feed method using the fair and reasonable approach.”

Mansell recognises exiting a legacy pension will not be mandatory and the treatment of reserves for a deceased member is not a dead end, but should become part of any consideration around moving out of these closed-end products.

“The SMSF sector requested some action on this point and I am unsure what became of that, but what we have gives us a choice – to hold on and drip feed the reserve out or exit the pension, use the contribution caps and pay the tax,” she says.

Look before you leap

While pension commutations have been given the green light, SMSF practitioners and members should not rush into taking action, according to Steed, who sees what happens outside of the pension as being of critical importance.

“The calculation of the transfer balance account debit and the treatment of an excess commutation will be critical because one of the things I often see is many advisers who have a client with a legacy pension have inherited that client and don’t understand how these calculations will work,” she reveals.

“There is nothing intuitive in the calculation of the transfer balance account debit, so they should consider partnering with an SMSF legacy pension specialist because it is essential they understand how the calculation works and what the available balance will be, if any, to start a new account-based pension.”

The lack of widespread knowledge about the operation of legacy pensions and the amount of time involved in the commutation process, including extinguishing related reserves, have likely been factors in the final amnesty period being set at five years rather than two.

“There is much to consider, including whether someone should retain their legacy pension or if they do exit, where the money should go,” Hallinan indicates, adding issues related to death benefits, estate planning and tax inside an SMSF will need to be considered as well.

“The obligations for financial advisers will be onerous and they will need to understand all the issues as a legacy pension exit will not be an execution-only approach.”

Aware of the need for guidance, Bussoletti reveals plans are already in place to assist practitioners who may start to see old pensions resurface, particularly as they can now offer practical help to clients seeking a way out.

“We have already flagged education in this area as an opportunity for the SMSF sector. It was a specialist area and many practitioners are still well versed in them and we expect to draw on their collective experience,” he states.

“It will also be a challenge because of the historical nature of these pensions and the advisers who started them have in some cases moved on and those now dealing with them have never done so before.”

A small chance of failure

As the SMSF sector continues to assess the implications of the most important changes to legacy pensions in nearly 20 years, it is also keeping an eye on both the calendar and Canberra.

One of the surprising factors about the changes is how little fanfare accompanied them, with the government giving no indication it was moving in that direction. To this point, the first indication Capital Hill had progressed beyond the consultation phase was when the measure appeared on the federal register of legislation.

Since the amendments are to existing superannuation regulations, they were presented for approval using a legislative instrument, rather than having to run the gauntlet through both houses of parliament in the same way the Division 296 bill is currently doing.

However, this does not mean their future is guaranteed and regulations enacted in this way still have to be tabled in parliament within six sitting days of gaining approval, with another period of 15 sitting days beginning after that during which a motion to disallow them may be moved. As such, the earliest date this process can be completed is 14 April 2025 in the House of Representative and 13 May 2025 in the Senate.

However, it cannot be derailed by the calling of an election early next year as that event would only pause the disallowance period until the new parliament reconvenes.

More importantly, the regulations have been law since 7 December and legacy pension holders can act accordingly, even if they become disallowed at a future date. Steed, however, sees moves like this as being highly unlikely.

“These are not contentious changes and it was the current opposition that first proposed them when they were in government, and they would be even more hard-pressed then to oppose them if they win the next election,” she explains.

So if the timetable plays out unencumbered, the long wait for nearly 17,000 legacy pension holders may finally be over and they can use their ‘free pass’.

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What’s been approved

The legacy pension reforms, which took effect from 7 December and contained within Treasury Laws Amendment (Legacy Retirement Product Commutations and Reserves) Regulations 2024, deal with the commutation of lifetime pensions, life-expectancy pensions and market-linked pensions that were issued before 20 September 2007, the reserves supporting those pensions and other unrelated reserves.

While the regulations have two parts, dealing with pension commutations and reserve allocations, they are linked as the latter addresses how any amounts that once supported a commuted legacy pension can be allocated to the income stream recipient and be redeployed in a number of ways.

It is important to note while the changes offer release for income streams that have been locked in for many years, certain rules will apply.

The first of these is a five-year window has now opened to allow legacy pensions to be fully commuted and either cashed out as a lump sum, rolled back into an accumulation account or, depending on transfer balance cap space, used to commence a new account-based pension.

It is significant the commutation will give rise to a transfer balance debit, which needs to be calculated using a complex formula. The transfer balance debit is likely to be noticeably less than the asset supporting the pension and, if cashed out, the payment will be tax-free where the recipient is over 60.

If the commutation is rolled back into an accumulation interest, it will be treated as an internal rollover rather than a contribution, and if used to commence a new pension, the resultant transfer balance credit will be offset by the debit materialising from the commutation.

Reserve allocations will not have a five-year window applied to them. Instead, allocations to a member’s account can be made where a legacy pension ceased before the start of the five-year commutation window, during that period or after it ends.

Another point of difference is the pension reserve reforms will apply to lifetime, life-expectancy and flexi-pensions, but not market-linked pensions issued before 2007 as these structures have no supporting reserves.

There will also be different treatment of reserve allocations depending on the recipient, with amounts directed to the pension recipient not counting toward the individual’s contributions caps.

Allocations to another member will receive the same treatment as long as they do not exceed 5 per cent of the member’s account balance, known as the ‘fair and reasonable’ approach in the Superannuation Industry (Supervision) Regulations. If the limit is breached though, the entire allocation will be treated as a nonconcessional contribution.