Automatic pension reversion: still worthwhile?

Introduction

In recent times we have seen significant changes to the rules surrounding pensions. At last, these rules appear to be reasonably settled with the finalisation of TR 2011/D3 (in the form of TR 2013/5 and SMSFD 2013/2) and the expanded income tax regulations (refer to regs 307-125.02 and 995-1.01 of the Income Tax Assessment Regulations 1997 (Cth) (‘ITAR’)).

The new pension rules differ quite significantly to what the industry thought they would look like. It follows that strategies that were developed and implemented while the new rules were being finalised may no longer be appropriate. Now is an excellent time to review each client’s pension strategy to make sure it achieves the best outcome for each client bearing in mind their particular circumstances and is appropriately documented especially in view of their estate plans.

This article focuses on automatically reversionary pensions (‘ARPs’) and examines their appropriateness in the wake of the new rules. The bottom line is that ARPs are not necessary for everyone but do have a strategic role to play. Unless you are aware of the distinctions, you and your clients may miss out on strategic advantages!

Reasons against an ARP

Pension exemption continues regardless

Previously, one main reason behind the reversion of pensions was to ensure that the pension exemption continued past death. This may no longer be relevant.

More particularly, the new income tax regulations extend the pension exemption (assuming the pension does not automatically revert upon death) until it is practicable to pay out a deceased pensioner’s benefits. Therefore, an ARP is not necessarily needed to protect the tax free status of pension assets post death.

The explanatory statement provides some insights into what constitutes ‘as soon as practicable’. The examples given indicate that ‘as soon as practicable’ is somewhere between 92 and 169 days (averaging out to 3.8 months).

This is not to say that an SMSF that takes longer than 169 days to commence to pay benefits will miss out on the extension of the pension exemption. However, if an SMSF does take longer than say six months, the ATO may closely check whether the pension exemption has been stretched too far.

No risk of interests mixing

Once a pension ceases, it typically rolls back into accumulation. This can result in the unwanted merging of the tax free and taxable components of the interests. Naturally, an ARP does not cease when the pensioner dies. Therefore, ARPs were previously used as a tool to ensure a member’s pension and accumulation interests remained separate upon death.

Moving forward, however, this is not necessarily required. The new tax regulations provide that a pensioner’s interest will retain the proportions of the tax free and taxable components as at the time of the pensioner’s death even if the pension is not an ARP.

There is one proviso to the above: where insurance proceeds or an anti-detriment increase are paid into the pension interest following the member’s death. Such payments will typically form part of the taxable component (discussed further below).

Payment of in kind death benefits

Generally, a pension cannot be paid in kind. However, the pension exemption can now apply to a lump sum.

The starting position is that a lump sum death benefit can be paid in kind and ‘lump sum’ is expressly defined in the Superannuation Industry (Supervision) Regulations 1994 (Cth) (‘SISR’) to include ‘an asset’ (SISR reg 6.01(2)). There is no corresponding definition in respect of pensions and the ATO has taken the view that a pension cannot be paid in kind (see SMSFR 2008/2 [73]). The new income tax regulations and TR 2013/5 have provided some flexibility on this point, however.

TR 2013/5 expressly states that a pension (that is not an ARP) immediately ceases upon the pensioner’s death ([29]). It follows that any associated death benefit is a lump sum payment and not a pension payment. Indeed, the new tax regulations treat the lump sum payment as a pension payment merely for the purposes of the fund claiming the pension exemption up to the time of that lump sum payment. More particularly, the new tax regulations provide that (ITAR 1997 reg 995 1.01):

the amount paid as the superannuation lump sum, … is taken to be the amount of a payment from a [pension]… [Emphasis added]

It follows that it is possible for a lump sum payment to be made following the death of a pensioner without the pension exemption ceasing and therefore without giving rise to a CGT-related liability at the SMSF level (subject to the proposed $100,000 cap on the pension exemption).

This is not possible, however, in the case of an ARP since the pension continues after death and the above regulation does not apply.

Eligibility for the age pension

A social security reason also exists that may make ARPs (or, indeed, any form of pension reversion) unattractive.

By way of background, a member’s eligibility for the Centrelink (or social security) age pension ultimately depends on the application of both the ‘income test’ and the ‘asset test’. The test that results in a lower Centrelink pension payment applies so that the lower amount, if any, is paid.

Generally, when a member commences an account style pensions (eg, transition to retirement income stream or account-based pension), the full amount received from that pension is fully assessed against Centrelink’s income test apart from the ‘deductible amount’ (which uses a formula to reduce the assessable amount).

This deductible amount is calculated by dividing the capital used to originally fund the pension by the person’s life expectancy (or any longer life expectancy of their spouse if the pension is reversionary to their spouse). The longer the life expectancy, the smaller the deductible amount. Therefore, where a member is in receipt of a reversionary pension from someone with a greater life expectancy than them, it could impact on the member’s eligibility for the age pension.

Thus, making a pension revert upon death may have an adverse social security impact.

(For completeness, note the Labor Government announced on 5 April 2013 a change to the policy that is proposed to apply the deemed rate of return test on pension assets that commence after 1 January 2015.)

Reasons for an ARP

Maximisation of the tax free component upon receipt of an insurance payout

Where the SMSF is likely to receive a significant insurance payout upon a member’s death (and the associated insurance premiums were paid from the member’s pension interest) an ARP is likely to be worthwhile. This is especially the case where the member’s interest has a high tax free component.

The reason for this is that a pension that does not automatically revert is taken to cease upon death and, under the new income tax regulations (ie, ITAR reg 307-125.02), insurance is not included when the tax free and taxable components of the death benefit are being calculated. Thus, insurance proceeds will broadly form part of the taxable component upon the death of a pensioner (in the same way as earnings are normally treated when generated whilst an SMSF is in accumulation mode).

A different outcome occurs where the member’s pension automatically reverts to a beneficiary (and therefore does not cease upon death). In this case, the insurance proceeds will take on the proportions of the pension interest as at the date of the pension’s commencement.

To illustrate this point consider Joanne. Joanne has a $500,000 pension interest in her SMSF comprised entirely (ie, 100%) of the tax free component. She also has a $250,000 accumulation interest in her SMSF comprised entirely (ie, 100%) of the taxable component. The trustee of Joanne’s SMSF holds a $500,000 life insurance policy in respect of Joanne and each year the associated premiums are paid from Joanne’s pension interest. Joanne’s pension does not automatically revert upon death. On 1 October 2013, Joanne passes away.

The practical implications of the above are as follows. In accordance with the views expressed in TR 2013/5, Joanne’s pension immediately ceases. Under the new pension rules, for all intents and purposes Joanne’s accumulation ($250,000) and pension interests ($1,000,000) remain separate and the tax free and taxable components do not merge. Further, the pension exemption continues until it is practicable to pay out Joanne’s death benefit.

There is one negative, however. The pension is treated as having ceased at the time the insurance proceeds are paid into the SMSF. Therefore, they form part of the taxable component in the same way that they would have, had they been paid into an accumulation interest. As a result, the 100% tax free status of Joanne’s pension interest is now diluted to 50% (ie, $500,000 tax free and $500,000 taxable arising from the insurance proceeds).

Now consider the same facts as above except that, this time, the pension automatically reverted upon death. Similarly to the above, in this case Joanne’s accumulation and pension interests remain separate and the tax free and taxable components do not merge. Further, the pension exemption continues (although this time, indefinitely). However, there is one major difference: the pension has not ceased and therefore the insurance proceeds will take on the proportion of the tax free and taxable components of the pension interest as at the date of the pension’s commencement.

For Joanne, this means that the insurance proceeds will be comprised entirely of the tax free component. That is, the full $1,000,000 is tax free due to her pension being an ARP. Naturally, careful attention to having the appropriate documentation (including the SMSF deed, pension documents, product disclosure statements (‘PDS’) and death benefit nominations) is required to achieve this outcome, as discussed further below.

While insurance within an ARP pension strategy that is appropriately documented can result in a sound strategic outcome, there probably are not a lot of clients who would satisfy the required criteria. In particular, a 2008 report indicated that less than 13% of SMSFs claim insurance premiums. Moreover, as people get beyond their 50s, they often cease their insurance for numerous reasons. However, given the strategic advantages that can now be gained from having insurance in a pension fund, this may prompt advisers and clients to reconsider their insurance needs especially now that insurance must be regularly considered in each SMSF’s investment strategy.

Is it necessary to rectify the situation?

The release of TR 2011/D3 caused an increase in the number of advisers seeking to ensure that the pensions of their respective clients automatically reverted upon death. At the time, this was typically a sensible action to take, as it prevented the merging of different interests (thus, preventing the dilution of the tax free component) and also ensured that the pension exemption continued. However, the recent pension changes allay these concerns.

Today, an ARP may not be the best strategy in all cases and does not necessarily give rise to the most tax efficient outcome. Therefore, advisers need to review each and every one of their client’s pension and related strategies to ensure they remain appropriate. The following example highlights this point.

Consider Paul and Nicole. Paul and Nicole are spouses and both 62 years old. They are the members of the P&N Super Fund (‘Fund’). Paul and Nicole are both receiving pensions from the Fund. The characteristics of these pensions are as follows:

As a result of the release of TR 2011/D3, both Pension P and Pension N were made ‘automatically reversionary’. More particularly, the rules of the pensions state that upon Paul’s death, Pension P automatically reverts to Nicole and, similarly, upon Nicole’s death, Pension N automatically reverts to Paul.

Nicole has been battling a serious disease and passes away. Upon her passing, Pension N automatically reverts to Paul. Paul, being Nicole’s spouse, is a tax dependant and Paul therefore receives her death benefit tax free. Paul’s member benefits in the Fund can now be depicted as follows:

Paul is struck by grief by the passing of his wife and soon afterwards he passes away too. His death benefit is paid directly to his independent, adult daughter, Kylie. This payment gives rise to a $67,650¹ tax liability in Kylie’s hands.

Now consider the implications if Pension N had not automatically reverted. In this case Paul would have had the opportunity to receive Nicole’s death benefit as a lump sum payment outside of super. Assuming this occurred, Paul would still have received Nicole’s death benefit tax free. However, he would then have the opportunity to recontribute the $300,000 into super (subject to the contribution caps) and commence a new pension. Paul’s interests in the Fund would then look like:

This time, upon Paul’s death, Kylie pays a total of $33,000². This is a tax saving of $34,650.

¹ ($200,000 x 16.5% = $33,000) + ($210,000 x 16.5% = $34,650)
² $200,000 x 16.5%

Making pensions reversionary ‘mid-stream’

It is possible to revert existing account style pensions (eg, transition to retirement income streams or account-based pensions) mid-stream. Similarly, it is possible to make existing account style pensions that are reversionary, non-reversionary mid-stream. Naturally, this is subject to the wording in the specific documents (eg, the pension documents and the terms of the SMSF deed). (Expert advice should be obtained however before varying a defined benefit pension.)

In the March 2013 NTLG Superannuation Sub-Committee minutes, the ATO was expressly asked whether an account style pension can be made reversionary mid-stream. The ATO confirmed this position, subject to proper documentation.

SMSF documentation is key to your strategy

As discussed in several areas above, the key to getting the above strategies right is having appropriate documentation in place. Indeed, many document suppliers have not kept up to pace with the recent raft of reforms impacting on pension strategies. Now more than ever a strategic SMSF deed with appropriate pension documentation and any binding death benefit nomination must have regard to these documents so there is no inconsistency.

Many SMSF deeds, for instance, do not provide the power for the trustee’s discretion to be fettered (or limited). Thus, most reversionary pension nominations are at best a mere wish.

The ATO require that a reversionary nomination must be ‘locked in’ from a legal perspective as discussed in paragraph 125 of TR 2013/5 where a reversionary nomination is not left to any discretion. Further, the pension documents should also state that the reversionary nomination is either non-reversionary, a discretionary reversionary nomination (as a non-ARP) or is a ‘locked in’ reversionary nomination to provide an ARP. The right choice depends on which strategy is chosen for your client depending on their circumstances (there are real dangers for a one size fits all approach).

Also, the relevant PDS for both the SMSF and pension should clearly communicate these options to ensure members are armed with sufficient information to make an informed judgment. As you can appreciate, advisers have some work on their hands to ensure these points are appropriately covered with each client and they are not going to be liable for lost opportunities, damages claims, etc.

Conclusion

There is no doubt that the recent pension changes have removed much of the impetus to ensure pensions automatically revert upon death. However, there is one key circumstance where an ARP may still be ideal, and that is broadly where a large insurance payout will be received upon death.

Moving forward advisers need to take proactive steps to ensure each client’s pension and related strategies remain appropriate.

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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.