Market linked pensions and transfer balance cap provisions
Where a market linked pension (‘MLP’) is being paid just before 1 July 2017, the MLP will fall within the definition of a capped defined benefit income stream for the purposes of the transfer balance cap provisions.
Importantly, the total balance of an MLP commenced just before 1 July 2017 can be retained within the retirement phase under the superannuation reforms, despite the current transfer balance cap of $1.6 million that operates in respect of account-based pensions etc. Thus, an MLP will not give rise to an excess transfer balance despite the market linked pension balance counting towards the transfer balance cap and exceeding $1.6 million.
This article considers when it may (or may not) be beneficial to commute an MLP from 1 July 2017.
Benefits of commuting a market linked pension
For the purposes of the transfer balance cap, the special value of an MLP is determined by multiplying the annual entitlement (first payment divided by the number of days in the first payment period multiplied by 365) by the number of years remaining on the term of the pension (as rounded up to a full year).
Generally, this special value for transfer balance cap purposes artificially inflates the actual value of an MLP that is a capped defined benefit income stream.
Therefore, unless the actual value of the market linked pension exceeds $1.6 million, such that a member receives the benefit of a higher amount being retained in retirement phase and the corresponding tax benefit, the member is likely to be disadvantaged from a transfer balance cap perspective in that they can effectively retain less than $1.6 million in retirement phase.
Where fund members are receiving an MLP with an actual value of less than $1.6 million, a strategy to address this disparity may be to commute the pension from 1 July 2017.
As an MLP falls within the definition of a capped defined benefit income stream for tax purposes if it was in retirement phase just before 1 July 2017, an MLP commenced on or after 1 July 2017 is outside the definition of a capped defined benefit income stream and accordingly, the ordinary transfer balance cap provisions would apply. In this scenario, the value of the market linked pension for transfer balance cap purposes would be its ordinary value.
There may be situations, however, where it would be preferable to continue to receive an MLP that satisfies the definition of a capped defined benefit income stream, despite the special value artificially inflating the value of the pension for transfer balance cap purposes and thus, reducing the actual amount that can effectively be retained within retirement phase to in effect less than $1.6 million.
Disadvantages of commuting a market linked pension
Where an MLP is automatically reversionary, on the death of the member, the reversionary beneficiary will receive as ongoing pension payments the remaining balance of the deceased member’s market linked pension.
Assuming the fund deed permits the payment of a reversionary pension, the reversionary beneficiary will have 12 months from the date of death to restructure their superannuation benefits to avoid an excess transfer balance. Thus, any death benefits the reversionary beneficiary receives as a pension will count towards the reversionary beneficiary’s transfer balance cap.
However, to the extent the reversionary beneficiary receives an MLP that satisfies the definition of a capped defined benefit income stream, and the pension has not ceased for any reason, the market linked pension will not result in the reversionary beneficiary exceeding their transfer balance cap. This is the case even if the market linked pension exceeds the $1.6 million transfer balance cap, as the modified transfer balance cap provisions outlined above will continue to apply to the reversionary beneficiary. The market linked pension, however, will count towards the reversionary beneficiary’s transfer balance cap.
Thus, where the reversionary beneficiary is also receiving an account-based pension, or an MLP that does not satisfy the definition of a capped defined benefit income stream, and their existing pension and the death benefit pension together exceed their personal transfer balance cap, excess transfer balance tax could apply. In this scenario, the reversionary beneficiary could elect to commute their existing pension (to the extent permitted under superannuation law, the fund deed and the pension documents) and roll the commuted amount back to accumulation phase (and retain those benefits in superannuation).
Importantly, the reversionary beneficiary cannot commute and roll their existing market linked pension back to accumulation phase. Further, any commuted amount from their existing market linked pension cannot be paid as a lump sum benefit.
Where the reversionary beneficiary’s transfer balance cap is effectively exhausted by reversionary pensions that are capped defined benefit income streams, any additional death benefits received will need to be cashed to the reversionary beneficiary in the form of a lump sum payment, such that the amount cannot be rolled into accumulation phase and retained within superannuation.
Just before 1 July 2017, Don (age 80) and Rosie (age 70) are both receiving market linked pensions with actual values of $3 million and $1 million respectively. Each pension is automatically reversionary to the member’s spouse. Further, the term of Don’s market linked pension has been calculated based on Rosie’s age.
As Don’s market linked pension is well above his $1.6 million transfer balance cap, Don elects to continue to receive his existing market linked pension without modification.
As the value of Rosie’s market linked pension is less than $1.6 million, Rosie could consider commuting her market linked pension and commencing a new market linked pension from 1 July 2017. This strategy will ensure her market linked pension has an actual market value rather than a special value for transfer balance cap purposes.
The rationale for this approach is that the special value formula may artificially inflate the value of her market linked pension, thereby effectively reducing the amount Rosie can retain in the retirement phase, such that she does not get the benefit of the full $1.6 million transfer balance cap.
Further, as her market linked pension would no longer satisfy the definition of a capped defined benefit income stream, any pension payments received would continue to be tax free under the ordinary rules that apply to pension payments from taxed element benefits once the member reaches age 60.
As Rosie’s market linked pension would no longer satisfy the definition of a capped defined benefit income stream, however, if she receives Don’s market linked pension on his death as reversionary beneficiary, Rosie would exceed her transfer balance cap and would not be able to commute her market linked pension, thereby incurring excess transfer balance tax in respect of her market linked pension.
Similarly, if Don received Rosie’s market linked pension (commenced on or after 1 July 2017) as reversionary beneficiary on her death, he would be required to commute the market linked pension within 12 months and pay out the benefit as a lump sum. Importantly, the commuted amount would not be able to be retained within superannuation without Don exceeding his transfer balance cap.
Therefore, Rosie may wish to consider retaining her existing market linked pension and ensuring it continues to satisfy the definition of a capped defined benefit income stream.
Before any steps are taken to commute an existing market linked pension and commence a new market linked pension, we strongly recommend legal advice is obtained on whether the existing market linked pension can be commuted under the governing rules of the fund and the relevant pension documentation, as well as the requirements that must be satisfied under superannuation law.
It is also critical that the terms of any new market linked pension commenced strictly complies with the pension standards under superannuation law and the terms of the fund’s governing rules.
Please let us know if you would like to speak to a lawyer in our team experienced in advising on, and documenting the commutation and commencement of market linked pensions.
We also recommend actuarial advice is obtained before commuting an existing MLP.
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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.