A new super playing field

With the marketplace gearing up for over 55s to implement the Transition to Retirement (TTR) strategy, financial planners and accountants need to ensure they optimise the strategy for their clients.

Advisers who fail to explore the variables in the strategy risk penalising their clients thousands of dollars and, with wealthier clients, tens of thousands of dollars.

The press has so far highlighted many inefficient structures with the strategy. Sure, no matter what structure you put in place the client is likely to end their working life with a healthier account balance, but many of the strategies discussed by financial commentators have missed the mark.

Complex calculations

The TTR calculations are complex and time consuming, even though some basic modelling tools have been made available by product manufacturers.

These tools start by asking ‘how much pension will you draw’, when this is the answer you should be seeking. This is the most difficult part of the calculation to determine. Once you have the optimum pension, the remainder of the calculations are easier to assemble.

Without a good deal of experience on TTR issues, many advisers cannot be expected to understand all the ramifications of the strategy to maximise the opportunity for their client. Issues such as:

~ Who exactly benefits from this strategy and by how much?;

~ What pension type do I use?;

~ Will this pension type remain suitable at retirement?;

~ What level of pension is best?;

~ Do I use all of my superannuation?;

~ What is the impact on my reasonable benefit limits (RBLs)?;

~ Can I use super splitting with my spouse to control RBLs?;

~ What is the impact on my unrestricted, unpreserved and undeducted benefits?;

~ Will I match my income or can I have a target income?;

~ Is drawing extra income and then re-contributing efficient?; and

~ For larger super balances, do I put all my superannuation into pensions?

Tax planning

Then there are the tax planning opportunities. For instance, in the case of a working married couple, should they both participate in the TTR strategy in full? Or do they both draw pensions and only one salary sacrifice and then split their super with their spouse?

As a small business do I use this strategy as a tax-efficient, cash flow tool? Do I have other assets such as shares and business real property that can be put into my self-managed superannuation fund?

Can I, and how do I, manage the capital gains tax position on in-specie assets? Am I able to make a double deduction to superannuation? Is it worth undertaking any of these points?

Other considerations are for clients who are not yet 55. Is there any benefit in looking at strategies to increase superannuation in preparation? What are those strategies?

Without sophisticated software modelling, advisers are unable to source the answers to most of the issues without an exorbitant cost to the client.

It is almost impossible for advisers to rely on their own resources to cope with the complexity, and dealer group technical resources will have similar issues coping with the expected demand when the push begins in earnest in the next few months.

However, as professionals, advisers are required to explain in detail to their clients the strategy, the implications and the benefits, the options and outcomes — a difficult task when the vast majority of advisers cannot determine these factors for themselves.

The benefits for clients

One of the first aspects advisers need to understand with the TTR strategy is what is generating the benefits for your client.

As a general rule of thumb, switching off the 15 per cent tax on the superannuation earnings by moving to a pension fund accounts for around 60 per cent of the benefit. Personal income tax savings account for around 25 per cent and the 15 per cent balance comes from compound interest on the increased superannuation balance.

So clearly, if you wish to maximise TTR you move as much of the superannuation to a pension as possible — but not in every case.

There are some people who will not benefit from moving all of their funds. Those with large superannuation funds and small incomes will generate more from a pension than they need, and some other pre-retirees are further restrained through high income and large super balances and the contribution cap of $100,587. Again they will generate more income than required.

Excess income

Generating excess income is the big no-no with TTR. Never generate more income than you need.

Sure, the technical information published has simply said “put the funds back as an undeducted contribution”. However, correct modelling shows you should rarely take excess funds.

Matching current income or establishing a target income and following that rule rigidly is a requirement. Optimise your client benefit by simply matching the amount of money held in superannuation to their income needs, and leave the balance in accumulation.

Undeducted contributions

Undeducted contributions are the jewel in the crown for TTR, particularly for the taxpayer in the 42 per cent and 47 per cent brackets. Again this requires a case-by-case calculation. For example, a fund that is 25 per cent undeducted contributions may increase the final benefit of this strategy from between 25 per cent and 35 per cent.

Undeducted contributions turbo-boost the benefits and, as a priority, advisers should discuss with clients their ability to access further undeducted contributions before commencing TTR.

Pension payment levels

If you follow the majority of articles written, the recommendation has been to commence pension payments at the maximum level. Intuitively this may appear correct because the pension will deliver income carrying 15 per cent rebates, or with the undeducted contribution, high levels of tax-free income.

We need to reflect back at this point to the rule of thumb that 60 per cent of the TTR strategy gain is delivered by turning off the superannuation earnings tax.

Therefore, when matching a client income, by withdrawing larger pensions you run down the 0 per cent taxed pension fund in order to make larger contributions to the 15 per cent taxed accumulation fund. This has an adverse effect on the outcome, particularly to the wealthier individual. For most clients the optimal answer is somewhere between minimum and maximum.

This can be seen in the 10-year benefit models for an employed 55-year-old individual with a non-commutable allocated pension of $1,000,000 and a salary of $200,000 (see table 1).

Blindly establishing a maximum pension in this instance could penalise the client nearly $70,000.

While the maximum pension outcome is assuming all the future contributions sit inside the accumulation account, further pensions could commence annually, or every few years and reduce this return variation. But, surely for the client this is confusing, untidy, and potentially expensive when optimisation can occur at inception.

Modelling suggests the maximum pension recommendation will be rare, but it can also be dangerous to arbitrarily select the minimum pension. Only detailed modelling can predict what the optimum pension will be, particularly when the client has less than 10 years for the TTR strategy.

If there is a further measurable benefit to the client through optimising, surely the adviser has a fiduciary duty to pass on that additional reward.

Non-commutable income streams

A non-commutable income stream under the TTR rules may either be a non-commutable pension/annuity or a non-commutable allocated pension/annuity.

For the majority of people at retirement, the pension choices will be the allocated pension and market linked pension or a combination of both depending on RBL and Centrelink requirements.

For the average Australian commencing TTR, a non-commutable allocated pension will be the preferred option and they will simply transition to a commutable allocated pension at retirement.

For those people approaching either the lump sum or pension RBL, there will be the necessity to project RBL positions and spouse splitting to determine the establishment pensions for TTR.

The last thing an adviser should be caught not doing is forecasting the outcome of the strategy, and be forced to commute the allocated pension at retirement to buy a market linked pension and further enhance the RBL problem. And do not forget that pensions established under TTR are indexed at AWOTE when you are seeking relief under the pension RBL rules.

While couples can obtain relief by super splitting with their spouse, same sex couples and single people have no such advantages and will require careful management of the pension selection.

RBL and spouse splitting

With the introduction of the RBL-sensitive TTR strategy, the potential exists for larger future superannuation contributions and the greater likelihood RBL thresholds may be breached.

But the flow-on benefit of splitting super with their spouse may be the end of any issues with exceeding the lump sum RBL for the majority of taxpayers, and those with pension RBL issues may very well see their concerns disappear into the wind also.

The introduction timing of January 1 has been impeccable for those with RBL concerns, given the abolition on December 31 of lifetime complying pensions, regularly used in the past by self-managed superannuation funds (SMSFs) for RBL ‘compression’ strategies.

Unless a person currently has a pension RBL issue, or the couple will both make maximum deductible contributions, currently $100,587, for a number of years from age 55, pension RBL problems will trouble few people in the future with super splitting.

With larger superannuation account holders, there may be some management issues to optimise the balance of funds held in the non-commutable pension streams.

An example of this is a 55-year-old person earning $180,000 with a superannuation fund of $900,000 who implements a non-commutable income stream under the Transition to Retirement rules. The spouse has no superannuation.

Without super splitting, in 10 years the person’s RBL assessed benefit will be $2,696,438 against a projected pension RBL of $1,928,782.

This leaves $767,656 in excess benefits that will not receive the 15 per cent rebate and will be taxed at 39.5 per cent (Medicare inclusive) on withdrawal.

By implementing the 85 per cent spouse split, the member RBL assessed benefit will be $1,337,486 and the spouse account will be $1,358,952. Because both benefits exceed the projected lump sum RBL of $964,395, the couple will each be required to put 50 per cent of their funds in a non-commutable market linked pension to qualify for the full rebate.

The optimum split in this example is 59 per cent, leaving the spouse with an account balance of $943,273 and below the lump sum RBL threshold. The member is still below the pension RBL threshold with $1,753,165, requiring a market linked pension of $876,583, compared to $1,348,219 jointly under the 85 per cent spouse split.

This has maximised the level of accessible funds retained in the allocated pension income stream.

The self-employed

A topic within TTR that has received little or no coverage is the impact of the strategy on the self-employed person. They are not treated as favourably with this strategy because of the variation in deductibility of contributions and the requirement to put more funds into superannuation to gain the same tax deduction as an employee.

Generally, the self-employed person with an average income will lose at least 30 to 40 per cent of the lump sum benefit compared to an employee, but does recover some of this because of the level of undeducted contribution generating tax free pension income in the future.

However, for higher income earning, self-employed people, the lump sum impact can be severe (see table 2).

Clearly, the accounting profession will keep the impact of TTR in mind when putting business structures in place for their clients in the future.

Be prepared

Almost all income earners over the 15 per cent marginal tax rate will benefit from TTR provided they have a healthy superannuation balance.

Wealthier clients can achieve some astonishing benefits from implementation. Although, if the client already contributes the maximum deductible amount to superannuation then TTR is of no benefit.

If you have not researched your database to find suitable clients, then be prepared to potentially lose those clients to more astute financial planning competitors or accountants. Heed the warning — they will be active on this strategy.

Barry Ward CFP is a principal of the Ward Financial Group.