Complying lifetime, life expectancy and flexi pensions (the “defined benefit” types of legacy pensions) played a valuable role in their heyday – they helped some people save tax and others maximise their age pension. But these days most have been wound up. 

Some still remain though and the Division 296 tax legislation (if passed) will introduce some new problems – annual valuations (and therefore increased cost), a unique earnings calculation and (subject to yet-to-be-released regulations) a risk of artificially high earnings in the year of commutation (ie cessation).

Why most SMSF are already unwinding legacy pensions

There are many good reasons to wind up any legacy pension in an SMSF (including both defined benefit and market linked pensions):

• Simplicity & cost - less complicated pension payment calculations and actuarial certificate requirements.
• Flexibility - better access to the whole super balance at any time rather than the restrictive nature of these pensions. Converting to another type of pension (or even back to accumulation phase) gives those who want it the opportunity to draw down their balance more slowly (whereas market linked pensions, for example, tend to force very large withdrawals as they near the end of their term) or more quickly (whereas legacy pensions either restrict how much can be drawn each year and prevent ad hoc withdrawals entirely or – in the case of flexi pensions - make them difficult).
• Estate planning - defined benefit pensions inevitably result in reserves being leftover after the pensioner has died. These are much easier and more tax effective to deal with during the pensioner’s lifetime – which usually means winding up the pension. Even market linked pensions are tricky here. They only allow the full balance to be withdrawn once the pension has reached the end of a pre-determined term which means the balance can’t be withdrawn earlier to avoid death taxes.
• Personal tax – complying lifetime, life expectancy and most market linked pensions all result in tax on the pension payments themselves for payments over $125,000 during 2025/26 (this threshold increases every few years and will be $131,250 in 2026/27).
• Fund tax – sometimes it’s possible to increase the amount of income the SMSF can treat as tax exempt (ECPI) by winding up a legacy pension but other times it’s not – this is a calculation that would need to be done on a case by case basis before concluding it was a beneficial to wind up.

Why some SMSF legacy pensions are being kept

Nonetheless, some still remain in SMSFs for valid reasons:

• Social security benefits – legacy pensions benefiting from an asset test exemption will lose that if they’re wound up. Sometimes this is such a large benefit it’s worth hanging on to the legacy pension (or at least continuing it until the amnesty is close to expiring in December 2029).
• Estate planning – paradoxically it can be beneficial to have a defined benefit legacy pension on death because the reserves used to pay it aren’t automatically a death benefit for the (deceased) pensioner. They might be harder to get out of super but at least there are choices.

We can help wind up these pensions (see our resources and services here Legacy Pensions and Reserves) but whatever has been decided to date, it’s worth noting that Division 296 tax presents some additional challenges.

Three new Division 296 headaches for legacy defined benefit pensions in SMSFs

Special valuations required – every year

Currently, defined benefit pensions are largely ignored when it comes to annual reporting for total super balance purposes. Instead, the law relies on the value reported for these pensions back in 2017 for an entirely different purposes – the transfer balance cap. At the time, the reporting was fairly rough and ready. Lifetime pensions, for example, were all valued at 16 times the annual payment at the time. It didn’t matter how old the member was, whether the pension was indexed, whether there was a reversionary beneficiary or any other feature of the pension. But at least it meant the calculation was simple and only needed to be done once.

If Division 296 tax is passed as planned, this will change. Defined benefit pensions – even in SMSFs – will need to be revalued every year.  That would be easy enough if the value was just the account balance supporting them. Or even the actuarial value from the fund’s actuarial certificate. But it won’t be either of these things. It will be something like an actuarial value (ie genuinely looking at the features of the pension and the age of the recipient) but using pre-determined factors rather than the actuary’s actual calculations.

As a result, these funds will need a separate calculation – likely at an additional cost – every single year starting from 30 June 2026.

This cost will impact every SMSF with a defined benefit pension – not just those with members paying Division 296 tax.

A different “earnings” figure to report

In an SMSF, the amount of “earnings” taken into account for Division 296 tax will be relatively intuitive.

More or less, it’s the member’s share of the fund’s taxable income (ie, the amount included on its tax return) with some adjustments to:

• Ignore any taxable contributions – this is a tax that relates entirely to investment income,
• Include any income that’s normally exempt because the fund is paying pensions, reduced by expenses relating to that income (ie, we pretend there weren’t any pensions for this calculation), and
• Exclude capital gains that built up before 30 June 2026 for funds that opt in to some specific transitional rules for capital gains.

But the calculation is entirely different for defined benefit interests (ie, not all legacy pensions – this doesn’t apply to market linked pensions).

It’s like this:

(Total super balance (TSB) at the end of the year less TSB at the start of the year – Contributions + Withdrawals) x a factor

• The TSB at the end and start of the year are worked out using the new valuation rules mentioned earlier.
• Contributions will be $nil for an SMSF pension.
• For a pension that’s in place all year, withdrawals would normally be the pension payments.
• We don’t know what the “factor” will be yet – that will be in the regulations.

In fact, this is simpler and more predictable than other types of pensions where the earnings amount relies on the vagaries of investment markets, choices made about selling or holding assets etc.

It’s also likely to be much lower than the earnings would be if the whole amount backing the defined benefit pension had been turned into a new pension or accumulation account for the member.

But the “earnings” figure is certainly less obvious and again, requires additional care and consideration.

Often, the pensioner also has other super accounts in the same SMSF (say an accumulation account or an account-based pension). The earnings for those accounts will be worked out in the usual way (ie, a share of the fund’s taxable income with adjustments). That member’s earnings for the year (to be reported to the ATO for Division 296 tax) will therefore be a combination of this “normal” amount and the “special” amount for a defined benefit pension. Again, that’s likely to be a slightly trickier calculation.

Possibly – a mid year commutation risk

This one may or may not be a risk posed by Division 296 tax. We still need the regulations to see whether it’s a problem.

But it’s interesting to look at the formula above and speculate what might happen if the pension is commuted mid year. The total super balance amount for the commuted defined benefit pension at the end of the year would be $nil. But what would the withdrawal amount be? If it was the full account balance supporting the pension (because this is what was paid to the member as a commutation value), would this whole amount be added back in the earlier formula? If this was a lot more than the TSB at the start of the year (which it often will be), a very large amount would fall out of the formula as being “earnings”.

Even if that is the outcome, there are likely to be approaches we can take to improve the situation but again, it will require careful planning. It will be easy to muck it up.

Key takeaways for SMSFs with defined benefit pensions

• They may have served their purpose and it may be the right time to wind them up.
• Do this carefully to make sure you / your client understand what they’re giving up and what they’re gaining.
• Consider bringing your decision forward to before 30 June 2026 to avoid some of the additional work described here for Division 296 tax.

We’ll be covering Division 296 tax in detail in our forthcoming masterclass (see here for registration details: Heffron - Event: Division 296 Tax Masterclass | March 2026.) While the session will be focused largely on typical SMSFs, we will touch on some of the defined benefit issues facing both SMSF members and members of large funds.