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Defined benefit pensions and the transfer balance cap

For retirees with a defined benefit income stream, understanding how they will be impacted under the incoming superannuation reforms is a potential minefield. This article explains some of these complexities.

What are defined benefit pensions?

Defined benefit pensions promise members a defined series of payments, typically for life. Former public servants are the most common recipients, although some companies also offered these types of schemes to their employees. SMSFs were also able to offer their members defined benefit pensions up until 2005, although there was no guarantee that these funds could meet the pension payments. The amount received by the pensioner may index each year benchmarked to a factor such as CPI and the pension may be reversionary to a spouse upon death of the primary pensioner.

The Commonwealth Superannuation Scheme (CSS) and the Public Sector Superannuation Scheme (PSS) are Australia’s two largest defined benefit pension schemes although they have been closed to new members for a number of years. At 30 June 2016, there were around 110,000 pension accounts being paid from CSS.

The benefits paid to pensioners from a public sector scheme are generally not tax free after age 60 like those paid from an account-based pension (ABP). This is because some or all of the benefit is paid from an untaxed source meaning it is paid directly by the Government and not from the member’s accumulated superannuation contributions and earnings. The untaxed component of a benefit is treated like a salary subject to tax at the pensioner’s marginal tax rate, however once a pensioner reaches age 60 they will receive a tax offset and be subject to tax at marginal tax rates less a 10% offset.

How are these lifetime pensions valued under the transfer balance cap?

From 1 July 2017 there will be a cap of $1.6 million on amounts that can be transferred into the tax free retirement phase. Defined benefit pensions must be included in the value of total retirement phase balances that count towards this cap.

For the purpose of valuing defined benefit income streams, the transfer balance cap legislation identifies specific types of annuities and pensions as ‘capped defined benefit income streams’.

Members may need to talk to their fund in order to determine whether their defined benefit pension meets this definition. Typically the definition will be met where it is a pension that is non-commutable, has no residual capital value, is paid for life, and the size of the benefit payment each year is fixed or indexed according to defined terms.

A capped defined benefit income stream that is payable for life will be assigned a ‘special value’ under the transfer balance cap equal to 16x annual entitlement. The annual entitlement is worked out by annualising the first income stream benefit payable in an income year.

For example, consider a pensioner who has a lifetime capped defined benefit income stream at 1 July 2017 which is paid monthly. Their first payment for the income year will be paid on 31 July for $10,000.

The annual entitlement for the purpose of the transfer balance cap is 12 x $10,000 = $120,000.

The special value of the income stream for the purposes of the transfer balance cap is 16 x $120,000 = $1,920,000.

To see how this special value is used, consider two pensioners John and Kyle who are both over age 60 and receiving lifetime defined benefit pensions at 1 July 2017:

  • John has a lifetime pension paying $90,000 per annum and also an ABP in a retail fund valued at $480,000 at 1 July 2017
  • Kyle has a lifetime pension paying $120,000 per annum at 1 July 2017 and no other superannuation balances

At 1 July 2017, the following amounts will count towards John’s and Kyle’s transfer balance cap, potentially leading to an excess transfer balance:

Both pensioners have a potential excess of $320,000 above the $1.6 million transfer balance cap at 1 July 2017.

Dealing with excess transfer balances and lifetime pensions

John has an ABP valued at $480,000 at 1 July 2017 that is able to be commuted. The $320,000 excess must be commuted from the ABP balance to an accumulation phase superannuation account (or withdrawn from superannuation) to comply with the transfer balance cap.

John establishes an accumulation account with his retail super fund and commutes $320,000 from his ABP. At 1 July 2017 he now has:

  • lifetime pension paying $90,000 per annum
  • ABP valued at $160,000
  • accumulation account valued at $320,000

John’s transfer balance account is equal to the special value of his lifetime pension plus the value of his ABP = 1,440,000 + 160,000 = 1,600,000. No transfer balance cap excess remains.

Kyle also has an excess of $320,000 however his lifetime pension is non-commutable. Special rules come into play which excuse the potential excess transfer balance. Rather than reducing the pension to comply with the cap, Kyle’s pension will be subject to different tax treatment.

Changes to tax treatment of defined benefit income

Where a pensioner has a capped defined benefit income stream they will be subject to the defined benefit income cap. This is set to the general transfer balance cap divided by 16. At 1 July 2017 this will be $100,000.

There are some complex rules to determine a retiree’s personal defined benefit income cap that depend on the tax treatment of income payments. Generally where a pensioner receives income solely from an untaxed source, or solely from a taxed source and the pensioner has attained age 60, at 1 July 2017 their defined benefit income cap for the 2017-18 year will be $100,000.

Income in excess of an individual’s defined benefit income cap will be treated differently depending on whether it was from a taxed or untaxed source. In essence, 50% of an excess amount from a concessionally taxed source will become assessable income for the individual and not eligible for any tax offset. An excess amount from an untaxed source will not be eligible for the 10% offset in the pensioner’s tax return, i.e. the tax offset will be capped at $10,000.

Pensions paid from public sector schemes often include an untaxed source amount and may or may not also contain a taxed source amount. Defined benefit income streams paid from an SMSF will not contain an untaxed source.

In 2017-18, Kyle expects to be paid $120,000 from his lifetime pension. His pension is paid from a public sector scheme and is solely from an untaxed source meaning his defined benefit income cap is $100,000. His excess untaxed amount is therefore $120,000 - $100,000 = $20,000

As Kyle is over age 60 he would normally apply a 10% tax offset to his entire $120,000 income in his tax return. In 2017-18 Kyle will only be eligible to apply the 10% tax offset to $100,000 of his assessable defined benefit income. The remaining $20,000 will be subject to his full marginal tax rates.

Conclusion

Pensioners should speak with their income stream provider to understand the type of defined benefit pension they hold and the tax treatment of income payments. This information can then be used to determine how the pension will be treated under the superannuation reforms.

Further detail on the treatment of defined benefit income streams including detail on how to treat scenarios not fully explored here can be found in Accurium’s decision charts for defined benefit income streams here.

 

Melanie Dunn is the SMSF Technical Services Manager at Accurium, a leading provider of actuarial certificates for SMSFs and a sponsor of Cuffelinks. This is general information only and is not intended to be financial product advice. It is based on Accurium’s understanding of the current superannuation and taxation laws and Accurium is not liable for any loss arising from reliance on or use of the information.

17 Comments
Jenny
September 27, 2017

I have just received a TBC on a reversionary pension for a CSS member whose wife died in July 2017.
The TBC is based on the pension paid to the deceased member not the amount of the reversionary pension. I was unaware that this is the way it is to be calculated. The surviving spouse is being disadvantaged as the TBC is now based o a pension that is no longer being received.

Neil
January 23, 2018

I received the following on TBC for a reversionary pension from Comsuper
- the requirement to capture the pension entitlement is in accordance with Item 1 of the table contained within section 294-25 of the Income Tax Assessment Act 1997 (ITAA) for those in receipt of the pension before 1 July 2017, or Item 2 of the same table if the pension commenced after 1 July 2017.

- The calculation of the credit is contained within Section 294-135 of the ITAA. This section of the Act requires CSC to divide “…the amount of the first superannuation income stream benefit…” a recipient is entitled to receive. The ‘first’ payment in this case includes the 7 payday calc for the death of a pensioner, so the entire pension is captured.

- There is no provision in the Act to exclude reversionary recipients from the TBC measure or to amend the TBC credit when the pension is paid at the lesser rate.

The 7 pay calc is outlined in section 94(3) of the Superannuation Act 1976.

Liam Shorte
April 16, 2018

Here is the treatment of CSS Reversionary pensions as outlined in their factsheet

Benefits paid to a spouse following the death of a pensioner
If the member was receiving a pension before they died, the first 7 pension payments made to a spouse will usually be based on the original pension rate, rather than the spouse rate. The TBC credit is required to be based on the first pension payment, which means the TBC credit calculated and reported against the spouse’s TBA will be based on the original pension rate. No adjustments will be made when the pension reverts to the lesser rate.
Example:
Bill is receiving a pension of $1,000 gross per fortnight when he passes away in August 2017. His spouse, Mary, is found eligible under the scheme rules and is entitled to a reversionary pension of 67% of the original pension rate, or $670 gross per fortnight. When Mary first starts to receive her reversionary pension,
she is entitled to 7 fortnights of pension at
the original rate of $1,000. As the TBC credit
is based on the amount of the first pension payment, Mary’s TBC Credit will be $417,142.86 ($1,000 ÷ 14 x 365 x 16).
There are no changes to eligibility for tax concessions, but reversionary pensions will be subject to the new tax restrictions for pensioners over 60. These changes also apply if the member was aged 60 or older at the date they died.

Is anyone fighting for fairer treatement of Widows/widowers?

Archie
April 11, 2017

Thank you for this article. It gets us a closer to understanding. However I need to see an example of a PSS pension - these have tax-free, taxed and untaxed components. Does anybody know the tax impact? The PSS certainly doesn't have this on their website. A shemozzle!

peter
April 12, 2017

Archie, look at the PSS website. I understand they will have further information, including a calculator to work out the "deemed employer support" on their site by end of April or early May. There is also a link to a recent webinar which discusses the changes on the website

Vincent
April 05, 2017

Great summary, Melanie. It is worth noting that as defined benefit pensions over $100K grow with CPI over the coming years, an increasing portion of the pension will be over the TBC and therefore attract higher tax. Hopefully low inflation in future years for them as they cannot commute their pensions to a lump sum and remove it from pension mode. Quite unfair and retrospective.

AlanB
April 05, 2017

I am an SMSF trustee struggling to understand the new rules and remain compliant.
Many trusteees will want to get their affairs in order to not exceed the $1.6m cap on 1 July.
I am currently drawing a pension from a SMSF and receiving a PSS pension.
I understand the member balance in a SMSF (consisting of only shares) is based on current share price valuations, which, plus the valuation of the PSS pension (fortnightly pension X 26 X 16) may put me close to or over the $1.6m cap.
Whether I am over or under the cap depends on my member balance, which depends on share prices at a point of time in the future.
Share prices may rise or fall significantly between now and 30 June so how do any of know what our SMSF member balance will be on 30 June?

One option to keep below the $1.6m cap is to withdraw funds from the SMSF. But the difficulty is not to withdraw too much from the SMSF, or too little and then exceed the cap.

I understand that if the balance is between $1.6m and $1.7m after 1 July there is six months to rectify, but that then means your cap is fixed and no longer indexed.

Bruce
March 31, 2017

Currently my CSS pension is taxed at my marginal rate less 10%. Does the legislation mean that this will still be the case except that I now have to transfer a sum equal to the deemed value from my current tax free AustSuper pension account to an accumulation account in order to keep the total less than $1.6m?

Or will my CSS pension of $4,000/month be tax free, the same as my current AustSuper pension account?

Roger P
March 31, 2017

For a CSS pensioner receiving a pension over $100,000 pa from both taxed and untaxed sources, but still under 60 years of age, then presumably the taxation regime is unchanged at July 2017 - basically marginal rate less a small partial offset - but no extra taxation for now. Is that correct?

ron furlong
March 31, 2017

The above comments leave me a little confused about timing/date of determining pension asset valuation. I was under the impression that 2359 hrs on 30 June was the deadline. There is commentary that accrual accounting techniques / post dated cheques etc will not be acceptable in meeting TBC limit and all transactions must be consummated by 30 June. So is this a correct summary please? If so, then shouldn't the income stream in June flowing from those assets be the one to be used to determine notional DBF value at 30 June? Using a pension payment in set in July (2017/18 income year and perhaps indexed to a higher value) - as shown in your worked example. Seems like back-dating and potentiall resulting in a higher value than the one appropriate to 30 June and in conflict with accrual accounting being unacceptable. The CSS DBF has advised they have no intention of advising notional asset valuation before July so how will 110000 pensioners approach TBC determination? Regards Ron

Melanie Dunn
March 31, 2017

Hi David

Yes the transfer balance cap and defined benefit income cap is now legislated.

Steve Martin
March 30, 2017

@Brian - It is the gross pre tax amount.

Brian Morley
March 30, 2017

Interesting article, but I am still left with one question: Is the "benefit payment" amount used for cap calculation the gross (pre-tax) or net amount? In my case, I have a CSS pension paying $73,000 ($62,210 after tax), which I need to combine with an SMSF pension account to determine the excess over $1.6M.

Melanie Dunn
March 31, 2017

Hi Brian

As noted by Steve the amount used for the valuing a defined benefit pension under the transfer balance cap will be the gross amount.

David Endean
March 30, 2017

Are these changes to super now legislated? i.e are they set in stone?

Liam
April 02, 2017

Yes it us set in stone now. Refer to the following for guidance

LCG 2016/D10: Superannuation reform: defined benefit income streams – non-commutable, lifetime pensions and lifetime annuities
LCG 2017/D1: Superannuation reform: defined benefit income streams – pensions or annuities paid from non-commutable, life expectancy or market-linked products
LCG 2017/D3: Superannuation reform: Transfer Balance Cap – Superannuation death benefits

Steve Martin
March 30, 2017

Thanks for this article! Very helpful. I was not aware that the defined benefit 'special value' will be based on the first payment in the 17/18 year. I had assumed it would be calculated on the amount as at 30 June 2017. It makes it just that much harder to get the pension and accumulation account in the SMSF sorted out early in the new financial year. Hopefully the fund providers will set out the indexation on pension payments early.

 

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