Transitioning into retirement

During the 1990s there was an explosion in the number of self-managed superannuation funds (SMSFs). Many of these will soon begin, or are already, paying a pension benefit to their members.

Of the different types of pension available, by far the most common is an allocated pension. It offers more flexibility than the other types, by allowing the recipient to withdraw lump sums, or vary the pension payments between a minimum and maximum level each year. Another attraction is that the remaining balance upon death is payable to beneficiaries.

An important advantage in receiving superannuation benefits as a pension is that a fund paying a pension to all members has a nil tax rate.

In fact, it is likely with an SMSF allocated pension that there will be a tax refund each year as franking credits generated on share investments are refunded.

This is a bonus compared to the pre-July 1, 2000 regime whereby imputation credits were not refundable. Such refunds certainly help defray the costs of what can be a reasonably complex structure.

From a tax perspective, an SMSF paying an allocated pension is an effective structure within which to hold a large proportion of retirement investment assets. The investments held are likely to be the same as those purchased personally, so it makes sense for clients to hold those investments through a personal SMSF.

However, once clients begin receiving a pension payment, the rules force them to take a payment each year and they will be taxed upon receipt of the pension.

Some argue this is wrong, as tax was paid when contributions were made into the superannuation fund and again on the earnings of the fund prior to the start of pension payments.

However, an allocated pension can still be taxed at a very low rate because clients are likely to be eligible for a 15 per cent tax rebate on the taxable portion of the pension and there may also be a tax-free component of the pension payments.

Case study

Bill, aged 55, has a balance of $700,000 in his SMSF. Of this $200,000 is an undeducted balance and $500,000 is post-June 1983 balance. As only $500,000 is measured against his lump sum reasonable benefits limit (RBL), Bill will receive the full 15 per cent tax rebate on taxable pension payments received.

With the $200,000 undeducted balance, Bill will receive $8,258 of his pension tax-free each year.

This is calculated by dividing the $200,000 by his life expectancy, per the 1997 government life tables, which is 24.22 years.

If the pension commenced on July 1, 2003, and Bill elects to receive the minimum pension, he will receive in his first year a gross pension of $35,451 — of this, $8,258 is tax free and $27,193 is subject to tax.

The tax payable would be $4,738 (including Medicare levy), however, with the 15 per cent rebate on the taxable portion of the pension totalling $4,079, the net tax payment is only $659.

The after-tax pension is very tax effective — $34,792 or $2,900 per month.

Bill’s pension payments will vary each year depending on the investment earnings of his allocated pension and whether he increases his pension above the minimum level.

It is also important to realise that the government increases the minimum and maximum amounts as a proportion of the pension balance each year. The older you are, the higher the proportion of the fund balance you are required to take each year.

For example, if Bill elects to receive the minimum pension each year, at age 55, the gross pension is 5.05 per cent of his starting balance that year, at age 65 it increases to 6.37 per cent, at age 75 it increases to 8.85 per cent and at age 85 it is 14.08 per cent and so on.

If Bill’s allocated pension was able to earn an average rate of return of 7 per cent per annum, his pension balance would increase from age 55 to age 68.

From then it would begin to decrease, at quite a rapid rate from around age 80, until the allocated pension is finally exhausted.

It is important to realise that an allocated pension is not designed to preserve capital in retirement, its purpose is to provide a retirement income.

Upon the death of a person receiving an allocated pension, the balance of the account is paid to the beneficiaries or estate.

This is a big advantage over complying lifetime pensions held by the life companies, where there is no balance payable upon the death of the member.

In the above example, if Bill subsequently died at age 75 — assuming he had received the minimum pension each year and the average earnings rate of his fund had been 7 per cent per annum — then he would have a balance of approximately $764,000 upon his death.

Assuming that Bill’s wife is the beneficiary of his fund, she could continue receiving Bill’s pension, with a recalculated tax-free amount each year, and with the minimum and maximum now calculated according to her age.

Alternatively, she could elect to receive the balance of Bill’s pension as a lump sum. Because the original balance was under Bill’s RBL at the time of commencement, this amount would be paid to her tax free.

If Bill’s children who are over 18 are to receive the balance of the allocated pension, then the remaining amount of the undeducted balance is paid tax free (this would be minimal after 20 years) and the balance is taxed at 15 per cent.

The laws governing an allocated pension are the same regardless of whether an SMSF or retail superannuation fund is paying the pension.

However, with an SMSF, the member will have greater control over the investments that the fund can make.

It is important with the asset allocation to ensure there is sufficient liquidity in the portfolio to ensure pension payments can be made each year.

For example, an allocated pension fund that is invested largely in residential property would find it difficult to meet the minimum pension payments, as the rental yield is often insufficient.

This scenario worsens as the person gets older and the minimum pension payments increase to, say, 10 per cent of the fund balance.

Once the pension commences, it cannot be added to.

A long-term investment approach to allocated pensions should be adopted with an appropriate allocation made to growth assets.

This is an income stream paid each year until the death of the member (assuming the fund balance doesn’t run out), and no one can be sure when that will be.

Michael Hutton heads the financial planning activities of accountants HLB Mann Judd Sydney.