Changing an account-based pension to a reversionary pension

Daniel Butler and Nathan Papson note that changing an existing non-reversionary defined benefit pension to be reversionary may give rise to certain issues.

The Australian Taxation Office’s (ATO’s) views in TR 2011/D3 highlight the importance of having appropriate documentation in place to ensure a pension is reversionary.

Since the release of this draft ruling, reversionary pensions have become a hot planning issue.

They allow a pension to continue to be paid to a surviving spouse retaining the pension exemption beyond the death of the pensioner, resulting in greater tax efficiency.

However, the question we analyse in this article is: can a pension that is commenced without a reversionary nomination, be readily ‘converted’ to a reversionary pension, without commuting the original pension and restarting a new pension which has a reversionary nomination?

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There is one school of thought that suggests this is not possible.

However, most advisers believe there is no issue when the pension is in the nature of an account-based pension such as an account-based pension, a transition to retirement income stream (TRIS) or an allocated pension (that commenced prior to 20 September 2007).

We will refer to these broadly as account-based pensions for simplicity.

This article seeks to clarify this point firstly by reference to account-based pensions and will only cover defined benefit pensions (DBP) such as lifetime, flexi and fixed term pensions that previously could have been commenced in self-managed super funds (SMSFs) before 1 January 2006 for completeness.

We note that due to specific legislative provisions, changing an existing non-reversionary DBP to be reversionary may give rise to certain issues.

ATO’s most recent view

What may have most recently given rise to the school of thought that suggests this is not possible was the ATO’s comments in the NTLG superannuation technical minutes of March 2010 where the ATO was asked a very different question to the question here.

Namely, there, the ATO was asked: does a reversionary nomination in an account-based pension take precedence over a binding death benefit nomination (BDBN) or are the trustees bound by the BDBN following the death of the original pension recipient? In addressing that question, the ATO remarked:

However, we would suggest that a pension that is a genuine reversionary pension, that is, one which under the terms and conditions established at the commencement of the pension reverts to a nominated (or determinable) beneficiary, must be paid to the reversioner.

Although this remark was made in a very different context, it does seem to suggest that if a pension is not established as a reversionary pension at commencement, it cannot be varied later to become a reversionary.  

Legislative analysis

Naturally, the law should be examined.

There is no express prohibition in the Superannuation Industry (Supervision) Regulations 1994 (Cth) (SISR) nor in the Income Tax Assessment Act (ITAA) 1936 (Cth) or ITAA 1997 (Cth) that precludes a reversionary beneficiary being nominated after a pension has commenced.

In particular, regulation 1.06(9A) of the SISR outlines the requirements for an account-based pension. Indeed, reg 1.06(9A)(c) allows a pension to be transferable to a beneficiary (including a reversionary beneficiary) on the member’s death.

There is also no express preclusion in relation to the definition of a TRIS in reg 6.01(2) or in respect of an allocated pension in reg 1.06(4).

Therefore, there is no express prohibition in the SISR or the ITAA 1936 or ITAA 1997 that a pension cannot be made reversionary after a pension has commenced.

Pensions — legacy rules

Prior to July 2007, most people were generally reluctant to convert a pension to become a reversionary pension.

Thus, most account-based pensions prior to July 2007 were commenced as non-reversionary pensions.

Reverting a pension could result in increased tax

Prior to mid-2007, the ‘deductible amount’ which represented the old tax-free component of a superannuation pension payment was calculated in accordance with s 27H of the Income Tax Assessment Act 1936 (Cth) (‘ITAA 1936’).

Broadly, this is calculated as the undeducted (now known as non-concessional) contributions used to purchase the pension, divided by the life expectancy of the beneficiary.

Where a pension was reversionary, the longer life expectancy of the member or reversionary beneficiary had to be used: see TD 2006/72.

As a result, the deductible amount calculated under ITAA 1936 s 27H would be decreased if the life expectancy used was increased.

As such, it was generally undesirable to revert a pension to a surviving spouse prior to mid-2007 for this reason.

In TD 2006/34 the ATO accepted that a change from a reversionary to a non-reversionary pension as a result of the marriage breakdown mid-stream could occur but the deductible amount under s 27H needed to be adjusted accordingly.

The ATO in paragraph 6 of TD 2006/34 states:

This is most likely to occur where the original pension was reversionary and subsequent to the marriage breakdown the pension ceases to be reversionary.

Additionally, there is no other reversionary beneficiary and the pension will cease on the death of the member spouse.

If the life expectancy of the member spouse is less than that used as the relevant number in the original calculation of the deductible amount then a different relevant number will need to be used in calculating the deductible amount of the new pensions.

Social security

Broadly, assuming someone satisfies the assets test and other criteria, Centrelink’s income test assesses a member’s pension income less a deductible amount calculated on a similar basis to s 27H of the ITAA 1936.

As such, if a member wanted to apply for Centrelink benefits such as the old age pension, it may be in their best interest to maximise their deductible amount in order to decrease the amount assessed under the income test.

Therefore, making a pension reversionary ‘mid-stream’ would typically decrease the member’s chance of being eligible for Centrelink benefits where the reversionary beneficiary has a longer life expectancy.

Past practice

It appears that the school of thought that ‘pensions must be commuted before being made reversionary’ also stems from the traditional or preferred approach practice above, especially prior to July 2007. 

In summary, prior to July 2007 it was general practice to make an account-based pension non-reversionary for tax and social security reasons and not to change them mid-stream.

Since mid-2007, the general practice has changed to commence pensions with a reversionary nomination unless this was not appropriate, eg, there is no surviving spouse.

This is because since 1 July 2007 the tax-free amount of a pension is generally determined according to the proportioning rule in s 307-125 of the ITAA 1997.

This depends on the amount of the tax-free component of the pension at commencement: s307-125(3)(a) of the ITAA 1997.

This contrasts to the calculation of the ‘deductible amount’ for pre-July 2007 pensions under s 27H of the ITAA 1936 which depended on the longer life expectancy of the member or reversionary beneficiary.

In summary, prior to July 2007, we understand that most account-based pensions were non-reversionary.  In contrast, from July 2007 onwards, we understand that most account-based pensions are reversionary. 

Making an account-based pension reversionary

Assuming there is flexibility in a fund’s governing rules and related documents (which may include deeds, resolutions, pension contracts and legislation, etc), there is no reason why the terms of a pension could not be varied after a pension commences (‘mid-stream’) to add a reversionary pensioner.

Indeed, this could, under an appropriately worded deed, be by way of a BDBN where a member specifies that their pension is to revert and continue to be paid to say their spouse upon and following their death.

(We are aware and have covered in a prior article the debate relating to whether a BDBN wins out in the event of conflict against a reversionary pension nomination. Please contact us if you would like a copy of this article).

Therefore, provided the documents provide the flexibility, a pension could be varied mid-stream to nominate a reversionary pensioner. 

Defined benefit pensions

For completeness, we will discuss the main reasons why defined benefit pensions (DBPs) should be treated differently in this context.

Broadly, the commencement of new DBPs in an SMSF was prohibited after December 2005 and grandfather relief was provided to those DBPs that were commenced in an SMSF prior to 31 December 2005.

Unlike ‘account-based pensions’, a DBP requires an actuarial calculation to determine the annual pension payment.

Broadly, the annual payment amount of a DBP is determined having regard to multiple factors including the amount of assets funding the pension, expected growth, mortality rates and whether the pension was reversionary or not.

Whether a DBP is reversionary is a significant factor in this calculation — as with a given pool of funds, the longer the period of the pension, the lower the annual pension payment (assuming all other factors are equal).

In essence, an SMSF trustee had to guarantee a member a certain sum each year, as indexed each year, for the remainder of the member’s life in respect of a lifetime DBP.

Where the pension was reversionary, this guarantee was generally extended for the longer life expectancy.

One of the requirements of a lifetime pension was that the size of payment of benefit in a year is fixed, allowing for variation only in limited circumstances (ie. in reg 1.06(2)(b), as specified in the governing rules).

It was rare in practice to vary a DBP once commenced, apart from exceptional circumstances: for example, after a marriage breakdown, or post-GFC, some SMSFs have had to vary payments due to insufficient liquidity.

Moreover, a change to a term or condition of a DBP may be viewed by the ATO or Centrelink as creating a fresh pension which is no longer eligible for grandfathered DBP relief.

See, for example, ATO SD 2004/1 and ID 2005/242 where the ATO outlined strict guidelines as to the requirements for DBPs.

In particular, ATO ID 2005/159 examined whether an SMSF trustee could pay a DBP to a reversionary beneficiary under div 9.2B of the SISR.

The ATO confirmed that the SMSF could, provided that the terms and conditions of the pension included the basis of the reversion when the original pension was established, and the original pension was established before or during the transitional period.

These comments (in ATO ID 2005/159) should be considered in view of the special rules phasing out DBPs in SMSFs introduced before 2006.

Conclusion

Being able to convert an existing account-based pension to a reversionary pension is a key SMSF succession planning strategy.

It can result in administrative efficiency, rather than having to commute an existing pension and then commence a fresh ‘reversionary’ pension.

We note there is conflicting ATO views, albeit in different contexts as outlined above (ie, ATO TD 2006/34 in respect of s 27H of the ITAA 1936, the ATO’s views expressed in ATO ID 2005/159 in respect of reverting a DBP and the NTLG superannuation technical minutes of March 2010 in respect of BDBNs and reversionary pensions).

We also understand that this matter is being reviewed by the ATO and Treasury in their broader finalisation of TR 2011/D3 and the treatment of pensions on the death of a member.

There may be some legislative change that may soon be released to cover some of these issues and this area should therefore be closely monitored.

The finalisation of TR 2011/D3 is also eagerly awaited.

While we consider the law to be clear for allowing a reversion of an account-based pensions mid-stream, given the different ATO views, until greater clarity issues, the safer course would be to commute and start a fresh pension if a reversionary nomination of an existing non-reversionary pension is desired.

However, for those who do not wish to go through the extra administrative hassle of commuting and starting a fresh ‘reversionary’ pension, they should either seek written comfort from the ATO or obtain further expert advice.

Daniel Butler is the director and Nathan Papson is a lawyer at DBA Lawyers.