In 2018 your SMSF pension choices are defined for you, it’s an account based pension or it’s nothing. Whilst innovative income stream products may be around the corner they will take time to become mainstream. In the early 2000’s pensions were also defined but that had a whole different meaning. Now it’s time to define what action, if any, needs to be taken with those SMSF defined benefit pensions.
Given they were commenced what seems a lifetime ago, you might need a refresher.
Reasons for SMSF defined benefit pensions
Was it set up to access the higher Pension Reasonable Benefit Limits (RBL)? Did the allure of 100% Asset Test Exemption (ATE) from Social Security make them an irresistible alternative? SMSF defined benefit pensions were mostly set up to satisfy laws and concessions of a time long gone. Whilst some may still attract that elusive Social Security asset exclusion others are a constant source of trouble. After all this time we are still grappling with solvency reserves, actuarial costs, and diminishing tax exemptions. It begs the question, what can we do with them?
First things first, if your clients still have SMSF defined benefit pension that were established for RBL compression, my immediate response is why? Sure it served a purpose but that purpose disappeared in 2007 and so should have the pension. It’s not too late to act, but it may be too late to benefit from your actions.
Asset Test Exemption
Ok so how about those Asset Test Exempt Pensions? Haven’t they been a joy to deal with through a number of market crashes since 2000. Trying to satisfy the ‘high probability’ of lasting through the term which in some instances is an indeterminable reversionary lifetime. Yes they are 100% exempt from the Asset Test for Social Security purposes if established prior to 20 September 2004. Question is how much is member balance and how much is reserve?
If the pension is a fixed term and that term is expiring soon, as many will and have, then what you may actually have is an exemption that is about to expire and a lump of money with a caution sign attached. Catch is once the term is up the value of the pension is nil, regardless of what might be in the fund. There is actually no value left for the member as one of the original requirements of the pension was that it had a nil residual capital value. What does that mean for the money still in the fund? It means you have a reserve without a pension liability and that’s not a good reserve to have! OK so it’s not the end of the world but it’s going to require some serious consideration.
The clock is running
For many fixed term pensions this question has a time limit and that limit is fast approaching. For some that time may have passed without awareness of the consequences. When the term is up, so to speak, so is the pension. What is left is an account balance that for all intents and purposes is not the members, not directly anyway. It’s a reserve and it’s subject to tax and potentially subject to an excess concessional contribution liability upon allocation. So the question becomes, is it possible to avoid this inconvenience and take back control of money for the member, despite what the law or others might say. The short answer is yes but there are consequences.
Allocations from reserves
Non-pension reserves can be allocated so long as the allocation is fair and reasonable. This means all members receive some, not just the pensioner. In addition the allocation must be less than 5% of the member’s fund balance. Achieve this and there is no reserve allocation issue. Does anyone spot the flaw with this? If the pension had nil residual capital value it means the member’s balance is nil! Any allocation to that member is going to represent more than 5% of their member balance. Of course it is totally possible the ATE pension sat alongside an account-based pension meaning an allocation would be possible. Alternatively the client may not care about unfair allocations and be happy to pay tax!
If the pension is commuted prior to cessation the commutable value and the accompanying reserve may be utilised to commence another complying pension, a Market Linked Pension, within the SMSF. This will result in a loss of the ATE status of the pension, but perhaps that is inevitable anyway. What it does is provide some certainty around how much money the member has. It also provides greater clarity around estate planning. The downfall is the transfer balance cap. If the pension plus reserve is more than the transfer balance cap there are problems. Market Linked pensions commenced post 1 July 2017 are not capped defined benefit income streams. If a pension is commenced for more than the cap and it is a non-commutable pension the ATO says you’re stuffed! Ok perhaps they don’t use those words. Therefore be careful to ensure any allocation from reserve doesn’t exceed the cap.
The final curtain
There is a final option, you can leave the reserves and wait for the member to die! It’s possibly not a strategy you recommend directly to the member but it may open up some other doors.
Anyone contemplating commuting existing SMSF defined benefit pensions should seek appropriate advice including from the Fund’s actuary.