Defined benefit pensions and the Budget changes

Strategies

Tuesday 14 February 2017

The recent super reform changes include a number of implications for certain defined benefit income streams, referred to as capped defined benefit income streams in the legislation. These income streams are ‘capped’ because the amount that is assessed towards the member’s transfer balance account may be limited in certain circumstances.

the introduction of a defined benefit income cap will have an impact on certain defined benefit pension members

Additionally, the introduction of a defined benefit income cap will have an impact on certain defined benefit pension members who receive more than $100,000 per annum in pension payments.

This article provides financial services professionals with an overview of both the transfer balance cap implications and the new tax treatment of defined benefit pensions.


What is a capped defined benefit income stream?

The definition of a defined benefit income stream for the purpose of the new law is broader than what is commonly understood to be a defined benefit income stream and specifically includes:

  1. lifetime pensions commenced at any time
  2. lifetime annuities in place just before 1 July 2017
  3. market linked pensions and annuities (also known as term allocated pensions or TAPs) and RSA market linked pensions in place just before 1 July 2017
  4. life expectancy pensions and annuities in place just before 1 July 2017.

From the above, pensions such as term allocated pensions (TAPs), must be commenced before 1 July 2017 to be considered capped defined benefit income streams. These pensions, if commenced on or after 1 July 2017 are not considered capped defined benefit income streams. For example, if a client had a TAP in place immediately before 1 July 2017, commuted that TAP during 2017/18 and used the proceeds to commence a new TAP, the new TAP would not be considered a capped defined benefit income stream.

Another important point is that reversionary pensions are considered to be a continuation of the original income stream after reverting to a beneficiary. Therefore the start date for the pension will be based on the original start date for the deceased member rather than when the pension reverts.


Defined benefit pensions and the transfer balance cap

Defined benefit pensions count (ie are credited) towards the transfer balance cap - this amount is referred to as a ‘special value’.

The method for calculating the special value at 1 July 2017 will vary depending on the type of defined benefit pension.


1. Lifetime defined benefit income streams

For lifetime defined benefit pensions (covered in points 1 and 2 above), the special value is calculated as follows:

special value

=

annual entitlement x 16


The annual entitlement equals the first income payment divided by the number of whole days to which it relates and is then multiplied by 365.

Example

Joan has a lifetime pension and receives fortnightly payments and her first payment for 2017/18 of $4,200 is received on 7 July 2017. Joan’s annual entitlement will be calculated as follows:

annual entitlement

=

(4,200 / 14) x 365

=

109,500

Based on an annual entitlement of $109,500, the special value of Joan’s pension and the amount that will count towards her transfer balance cap will be $1,752,000 (ie $109,500 x 16).


2. Life expectancy and market linked income streams

The calculation of the special value for life expectancy and market linked income streams is different to the calculation for lifetime products. The special value for these income streams is calculated as follows:

special value

=

annual entitlement x remaining term (rounded up)


The annual entitlement calculation is the same as that for lifetime income streams.

The remaining term is the number of years remaining at 1 July 2017 rounded up to the next whole number. For example, if a TAP’s remaining term at 1 July 2017 is 13.1, the remaining term for the purpose of this calculation will be 14.

As the special value is based on the first pension payment received in the financial year, where possible, there may be an advantage in ensuring the lowest pension payment is drawn at the time. This is particularly relevant for TAPs, as the standard annual pension payment can be varied by plus or minus 10 per cent. Therefore taking the lowest pension will result in a 10 per cent lower special value. The lower payment will need to be in place for the first payment.

Greg has a TAP where the standard pension is $98,200 per annum for 2017/18 with a term remaining of 6.25 years. If Greg takes the lower pension, the annual pension will be $88,380 (ie the standard pension reduced by 10 per cent) whereas the maximum pension would be $108,020 (ie the standard pension increased by 10 per cent). In addition, Greg has an account based pension with an account balance of $900,000 at 1 July 2017. The impact of varying the TAP terms on Greg’s transfer balance account is shown in the table below.

Cap value (TAP at 90% of standard pension)Cap value (TAP using standard pension)Cap value (TAP at 110% of standard pension)
Special value for TAP $618,660 $687,400 $756,140
Account based pension $900,000 $900,000 $900,000
Total - transfer balance account $1,518,660 $1,587,400 $1,656,140

From the table above you can see that the special value of the TAP can vary by $137,480, depending on whether the lowest or highest pension payment is selected. If Greg limits his TAP payments to less than $100,000 per annum, he will avoid having an excess transfer balance. That is, a TAP pension of $100,000 per annum will result in a special value of $700,000 (ie $100,000 x 7) and when added to the account based pension balance of $900,000, will take Greg to his transfer balance cap of $1.6 million.


Exceeding the transfer balance cap

Ordinarily where an individual’s transfer balance account exceeds their transfer balance cap, the individual will have an excess transfer balance. However where the individual holds a capped defined benefit income stream, their excess transfer balance will be the lesser of the following two amounts:

  • the individual’s transfer balance account less their transfer balance cap
  • the individual’s transfer balance account less the balance relating to their capped defined benefit income stream.

Therefore a capped defined benefit income stream cannot of itself result in an excess transfer balance. Where an individual holds both a capped defined benefit income stream with a special value that is greater than the transfer balance cap and also has a non-capped defined benefit income stream (eg an account based pension), the excess transfer balance will be limited to the transfer cap credit associated with the non-capped defined benefit income stream.

Example

Lara has a defined benefit income stream with a special value of $1.7 million and account based pension valued at $300,000 at 1 July 2017. Lara’s transfer balance account has a balance of $2.0 million and has an excess transfer balance of $400,000. Where Lara commutes her account based pension in full ($300,000), the remaining excess amount will be $100,000. As there are no remaining commutable income streams the excess of $100,000 is disregarded.


Draft regulations have been released which will allow for the commutation of certain defined benefit incomes streams where the individual has, or expects to have, an excess transfer balance. The amount that can be commuted is limited to the excess transfer balance amount or the expected excess transfer balance amount. Despite the proposal to allow commutations from a defined benefit income stream, there does not appear to be a requirement that would force the individual to commute their defined benefit income stream. Where the income stream provider receives a commutation request from the Australian Tax Office (ATO), the law states that the income stream provider may choose not to comply with the commutation request. In such a case, the income stream provider must notify the ATO of that choice.

Therefore it will be important to firstly know whether the income stream provider allows for the commutation of capped defined benefit income streams and secondly whether they will comply with a commutation authority from the ATO or make a choice not to comply with this request. When deciding which income stream to commute it will also be important to consider factors such as the Centrelink implications, access to capital, pension reserves (for defined benefit pensions within a self-managed superannuation fund) and estate planning outcomes.


Commutations and the transfer balance cap

A commutation from a defined benefit income stream will reduce (ie debit) the amount counting towards the individual’s transfer balance account and therefore reduce the amount counting towards their transfer balance cap.

Common scenarios involving the commutation of defined benefit income streams include where:

  • a TAP is transferred from one provider to another
  • an SMSF is wound up and the defined benefit income stream balance is transferred to a retail TAP
  • an SMSF lifetime or life expectancy pension fails to meet the high probability test requirement and is commuted to start an allowable income stream.

Where the income stream is commuted in full, the value of the debit will be equal to the value of the credit initially recorded in the individual’s transfer balance account for that pension, meaning no transfer balance will remain for the purpose of that defined benefit income stream.

Where there is a partial commutation, the debit will represent a proportion of the original special value recorded in the transfer balance account. The value of the debit is calculated as follows:

OC x (1 -
SV after commutation SV before commutation
)

 

Where:

OC

= Original credit

SV after commutation

= Special value just after partial commutation

SV before commutation

= Special value just before partial commutation


The proportionate nature of the formula is aimed at reducing the value counting towards the transfer balance cap to nil where the defined benefit income stream is fully commuted by way of partial commutations.


Death benefits and the pension transfer balance

A capped defined benefit income stream received as a result of death will count towards the beneficiary’s transfer balance cap. The timing of the credit to the transfer balance account for the beneficiary varies depending on whether they receive the pension as a reversionary beneficiary or not.

Where the recipient is a reversionary beneficiary and the deceased dies on or after 1 July 2017, the credit to the recipient’s transfer balance account will occur 12 months from the date the member passed away. Where the deceased passed away prior to 1 July 2017 and the pension reverts prior to 1 July 2017, the credit will arise in the beneficiary’s transfer balance account at 1 July 2017.

The amount that is credited to the reversionary beneficiary’s transfer balance account is calculated in the same way as if they were commencing the pension. For example, in 2017/18 Gwen became the reversionary beneficiary of a lifetime pension with the first fortnightly payment being $1,400. As this is a lifetime pension, the special value will be calculated as the annual entitlement multiplied by 16. The annual entitlement will be $36,500 (ie $1,400 / 14 x 365) and the special value will be $584,000.


Defined benefit pensions and income tax

New rules apply to the taxation of defined benefit income streams where the amount of income received exceeds a new limit, called the defined benefit income cap. The defined benefit income cap for 2017/18 is $100,000. The defined benefit income cap is calculated by dividing the general transfer balance cap by 16 and will increase when the general transfer balance cap increases due to indexation. As the defined benefit income cap is based on the general transfer balance cap and not the individual’s personal transfer balance cap, the individual will benefit from the full indexation even if they have used part or all of their transfer balance cap.

Defined benefit income stream payments count towards the defined benefit income cap where either:

  1. the individual is over 60 at the time of payment, or
  2. the individual is under 60 and they are the recipient of a death benefit defined benefit income stream where the deceased was 60 or over at the time of death.

Defined benefit income stream payments from both taxed and untaxed sources count towards the defined benefit income cap however the tax treatment is different depending on the source of the pension.

Where an individual has defined benefit pension income from both taxed and untaxed superannuation funds, the income from the taxed source will count towards the defined benefit income cap first, with the income from the untaxed source added second.

The table below compares the existing tax treatment to that commencing from 2017/18.

Type of schemePre 2017/18 treatmentTreatment from 2017/18
Income up to $100,000 capIncome above cap
Taxed (including tax free component) All tax free Income up to $100,000 cap - Tax free Income above cap - 50% included in assessable income
Untaxed scheme Assessable, 10% tax offset on element untaxed Income up to $100,000 cap - Assessable, 10% tax offset on element untaxed Income above cap - Assessable, no 10% tax offset

Example

Evan is 64 and in receipt of defined benefit pension payments of $110,000 per annum from a taxed source and $40,000 per annum from an untaxed source. The $110,000 counts towards the cap first with the $40,000 from the untaxed source being added on top. In relation to the income from the taxed source, $10,000 exceeds the defined benefit income cap and so 50 per cent or $5,000 is added to Evan’s assessable income. As Evan has already exceeded his defined benefit income cap from the taxed source, the whole of the untaxed source income of $40,000 is in excess of the defined benefit income cap. As such Evan loses the 10 per cent tax offset on the $40,000, meaning his tax offsets reduce by $4,000.


The defined benefit income cap is reduced in the following circumstances:

  1. the capped defined benefit income stream commences part way through a year
  2. the recipient of the capped defined benefit income stream turns 60 part way through the year (also applies to death benefit capped defined benefit income streams where the deceased wasn’t 60 or over at the time of death).

Returning to Evan, if he is 59 at 1 July 2017 and turns 60 on 12 September 2017 he will be 60 for 80 per cent of the year and as such his defined benefit income cap will be $80,000 (ie 80 per cent of $100,000). The formula for this calculation is as follows:

GTBC 16
x
(1 + Days remaining) Number of days

 

Where:

GTBC

= The general transfer balance cap for the financial year

Days remaining

= Number of days remaining in the financial year after that day

Number of days

= Number of days in the financial year

 

The reference to ‘that day’ is the reference to the date they turn 60.


In applying the formula to Evan:

=
$1,600,000 16
x
(1 + 291) 365

= $80,000


Conclusion

It is important that financial services professionals understand the treatment of capped defined benefit income streams under the new laws and consider the impact that these pensions may have on their clients’ overall retirement plan. Where a defined benefit income stream results in a client exceeding the new transfer balance cap, any other non-defined benefit income streams (eg account based pensions) the client has may need to be commuted to avoid excess transfer balance tax.

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