Pension Reserve Reform (Part 3)

Pension Reserve Reform deals with the treatment of amounts (called “surplus amounts” or (released) “pension reserves”) which are no longer required to support the payment of a legacy pension because the pension has ceased (whether due to the death of the pensioner or because the pension has been commuted (under the proposed commutation reforms).

When a legacy pension ceases due to the death of the member (assuming the pension is not reversionary) the amount previously supporting the pension (“the surplus amount”) is now available to the trustee and can be allocated by the trustee to member accounts.

When a legacy pension is commuted under the proposed changes, the member will be entitled to receive the commutation amount (which will be an actuarially determined amount) which will, in general, be less than the amount which was previously supporting the pension. This surplus amount will now be available to the trustee and can be allocated by the trustee to member accounts.

The pension reserve reforms will apply to lifetime, life expectancy pensions and, also flexi-pensions. Flexi-pensions are lifetime pensions which can be commuted. However, the maximum commutation value is limited by the SIS Regulations. The pension commutation reforms do not apply to flexi-pensions as they are currently already commutable. The commutation of flexi-pensions will generally give rise to a surplus amount (as the commutation amount is generally less than the pension account balance) which is then “trapped” within the fund.

The surplus amount being “trapped” in the fund in the sense that the surplus amount is not, under current rules, readily or easily allocated to the members without incurring significant tax liabilities.

The issue of “trapped” reserves does not arise in respect of market linked pensions. These pensions are account style pensions. They are payable for a fixed period of years albeit the fixed period is related to the life expectancy of the member or, if the pension is reversionary, possibly the life expectancy of the reversionary beneficiary.

Market linked pensions terminate either by account-exhaustion, death of the recipient or expiration of the specified term. In the first situation, the account-balance of the pension has declined to zero. In the two other situations, there could be a balance remaining. The current rules applying to market linked pensions requires the balance of the pension account to be paid out within 28 days and that payment is treated as a death benefit of the deceased pensioner.

Current treatment of surplus amounts

On the commutation of a lifetime, life expectancy or a flexi-pension by the member receiving the pension – the portion of the fund previously supporting that pension which is in excess of the commutation value of the pension, is no longer be required for that purpose and will become a “surplus amount” in respect of that member.

The surplus pension amount is not automatically part of the member benefit. The trustee may allocate a surplus amount to that member (or even another member) of the fund. Once the allocation is made, the allocated amount will then become part of the member account of the member. However, this allocation will generally be treated as a concessional contribution of the member to whom the allocation has been made and consequently, the fund will incur a 15% tax liability on the allocated amount.

Additionally, the allocation will reduce the amount of the member’s concessional contribution cap in the income year in which the allocation is made.

However, this treatment is subject to two exceptions: the “replacement pension exception” and the “fair and reasonable exception”.

Replacement pension exception

The first exception is that the allocated amount is immediately applied as the initial pension balance of a market linked pension for that member, then the allocated amount is not treated as a concessional contribution of the member. In this way a lifetime or life expectancy pension can be commuted and the commutation value applied as the purchase price of a market linked pension. While SMSFs cannot issue a new market linked pension after 20 September 2007, an exception applies where the initial pension balance of the market linked pension is derived from the commutation value of a lifetime or life expectancy pension.

Fair and reasonable exception

The second exception is that if the surplus amount is allocated to all members of the fund on a fair and reasonable basis (that is, for every member in proportion to their then account balance in the fund) and the total amount allocated to each member in an income year does not exceed 5% of the member's account balance. If the 5% cap is breached, then the entire allocation will be treated as a concessional contribution rather than merely the excess above 5% and a tax liability of 15% will be incurred by the fund.

Proposed treatment of surplus amounts

Under the proposed treatment, allocations to member accounts from surplus amounts will be treated as non-concessional contributions of the relevant members. Consequently, a much higher contributions cap will apply ($120,000 v $30,000) and the allocated amount will not be subject to 15% tax (as non-concessional contributions are assessable contributions).

Also, the two exceptions – the “replacement pension” exception and the “fair and reasonable” exception – still apply, with the “replacement pension” exception being far less stringent in its application.

Additionally, a new exception has been introduced which deals with the situation where a non-reversionary legacy pension (including flexi-pensions) has ceased by reason of the death of the pensioner and the amount is allocated to a member account of a member who is a dependant of the deceased pensioner.

“Replacement Pension” Exception

This exception will now apply with the following two beneficial changes. First, the entire amount of the surplus amount can be allocated the relevant member’s account (previously only the commutation value of the pension could be allocated). Secondly, the allocated amount need not be used as the initial balance of a replacement pension in the form of a market linked pension.

The allocated amount could remain in accumulation phase, be cashed out (tax free as the member has most likely already attained age 60) or be used to commence an account-based pension (subject to transfer balance cap space).

“Fair and reasonable” exception

This exception continues to apply on the same terms as before – ie allocation to all members in proportion to their member account balances and the allocation must be less than 5% of the relevant members’ account balance.

However, now the allocation will now be treated as a non-concessional contribution rather than a concessional contribution.

“Death benefit” exemption

The new exception applies where the lifetime, life expectancy or flexi-pension has been commuted by reason of the death of the member to whom the pension was paid and the surplus amount is allocated to one or more member accounts of the dependants of the deceased member and then that allocated amount is paid out as a superannuation death benefit which is in the form of a superannuation lump sum.

The result of the new exception is that the surplus amount is allocated to a dependant of the deceased member, the allocated amount will not be counted as a non-concessional contribution. The allocated amount must then be paid out as a lump sum death benefit which will be tax free if the member is a death benefits dependant of the deceased but taxable at 15% if the member is a non-death benefits dependant of the deceased member.

There is no requirement for this exception to apply on a “fair and reasonable” basis. Consequently, the trustee could choose to allocate the surplus pension amount to one or more of the dependants of the deceased member to the exclusion of the other or others not chosen. Further, there is no requirement that the allocation must be equal in amount.

For the purposes of this exception, the executor/legal personal representative of the estate of the deceased member is not a dependant of the deceased member.

Key Points of Reserve Pension Reform

• The reserve pension reforms are not subject to a 5-year window.

• The reserve pension reforms apply to legacy pensions which ceased before the commencement of the 5 year commutation window, during that window within the 5-year commutation window period or after the end of the 5-year commutation window period.

• The reserve pension reforms apply to flexi-pensions.

• The reserve pension reforms do not apply to market linked pensions (as these pensions do not have a pension reserve supporting them).

• The pension reserve reforms apply to legacy pensions which have previously terminated by way of death of the member or expiration of the payment period before the start of the reforms – so long as part of the pension surplus amount remains in the fund.

• The regulations simplify and improve the tax treatment of allocations of surplus amounts as follows:

• allocations from surplus amounts arising from the commutation of lifetime or life expectancy pension – allocations to the pension recipient – neither counted as a concessional nor as a non-concessional contribution of the pension recipient

• allocations from surplus amounts arising from the commutation of lifetime or life expectancy pension – allocations to another member (that is not the pension recipient) neither counted as a concessional or non-concessional contribution so long as allocation satisfies the “fair and reasonable/5% rule”

• allocations from non-pension reserves – neither counted as a concessional or non-concessional contribution so long as the allocation satisfies the “fair and reasonable/5% rule.