The Pension Reserving Trap
Josh Rundmann looks at the potential relevance of reserves in the modern era of superannuation for SMSF members.
The retirement income landscape has evolved over the last 15 years – particularly when considering the range of income streams which could be paid by self-managed superannuation funds (SMSFs).
Pre-2007, SMSFs were able to pay complying lifetime and life expectancy income streams (defined benefits), term allocated pensions (also known as market linked income streams) and standard allocated pensions.
Whilst allocated pensions are similar in operation to today’s account-based pensions, since 1 January 2006 there has been a prohibition on SMSFs commencing defined benefits and as a result these income streams have fallen from common memory.
Defined benefit income streams do not have a capital value, nor a residual value – they are a ‘true’ pension in the sense they represent a right to receive a regular income stream. The fund which is required to pay the income stream will have a pool of assets which it can use to satisfy that obligation, but the value of those assets has no direct bearing on the income stream itself.
These assets do not form part of the member’s benefits – they form a reserve within the fund which is drawn upon to fund these defined pension liabilities.
Additionally, some SMSF trustees use investment reserves, usually seen as a method to smooth investment returns. The theory here was that in good years a portion of the fund’s return was allocated to a reserve rather than to member balances. In bad years, this reserve was drawn upon to ‘top up’ the return from investments and help bolster member balances in periods of poorer performance.
Over the last decade however, using reserves within SMSFs has been a strategy relegated to the annals of history. Before we delve into the potential relevance of reserves in the modern era of super, let us revisit how reserves operate.
A reserve is a pool of capital within an SMSF which is not directly related to a member interest. The funds in the reserve are able to be used by the trustees as defined by the type of reserve. For example, a pension reserve is a pool of assets the SMSF can use to meet its pension obligations in relation to defined benefit pensions.
Similarly, an investment reserve is historically created by assigning investment return above a threshold to a reserve rather than increasing the member’s current interests within the fund.
One of the main points to consider with reserves is that no member is entitled to the funds within the reserve – it is separate to any member interest.
It is possible for a fund to allocate monies out of the reserve, however since 2007 allocations from reserves count towards the client’s concessional contributions unless one of the following exemptions is able to be applied:
The payment from the reserve is to meet a pension liability that is currently due (such as a pension payment for a complying lifetime pension);
The payment represents a commutation of a pension (such as converting a complying lifetime pension to another pension);
The payment is required to satisfy a death benefit payment under a pension interest;
The allocation is a contribution for the member (this simply removes double-counting); and
The allocation from the reserve is made in a fair and reasonable manner to every member of the fund (or a class of members) and is less than five per cent of the member’s interest in the fund at the time of allocation.
One of the factors re-igniting interest in reserves is the treatment of reserves used to fund defined benefit pensions within SMSFs, such as a complying lifetime or life expectancy pension. It seems that since 2007 most of these pensions have gone one of two ways:
1. They have run into trouble, by not being able to get their certificate stating the SMSF has a high probability of being able to meet the payments required under the pension. These pensions are generally commuted to a term allocated pension – and as such the reserves are used to fund the lump sum commutation.
2. They have a good problem in that the assets backing the defined benefit have at least held ground, if not increased in value. Whilst there is no problem today, it’s the end of the pension where the problems appear.
Under the second scenario, the capital held in a pension reserve may well exceed the actuarially determined capital required to fund the income stream.
However as some of these income streams have been in place for over 15 years, the pensioners are getting older and are questioning what happens to their SMSF when they pass away or the term on their pension is reached. So, what does happen?
Under the Superannuation Industry (Supervision) Act (SIS), a lifetime or life expectancy income stream is not to have a residual capital value. Once the pension has reached the end of its required payments, any assets which were being held aside to meet that liability are still held in reserve by the SMSF – however the reserve ‘defaults’ to a general reserve.
As the reserve is not allocated to a member, there is no one with an entitlement to this money. In fact, if the pension which has recently ceased was the only remaining member interest in the SMSF, the fund may find itself in a position where it has no liabilities to pay but does still hold a pool of assets. In some trust deeds, this may trigger a wind-up event for the fund.
What are the options?
There is no formal requirement that the reserves must be addressed, however in their current form they cannot be accessed by members and are effectively trapped. To access these funds, two operations must occur:
1. The reserves must be allocated to a member.
2. The member must then be able to access their super.
We discussed above that reserves allocated to a member will count as concessional contributions unless one of the exemptions is met. For most members, the only potential exemption will be the final one – the allocation is done on a fair and reasonable basis and is no more than five per cent of the member’s interest in the fund at the time of allocation.
If the member’s sole interest in the fund is the complying pension (which we are assuming has just ceased), then five per cent of $0 is $0. Any allocation above this limit will count towards the concessional contributions cap, which is $25,000 for the 2017/18 financial year.
For someone with time, it may be possible to divest of the reserve over time using the five allocation plus an amount to take the member’s total concessional contributions to $25,000, however for reserves which are substantial in value relative to member interests this approach becomes impractical. If the concessional contributions cap is breached due to allocations from reserves, the standard excess concessional contribution rules apply.
As a refresher, if an individual has an excess concessional contributions amount, this excess is taxed in the individual’s hands as income, and as such is effectively taxed at the individual’s marginal rate. The Australian Taxation Office (ATO) will issue an amended notice to reflect the individual’s higher income, and determine the tax payable on this income.
The excess comes with a 15 per cent tax offset (even in the case of an excess created from a reserves allocation) which reduces the cashflow cost of the additional tax bill. The outstanding tax owing is used to calculate an interest penalty, known as the excess concessional contributions charge.
Additionally, up to 85 per cent of the excess amount can be released from super as cash. The grossed-up amount of any released excess does not count as a non-concessional contribution. If the excess is not released, the gross amount is counted towards the individual’s non-concessional contributions cap in the year of the excess.
Once we have allocated the reserves, keeping in mind the potential impacts on our concessional contributions, the amount effectively forms part of the member’s accumulation interest and is preserved.
If the member who received the allocation meets a nil cashing restriction condition of release the funds are then able to be withdrawn as a super lump sum, or cashed as a retirement phase income stream. However, for members who have not met said condition, the reserve allocation is locked into their member account generally until they retire or reach age 65. This could be the case when allocating reserves resulting from the death of a complying pension recipient.
As a result, based on the black letter of the law, funds are left with two outcomes. The reserves can be allocated over time either within the five per cent member balance limit, or within the concessional contributions cap – giving a better tax outcome at the potential loss of access to capital.
Alternatively, the fund can purposely exceed the concessional contributions cap to release the capital through the excess concessional contributions rules, however this results in the benefit being taxed at the marginal rate.
An additional consideration involves increasing the members of the fund. Whilst a small fund is limited to four or less members, by increasing membership up to this limit the number of member benefits (and contribution caps) available to be allocated to increases; thus the faster the reserve can be converted into member benefits.
This could also prove to be a planning opportunity for certain families where the adult children leave super capital to help support their parents, where the parents may not be financial dependants. Traditionally a fund would not be able to distribute a death benefit to the parent of a member, unless they satisfied the SIS financial dependant or interdependency definitions to be considered as an eligible beneficiary. However, since the allocation from a reserve is not a death benefit the trustee is not restricted in the same way as they would if paying a death benefit.
Another key under this scenario is that the work test does not apply to the allocation of reserves – the amount may count towards the concessional contributions cap but it is not a contribution.
Given the massive complications this issue can create, many administrators and advisers in the industry have derived alternative approaches to dealing with reserves which have a more practical focus than that required under the black letter of the law.
Whilst there is an area of ambiguity over certain parts of the law, these approaches for the most part have not been challenged by the regulators which gives an indication that perhaps in some cases a pragmatic outcome may be possible.
Pre-empting the problem
In the case of a member of an SMSF receiving an income stream funded from reserves, it may be possible to look at commuting that income stream to a term allocated pension. Under SIS, complying lifetime and life expectancy income streams can be commuted to a term allocated pension at any time during the life of the income stream.
To commute the existing income stream, the trustee would require a calculation of the lump sum value of the income stream – and this lump sum can be allocated to the commuting member in anticipation for purchasing a term allocated pension without contribution cap issues. Note the commutation from the reserve must be paid to a term pension – an account-based pension does not qualify as an exemption from the reserve allocation rules.
This may help solve the problem by both reducing or eliminating the reserve in its entirety, however there could be Centrelink considerations such as the loss of a potential 100 per cent assets test exemption on the existing income stream, or a substantially different rate of pension required to be paid from the term allocated income stream due to the value of the commutation and the terms available for selection by the member. Finally, the commutation value may be less than the reserve itself, and thus the remaining reserve may need to be allocated to members as discussed above.
Reserves and the new world
Given the upcoming super changes, which introduce concepts that measure the value of an individual’s total member balances, using investment reserves has returned to the surface as a strategy that may allow clients to accumulate additional wealth within super.
The strategy allocates investment return not to member accounts, but to an investment reserve during their accumulation years. This allows the members to have lower account balances – and thus a lower total super balance – potentially allowing for additional non-concessional contributions. Once in retirement, the fund allocates investment return to the member’s pension interest, as well as an additional five per cent of the member’s balance is to be allocated from the investment reserve.
Whilst an interesting idea in theory, the same problems as discussed above may arise on death of the members of the fund. Regarding the ability to make additional non-concessional contributions by supressing a member’s total super balance, this would likely be a temporary benefit as by making the additional personal contribution for an individual with a total super balance close to the $1.6 million limit, the contribution itself would potentially increase the balance beyond this cap, and at that stage there is no additional advantage from a contributions aspect to allocating return to the reserve.
Once this strategy moves into the retirement phase, benefits become harder to find as the portion of the earnings which relate to the reserve are taxed at 15 per cent, and whilst a portion of the reserve can be allocated back into pension phase it is difficult to see a scenario where the longer term benefits of ‘topping up’ pensions by an additional five per cent are sufficient to outweigh maintaining a taxed investment reserve, especially given the complexities and tax costs which can be incurred in administering the reserve on death of the member.
A variation of this strategy involves using the funds allocated to the reserve to repay a limited recourse borrowing arrangement (LRBA) within the fund. As the repayment is not actually a distribution from the reserve this allows a mechanism to repay the debt using investment return, without increasing the value of member interests. Using such a strategy would involve the allocation of investment return not to a member interest, but to the reserve of the fund.
These funds are then used to assist in repaying the borrowings, which provides a positive outcome from both a cashflow perspective and a total super balance perspective as repayment of debt does not increase or decrease the total net value of the fund. This strategy could also provide benefits in the event Treasury legislate their previously announced plan to count outstanding borrowings from an LRBA towards a member’s total super balance, effectively by shifting the value of the debt into the fund’s reserves.
Using reserves to repay debt in this way may also help suppress a member’s total super balance through the creation of a reserve to hold investment return, similar to the first strategy discussed and thus comes with similar benefits and issues.
Whilst reserves may have a place in certain client’s plans, overall the key is understanding the options available for having the reserve paid to members, as well as the tax consequences of such allocations.
Josh Rundmann is technical services manager at IOOF.
Recommended for you
When entering paid employment, it’s not long before we are told that we’ll need to lodge a tax return but there are times when a person will be excepted.
Anna Mirzoyan examines how grandfathering affects income support payments and how factors such as paying for aged care can impact them.
There are specific requirements that only apply to trustees of self-managed superannuation funds, writes Tim Howard, including the allocation in their investment strategy.
Investments bonds offer a number of flexible, tax-advantaged benefits, writes Emma Sakellaris, but these are often overlooked as old fashioned when it comes to portfolio allocations.
