SMSFs and pensions - the asset test exemption minefield

The Heffron technical team take a look at the current state of play for defined benefit pensions and the social security asset test exemption rules and how they affect SMSF members. 

Defined benefit pensions are a thing of the past for many SMSF retirees. The new superannuation rules introduced from July 1, 2007 prompted many to convert their lifetime, life expectancy or fixed term income streams to alternatives, such as market-linked pensions or — where permitted — account-based pensions.

One group that have been quite hamstrung in this regard are those who commenced particular income streams (hereafter referred to as "complying lifetime" and "complying life expectancy" pensions) with a view to excluding some or all of their superannuation balance from the social security assets test.

The rules for clients in this position are a minefield.

Not only are they complicated but the process by which they are changed (announcements by the relevant minister, changes to Centrelink guidelines etc) is perhaps less accessible than other superannuation changes which are generally well publicised and explained by the Australian Taxation Office.

This article is our attempt to draw together the various rules as they stand today.

One clear theme emerged in the course of our research — the importance of actively engaging with Centrelink when any changes are made to these pensions.

Anecdotal evidence suggests some inconsistency between different offices and the consequences of getting it wrong are enormous.

Background

Until December 31, 2005, SMSFs could provide defined benefit pensions. A member receiving a complying lifetime or complying life expectancy defined benefit pension that met certain conditions was entitled to have some or all of the balance underpinning this pension excluded from the assets test for social security purposes.

The exemption was:

• 100 per cent for such pensions which started before September 20, 2004 (hence these pensions were often referred to as being ‘100 per cent ATE’); and
• 50 per cent for such pensions starting on or after September 20, 2004 but before September 20, 2007 (in practice, on or before December 31, 2005 for SMSFs given that they were not permitted to start new defined benefit pensions after that date).

The concession was valuable — it effectively allowed members to increase their age pension entitlements.

It also, however, presented problems. Funds needed to obtain an annual certificate from an actuary stating that there was a "high degree of probability" that the fund held sufficient assets to meet pension payments.

Additionally, failure to obtain such certification, such as when asset values fell and the actuary could no longer make the required statement, resulted in the loss of the asset test exemption and — in some cases — the raising of a penalty (referred to as a ‘debt’) by Centrelink.

In the worst case, the member’s social security entitlements were effectively reassessed for the previous five years as if their pension had never been asset test exempt in the first place.

To say that this treatment was incredibly harsh would be an understatement.

It was very difficult for members with these pensions to restructure them to deal with changing circumstances or significantly declining asset values.

There were strict rules governing when such pensions could be rolled over to other types of pensions and other funds.

Those rules presented many pensioners with some very difficult choices if they failed the high degree of probability test in their actuarial certificate.

Fortunately, the last few months have seen some legislative relief.

Lifetime and life expectancy 50 per cent ATE pensions

These pensions have always been simpler to deal with because the rules under which they operate are slightly more flexible.

It has always been possible to wind up these pensions and convert them to a market-linked income stream (retaining the 50 per cent ATE) if, for example, they failed the high degree of probability test.

The new pension could be provided within the same SMSF, another SMSF or even a retail/public offer fund.

Making the change did not trigger the raising of a debt by Centrelink. A debt would only arise if the member, say:

• Did something not permitted by the normal rules such as converting it to another type of income stream (an allocated or account-based pension), cashed out the pension as a lump sum etc;
• Failed the high degree of probability test and did not do anything about it within 12 weeks (for example, transfer to another ATE income stream such as a market linked pension or a life office annuity); or
• Did not obtain an actuarial certificate within the required timeframe (December 31 each year for funds with actuarial valuation dates of July 1).

100 per cent ATE pensions

For SMSFs, the 100 per cent ATE pensions (those which started before September 20, 2004) were and continue to be far more problematic.

Traditionally, if these pensions failed the high degree of probability test, there were very few options:

• Transfer to a life office annuity within 12 weeks of receiving notice of the failure via the actuarial certificate, as long as the certificate was obtained before December 31, each year, and retain the 100 per cent ATE. A key problem, of course, in transferring to an annuity is that the client must effectively surrender control of his or her superannuation capital. In addition, there are very few providers of these products — we are only aware of one that is currently accepting new business;
• Do nothing (lose all asset test exemptions and have a debt raised); or
• Convert to a market-linked pension either in the same SMSF or any other fund, but this meant losing all asset test exemptions and having a debt raised.

However, the fallout from the global financial crisis has prompted some relief. Now, when a 100 per cent ATE pension fails the high degree of probability test, the member has these options:

• Transfer to a life office annuity within 12 weeks of receiving notice of the failure via the actuarial certificate and retain the 100 per cent ATE (ie, this has not changed); or
• Do nothing, lose all asset test exemptions but have no debt raised (ie, the key difference now is that no debt will be raised); or
• Restructure to a market linked pension within the same SMSF and lose all asset test exemption but avoid having a debt raised.

The waiver of all Centrelink debts for those who choose the ‘do nothing’ option applies until June 2010. In other words, a fund that has an actuarial valuation date of July 1, 2009 might have received an actuarial certificate in December 2009, which must be lodged with Centrelink.

If the fund has failed the high degree of probability test and takes no further action, the 100 per cent ATE will cease in March 2010, 12 weeks after the certificate is submitted to Centrelink, but there will be no further action.

Importantly, the fund will continue to provide the same defined benefit pension as before, simply without any asset test exemption for social security purposes. This has some further ramifications:

• Annual actuarial certificates will continue to be required under the Superannuation Industry (Supervision) Act 1993 (SIS);
• Even if the financial position improves, to a point where in some later year, the actuary can certify that there is a high degree of probability that the fund will be able to meet its pension payments, the pension will not regain its asset test exemption — it is lost permanently;
• Depending on the fund’s financial position, the trustee many be forced to wind up that pension to comply with SIS requirements. However, if that wind up involves transferring to a market-linked pension (either within the current fund or another vehicle), a debt will be raised. In effect, the impact of this new relief will be negated. This relief was announced in early 2009.

The third option above — restructuring to a market linked pension without a debt being raised — is the most recently announced relief and it was introduced from November 2009. In fact, it does not apply to Small APRA Funds until February 2010.

Initially, this relief could only be accessed if the fund’s actuarial certificate was lodged with Centrelink before December 31, 2009.

However, very recent changes in December 2009 have seen this extended out to June 30, 2010.

In other words, a fund which fails the high degree of probability test as part of its July 1, 2009 actuarial valuation could, for example, obtain its actuarial certificate in February 2010, provide it to Centrelink immediately (albeit it would be late, and have lost its ATE status from January 1, 2010) and then change the pension to a market-linked pension some time before June 30, 2010 without having a debt raised.

Note that under these circumstances, the client could not transfer to an annuity and retain the 100 per cent ATE status because this is only available when the certificate is provided before December 31, 2009 and the transfer occurs within 12 weeks of the certificate date.

Some important points:

• The ability to restructure to a market-linked pension is extremely valuable. It enables those who fail the test to leave the defined benefit environment without having a debt raised. Given that defined benefit funds are typically more complex, particularly in relation to estate planning, and require greater levels of actuarial input and therefore cost, this is extremely valuable.
• The new market-linked pension must be provided within the same fund (ie, the SMSF) for the relief to apply. It cannot be rolled out to a retail fund, for example;
• The original 100 per cent ATE pension must be fully commuted and rolled over to a market-linked pension within the SMSF. We have interpreted this to mean that the entire balance supporting the member’s defined benefit pension must be applied to provide the market-linked pension;
• The relief only applies if the conversion to a market-linked pension occurs before June 30, 2010. A client could not opt for the new ‘do nothing’ approach, such as lose the 100 per cent ATE but have no debt raised, and then move to a market-linked pension (internally) in 2012. This would trigger a debt.
• Note that clients who failed the high degree of probability test as part of their July 1, 2008 actuarial valuation (and provided the associated certificate to Centrelink in, say, December 2008) could also choose to restructure to a market-linked pension now (before June 30, 2010) without having a debt raised.

What about the future?

At this stage, all the relief which has been announced to date expires at June 30, 2010.

Hence a fund that passes the high degree of probability test at its July 1, 2009 actuarial valuation but fails on July 1, 2010 will be subject to the original rules.

What if the fund doesn't fail the high degree of probability test?

All of the options for 100 per cent ATE pensions (and in particular, the latest relief) only apply where the fund has failed the high degree of probability test.

Where it has not, it is still generally not possible to restructure one of these pensions to a market-linked pension without risking a Centrelink debt.

It is worth bearing in mind, however, that the social security rules also permit SMSF trustees to transfer their 100 per cent ATE pensions to a life office annuity if they decide to close their SMSF because the administrative responsibilities associated with running the fund have become too onerous because of the age or incapacity of the trustee.

In this situation, the 100 per cent ATE would be retained but:

• The SMSF would need to be closed (any other pensions etc would also need to be rolled over to a retail environment). Note also that this would affect other fund members (such as children) — they would also need to rollover to a retail fund or a new SMSF; and
• The closure must be driven by the trustees deciding that they are not able to manage the fund any more, rather than simply a preference to move to another vehicle.

The latest relief will be welcomed by SMSF members with 100 per cent ATE pensions and we suspect many will be somewhat relieved to be able to leave the defined benefit environment without incurring a debt.

As mentioned earlier, however, we feel it is absolutely crucial any action taken by SMSFs is discussed in detail with the member’s local Centrelink office before any steps are taken.

The situation has changed several times in recent months and may well be varied again if and when common sense prevails and the relief is expanded and extended.

With that in mind, the purpose of this article is largely to alert advisers to the fact that some softening of the Centrelink debt rules has already been provided and that it is worth exploring the options available before assuming that transferring to a life office annuity is the only option.

Heffron are SMSF administration experts.