Up until about a fortnight ago draft regulations for the government's super reforms contained tax relief for a generation of pre-2007 pensions that are a legacy of a bygone era.
Unfortunately when the final regulations were released at the end of March, the relief was absent. It had been an entitlement giving retirees in self-managed superanuation funds (SMSFs) with market-linked, life-expectancy and lifetime pensions (collectively known as complying pensions) the choice of converting them at least partially into account based pensions. (Complying relates to pensions that complied with pre-2007 reasonable benefit rules.)
Holders of these pensions now face what a number of experts reckon is unreasonable, unnecessary and unfair tax treatment as a result of the government's July 1 super changes.
While retirees with account-based pensions are entitled to have $1.6 million in tax-exempt retirement accounts before they are required to transfer any excess super into taxable accumulation accounts, those with market-linked and other complying pensions are nowhere near as concessionally treated.
A retired reader illustrates this by outlining a circumstance where he will breach the $1.6 million pension limit — known as the transfer balance cap or TBC — with an market-linked pension (MLP) that he estimates will have a value of $1.2 million on July 1. MLPs are also known as term allocated pensions (TAPs) because the pension value is reset each year according to the remaining term of the pension. In this reader's situation, the term is 19 years.
The pension value will breach the TBC because of the formula used to place a value on MLPs, says pensions expert Meg Heffron of Heffron SMSF Solutions. It's a formula she describes as unnecessarily complex and unreasonable given the actual value of super supporting these income streams.
While the situation also applies to other pre-2007 pensions, the position is most obvious with MLPs because there is a very clear account balance – $1.2 million in this instance – that the pension is genuinely worth to the retiree.
Now the issue with the $1.6 million limit and MLPs, explains financial planner and pensions expert Peter Crump of ipac South Australia, is that the valuation uses the annual pension amount multiplied by the remaining term of the pension.
You calculate the pension valuation by dividing a special payment factor for the term into the account balance. For example, the MLP factor for 19 years is 13.71. So the annual pension that must be paid under the MLP rules is $1.2 million/13.71 or $87,527. When this is multiplied by 19, the result is a formula value of $1.663 million which exceeds the account balance by $463,000 and the $1.6 million TBC by $63,000.
One entitlement MLPs do have is a choice under a maximum and minimum payment rule of reducing annual payments to 90 per cent of the normal amount. This would reduce the value of the reader's account to $1.5 million. Regardless of this, it is still much higher than $1.2 million.
As far as exceeding the TBC is concerned, says Heffron, this becomes a problem if the reader has another super benefit such as an account-based pension in addition to the MLP. This is actually quite likely because as lump sums could not be withdrawn from MLPs, many retirees set up allocated pensions alongside them which did allow lump sum withdrawals.
Market-linked pensions are a legacy of previous government incentives to encourage people to take their super as pensions instead of lump sums. They were specifically designed to force people to withdraw their super balances over their life expectancy rather than the flexibility of an post-2007account-based pension where the holder could withdraw any amount at any time. Some of the complying pensions included social security assets test exemptions as an incentive.
In the reader's situation, the way the government has chosen to value his MLP will mean he cannot have much if any other super in an account-based pension. Unfairly, someone with an account-based pension with a $1.2 million balance would be allowed another $400,000.
Lyn Formica of McPhersons Super Consulting says where an SMSF member has an MLP that exceeds the TBC as well as an account-based pension, they will be forced to roll any ABP of the latter back to accumulation or commute a portion of this. In some cases a rollback or commutation of the entire account-based pension may be required. Importantly they won't be penalised as long as the only super they have is an MLP or other complying pension.
The only circumstance where they face extra tax under the new rules is where the annual pension payments from their MLP (or complying pension) exceeds $100,000. If the pension is paid from an SMSF, where income is normally tax-free after age 60, half the income above $100,000 will be taxed at marginal tax rates with no offsets or rebates.
This contrasts with the tax treatment of pensions from unfunded super schemes like government defined benefit pensions. Their penalty is the loss of a 10 per cent rebate on excess pension over $100,000.
Someone who is receiving $150,000 in MLP pension payments will therefore pay tax on $25,000 at their marginal tax rate (half of the $50,000 by which the income exceeds $100,000). This applies regardless of whether the MLP pension exceeds the TBC or not.
Heffron says a frustrating aspect of the super changes is that the government almost introduced a simple solution. Draft regulations issued before December added the power to roll back market-linked and other complying pensions to accumulation phase in order to deal with any excess over the $1.6 million cap.
This would have put recipients of these pensions in the same position as those with account-based pensions.
Unfortunately the regulations didn't appear in the final round presented to Parliament. This puts many in a position where they can't either fully utilise the $1.6 million TBC (unlike those with account-based pensions) or face taxes on income that might be worse than any right to roll back some of their MLP to accumulation phase where the fund will pay 15 per cent tax on investment income.