We have previously considered the effect of the new pension transfer cap on account based pensions and TRISs (whilst retaining their pension categorisation, TRISs will not count against the pension transfer cap from 1 July 2017), other pensions such as defined benefit pensions and Market Linked Income Streams have to be also considered in the context of the pension cap. Regrettably MLISs, while based on the market value of the underlying assets have been grouped together with true defined benefit pensions (life expectancy and lifetime pensions) on the basis that these pension types are non-commutable (or only so in very limited circumstances).
Interestingly, flexi pensions which are true defined benefit pensions have been separated from the above group on the basis that these pensions can be commuted. The non-commutable pension grouping of lifetime, life expectancy and MLISs present an interesting challenge to the pension cap rules in respect of valuations and the capacity to roll back to the accumulation phase.
As we have noted, the definition of a defined benefit income stream for the purposes of the new law is broader than what is commonly understood to be a defined benefit income stream and specifically includes:
- lifetime pensions commenced at any time;
- lifetime annuities in place just before 1 July 2017;
- market linked pensions and annuities (also referred to as taps – term allocated pensions) and RSA market linked pensions in place just before 1 July 2017; and
- life expectancy pensions and annuities in place just before 1 July 2017.
From the above listing, certain of these income streams such as MLISs 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 and are not considered to be capped defined benefit income streams. As a number of these pension income streams may be reversionary, any reversion of the income stream is considered to be a continuation of the original income stream in the hands of a beneficiary and therefore the start date for the reversionary pension will be based on the original start date for the deceased member rather than the date of reversion.
These pensions are subject to special rules to give effect to the constraints imposed on account based pensions and the pension transfer cap. The effect of the special rules is to give rise to a valuation methodology (particularly in cases in which there is no ascribable account balance) which will determine whether other existing account based pensions for an individual may need to be commuted in part or in full if the valuation of all of an individual’s pensions exceed the $1.6 million cap and also whether additional income tax may need to be paid on defined benefit pension income.
Interestingly, the Treasury Laws Amendment (Fair and Sustainable Superannuation) Regulations 2017 was released in draft form and has yet to be promulgated with submissions only due by 10 February 2017 and, if passed into the body of legislative instruments appear to offer the capacity to commute a non-commutable pension if the governing rules for the fund permit such commutation. The regulations provide for a possible commutation of the greater amount of the individuals access transfer balance or the “crystallised reduction amount” stated in the excess transfer balance determination issued by the Commissioner. These two amounts will generally be the same but could be different if the individual had already taken action to have a superannuation income stream commuted or the individual had commenced an additional income stream. Of course, in many cases such a commutation may not be able to be effected as it would contravene the governing rules of the fund. Importantly, in many cases it may also not be in the best interests of the individual to effect of the commutation.
The Tax Act describes these special pensions as “capped defined benefit superannuation income streams”. The definition excludes flexi pensions (those pensions commenced in accordance with Reg 1.06(6) of the Superannuation Industry (Supervision) Regulations 1994) which are commutable. Whilst these flexi pensions are able to be commuted, there can be significant disadvantages and complexities in effecting the commutation. These flexi pensions will be treated in exactly the same manner as account based pensions – if a flexi pension causes an individual to exceed the pension cap, it may be necessary to commute the pension.
In many cases such as Government or corporate defined benefit schemes, there may well be no attributable member account or balance, rather a contract or promise to provide a series of income stream payments over a specified period. To arrive at a valuation for such income streams the methodology requires one to consider the concept of the “annual entitlement”. The annual entitlement is based on the first payment made in the 2017/18 income year and is effectively extrapolated to an annual amount. For example, if an individual receives the fortnightly payment of $2,500 as the first payment in 2017/18, the annual entitlement would be calculated at $2,500/14 × 365 = $65,178. In respect to this methodology, we should expect further ATO guidance, particularly considering the capacity to manipulate the first payment in certain income streams in the first income year.
Valuation of lifetime pensions
The formula for the valuation of these pensions is quite simple as the annual entitlement is merely multiplied by a factor of 16. Unlike the factors contained in Sch 1B of the Superannuation Industry (Supervision) Regulations 1994 (“SISR”) utilised for the RBL valuations which took into account the age of the pensioner at commencement of the pension, the level of indexation applied to the pension payments on an annual basis and the extent of any reversionary entitlement, the new rules merely apply the one factor regardless of any other possible valuation parameters. It is therefore conceivable that a pensioner with a lifetime pension at the age of 80 will have their pension “overvalued” for pension cap purposes than, say, a pensioner with an identical pension entitlement whose pension would be valued at age 65. Given the imposition of a single valuation factor of 16, it would appear that on the basis of mortality and morbidity tables, an actuary may take a contrary view as to the appropriate valuation multiple and value the pension entitlements using a lower valuation multiple.
Valuation of fixed term pensions (life expectancy and MLISs)
These pensions have a different valuation methodology applied and are valued on the basis of the annual entitlement (refer above) and the number of years remaining in the term (rounded up to the nearest whole number). Therefore, if a MLIS commenced in January 2008 with a term of 35 years, at 30 June 2017, the MLIS will be valued utilising the remaining term of 25.5 years rounded up to 26 years. For payment purposes, if the balance of the MLIS is, say, $1 million at 30 June 2017, the remaining term of the MLIS would be rounded up (according to Sch 6 Clause 5 of SISR) to determine the payment factor of 16.89 implying an annual payment of $59,210 (payments are rounded to the nearest $10 and for the moment we will ignore the capacity to adjust payments by plus or minus 10% as per Clause 8). This then equates to a special value of $1,539,460 – the annual entitlement of $59,210 multiplied by the remaining term of 26 years – an amount considerably in excess of the asset value of $1 million. Our analysis shows that in all remaining terms from 35 years to 2 years (the final year has a pension factor of one), each calculation results in an excess valuation for cap purposes over the actual asset value of the MLIS. In some cases this excess is significant and would appear to offer an MLIS pensioner with a long remaining term a significant disadvantage for pension cap valuation purposes.
Of course, a MLIS pensioner can elect under Clause 8 of Sch 6 to take an annual amount that is 10% less than the standard payment amount or up to 10% higher than the standard payment amount. This would seem to indicate that a MLIS pensioner could elect to take an initial fortnightly payment of $2,044 on the basis of a 10% lower annual amount of $53,290 leading to a pension cap special valuation of $1,385,540, approximately 10% less than our initial special value cap calculation, notwithstanding that the pensioner may intend to take an annual total of 10% greater than the standard payment amount.
Conversely, a MLIS pensioner who may not be aware of such valuation anomalies, may elect to take an initial fortnightly pension payment of $2,498 on the basis of a 10% increase in the annual standard pension payment amount, leading to a special valuation cap counting of $1,693,380, 10% greater than the original counting (above).
Clearly, in the absence of any further guidance from either the ATO or Treasury, a MLIS pensioner should consider whether it would be appropriate to calculate carefully their initial pension payment in 2017/18 on the basis of the above and ensure that the calculations are performed utilising the lowest possible pension level to ensure a preferable special valuation cap calculation. In addition (and notwithstanding that a pensioner may not need an increase in cash flow payments from the pension) it may be worth considering whether it would be worthwhile to take the maximum level of pension payments in the current income year to ensure a lower asset balance on 30 June 2017 for valuation purposes.
Furthermore, it may be beneficial for a MLIS pensioner who will be exposed to an excess in special valuation counting to consider whether it would be appropriate to commute the current MLIS and commence a new MLIS from the commutation amount with payment and term parameters which would result in a lower special value for cap purposes. A MLIS can only be commuted to commence another MLIS or at death (subject to the provisions of the proposed Regulations (refer above)).
The special value
The special value of a capped defined benefit income stream gives rise to a separate balance referred to as a “capped defined benefit balance” and refers to the net amount of capital that an individual has transferred to their superannuation retirement phase to support capped defined benefit income streams. This balance is merely a subaccount of the individual’s transfer balance account and includes all credits and debits that relate to capped defined benefit income streams.
If an individual exceeds their pension cap because they have commenced a capped defined benefit pension, the excess is calculated as the lesser of the amount that exceeds the normal pension cap or the separate special balance that is the running total of only the individuals capped defined benefit pensions.
As an example of this counting, let’s assume that on 1 July 2017, Leslie holds a capped defined benefit pension which has a special value of $3 million and this is credited to Leslie’s transfer balance account and her capped defined benefit balance. Although Leslie has exceeded her $1.6 million transfer balance cap she does not have an excess transfer balance given that the excess is entirely attributable to her capped defined benefit income stream. Notional earnings do not accrue and Leslie is not required to reduce her retirement phase superannuation interests. Leslie however, would be subject to additional income tax rules in relation to her defined benefit income (refer below).
Further to this example, if Leslie subsequently commenced an account based pension with the commencement value of $200,000, the $200,000 would be credited to Leslie’s transfer balance account which increases in value to $3.2 million. Leslie now has an excess transfer to balance of $200,000 as the account based pension is not a capped defined benefit income stream. Leslie will therefore be required to commute the $200,000 account based pension and will be subject to excess transfer balance tax. If the commutation of the new superannuation income stream is not sufficient to fully remove the crystallised reduction amount ($200,000 plus notional earnings) any remaining excess will be written off to ensure that the notional earnings do not continue to accrue (s 294–70(1) ITAA 1997).
Debits to the individual’s transfer balance cap
A commutation from a defined benefit income stream will result in a debit counting toward the individual’s transfer balance account and thus reduce the amount counting towards their transfer balance cap. Such commutations may include circumstances in which an MLIS is transferred from one provider to another, a self-managed superannuation fund is wound up and a defined benefit income stream balance is transferred to a retail MLIS or a lifetime or life expectancy pension fails to meet the actuarial high probability test requirement in a self-managed fund and is commuted to start a permitted 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. Where there is a partial commutation (and bear in mind this may be permissible if the draft regulations that we have viewed are promulgated, subject to the governing rules of the fund), the debit will represent only a proportion of the original special value recorded in the transfer balance account.
Additional income tax rules for excess defined benefit income
As we have noted, excess capped defined benefit income streams in themselves do not cause an individual to breach their transfer balance cap. Broadly commensurate treatment is achieved by subjecting these arrangements to additional tax rules. An individual is liable to additional income tax consequences to the extent that the income from the defined benefit pension(s) exceeds a separate defined benefit income cap. Whether or not a tax liability will arise will depend on the individual’s wider circumstances for the relevant income year. Defined benefit income is taxed differently under Div 301 and Div 302 ITAA 1997 depending upon the age of the individual and whether the individual is a death benefit dependent.
The individuals defined benefit income cap for an income year is generally equal to the general transfer balance cap in the corresponding income year divided by 16. Thus, in 2017/18 we expect the income cap to be generally $100,000 ($1.6 million divided by 16). An individual’s transfer balance account is not relevant to calculating the defined benefit income cap or the amount (if any) of the individuals additional income tax liability. Only defined benefit income that is subject to concessional tax treatment will count towards the cap. In the event that an amount of defined benefit income is drawn into the individual’s assessable income, PAYG withholding obligations will apply to such payments.
An individual’s income cap will also be reduced if that individual becomes entitled to a concessional tax treatment in respect of defined benefit income during an income year or that individual is entitled to other defined benefit income that is not subject to concessional tax treatment. The defined benefit income cap is an annual cap that is reset, and may be reduced, each year.
Additional tax consequences for the individual with excess defined benefit income
As we know, superannuation income streams may be paid from a taxed or untaxed source or a combination of the two. The additional taxation consequences are different depending upon the source of the excess defined benefit income stream amount. Different rules also apply depending on whether the individual is under 60 years of age. Taxed source and tax-free component defined benefit income is considered first and applied to the defined benefit income cap before untaxed sourced income.
When the sum of the tax-free component and the taxed element of benefits that are defined benefit income and the assessable non-exempt income exceeds an individual’s defined benefit income cap, 50% of the excess is assessable to which no tax offset applies. For example, if Sarah (who has attained the age of 60) has an MLIS (which qualifies as a capped defined benefit income stream) and receives the pension payment of $150,000 and the $150,000 comprises entirely of a tax-free component and a taxable element in the current 2016/17 income year, the income is non-assessable non-exempt income. For the 2017/18 income year, the sum of the benefits (comprising the tax-free component and taxable element) exceeds her defined benefit income cap by $50,000 and she must therefore include an amount of $25,000 in her assessable income and is not entitled to a tax offset on this amount.
If an individual receives defined benefit income which contains an untaxed element of a superannuation income stream, the untaxed element is included in the assessable income of the individual and the individual is entitled to a tax offset equal to 10% of the untaxed element if they are 60 years of age or over or under 60 years of age and in receipt of a death benefit where the deceased died at 60 years of age or over. For example, Alistair is 63 and is receiving a life expectancy pension of $150,000 per annum. The pension is a capped defined benefit income stream and comprises a tax-free component of $50,000 and an untaxed element of $100,000. Alistair’s defined benefit income cap for the year is $100,000. The sum of the benefits comprising the tax-free component and the taxed element ($50,000) does not exceed the defined benefit income. From the 2017/18 income year, Alistair has no additional assessable income included under s 303-2. The $50,000 tax-free component of Alistair’s pension is non-assessable non-exempt income for the 2016/17 and later income years. For the 2016/17 income year, Alistair includes the $100,000 untaxed element of his pension in his assessable income and claims a 10% tax offset – the offset amounting to $10,000. For the 2017/18 income year, the total amount of Alistair’s defined benefit income (the sum of the tax-free component, the taxed element and the untaxed element) of $150,000 exceeds his defined benefit income cap of $100,000. Accordingly, his tax offset is reduced by $5,000 (being 10% of the $50,000 excess). He therefore receives a tax offset of $5,000.
We note that much of the information and calculations in this document rely on information provided in the draft Law Companion Guideline LCG 2017/D1 which describes how the Commissioner proposes to apply the amendments made by the Treasury Laws Amendment (Fair and Sustainable Superannuation) Act 2016. This draft document is subject to submissions which are to be received by the 17 February 2017 and consequently certain details in this document may need to change subject to any amendment of the Commissioner’s views.
It would appear from our analysis that a holder of an MLIS income stream may be significantly disadvantaged by the calculation methodology of the special value that will count towards the relevant caps. Given that our calculations suggest that there is potentially a significant difference between the asset value of a MLIS and the special value counted, it is possible that an MLIS with, say, an asset value of $1 million may have a special value approaching $1.6 million which may cause significant issues if the individual is also in receipt of an account based pension and the total of the two would exceed the pension cap. It would therefore be prudent to ensure that all such income streams are reviewed to ensure that any restructuring of the income stream can take place prior to June 30.