Legacy pensions–why the amnesty announced in the Budget should not include taxing reserves

27 May 2021
Meg Heffron

Meg Heffron

Managing Director

The announcement of a two year amnesty, possibly starting as soon as 1 July 2022, was music to the ears of anyone dealing with market linked, complying lifetime or complying life expectancy pensions.  

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Our clients with these pensions have been trapped in inflexible, unwieldy, expensive pensions while the rules for everyone else have been progressively simplified and improved (enormously) from 1 July 2007 onwards.

For some reason, successive governments have been reluctant to cut these people a break and have instead left them high and dry with pensions that effectively lock up their super, sometimes well beyond their own death.

Hopefully, there’s light at the end of the tunnel.

But there are two things that still worry me a lot about the government’s Budget Night announcement. The first is whether it will apply to all of these restrictive pensions (the reference to a start date of before 20 September 2007 has me worried). A recent article suggests that the SMSF Association has cleared this up with Treasury and the intention is to include all pensions (phew). 

My second worry is the intention to impose tax on the “reserves” associated with these pensions.

It’s the second worry that is the subject of this article - because after years of lobbying for this amnesty, I passionately want the Government to get it right. I want the change to be fair to all taxpayers (both those of us who are funding social security and superannuation concessions and the beneficiaries of this amnesty) and simple to implement with no “gotcha moments”. I also want it to achieve what I think is probably the Government’s goal – allow some of its citizens who made very long term superannuation, tax and social security decisions 15 or 20 or even 25 years ago when the rules were very different to simplify their affairs. A great outcome here (which will sound strange coming from a big SMSF advocate) would be to see a whole lot of very small and expensive SMSFs wound up.

So what is the problem?

First it’s important to note that reserves are only a problem for complying lifetime and life expectancy pensions – not market linked pensions. This is because market linked pensions don’t require reserves, they are just like account-based pensions in this regard.

For those pensions that do have reserves, the Budget announcements provided that the amnesty would allow recipients of these legacy pensions to fully commute their pensions and transfer the capital, including any reserves, to an accumulation account, an account-based pension (assuming they have enough room within their transfer balance cap to do so) or out of super entirely.

The supporting Fact Sheets included the following paragraph:

Any commuted reserves will not be counted towards an individual’s concessional contribution cap and will not trigger excess contributions. Instead, they will be taxed as an assessable contribution of the fund (with a 15 per cent tax rate), recognising the prior concessional tax treatment received when the reserve was accumulated and held to pay a pension.

I think it is probably a reasonable assumption that the “reserve” amount being referred to here is – at most – the amount held by the fund over and above the actuary’s “best estimate” of the value of the pension. In other words, if the member (let’s call him John) has a lifetime pension which an actuary has valued at $1m but the fund actually holds $1.5m to support it, the “reserves” would be $500,000.

Taxing the reserves as outlined above would cost John $75,000 (15% x $500,000).

The Fact Sheet suggests this tax is necessary to reflect past years of concessional tax treatment.

But is it?

That might be true if the “reserves” have come about from extra investment earnings that were exempt from tax while the pension was running. But actually, that’s not how it works.

For example, let’s say that when John’s pension started, the actuary said it was worth around $1.3m. And let’s also say that John put exactly that amount aside to provide his pension.  

Over time: 

  • his pension has been indexed (which makes the value of his remaining pension payments go up), but at the same time 
  • he’s getting older (which makes the value of his remaining pension payments go down – there are fewer of them left to be paid).  

The net impact in John’s case is that the value of his pension is now only $1m. But great investment returns have meant that his account has actually grown from $1.3m to $1.5m instead of falling to $1m in line with the value of his pension. (This disconnect between the value of the fund’s assets and the value of the pension is a permanent feature of these types of pensions – until actuaries can predict with absolute certainty from the outset when John will die and how much his fund will earn from its investments, it’s inevitable that the actuarial assumptions will be wrong. We haven’t reached the point where that’s possible yet, which is why we are called actuaries not psychics.)

Maybe under that scenario it would be reasonable to tax John’s extra $500,000 – if all of that bonus money has come from investment returns that weren’t being taxed in the fund while John’s pension account grew. But as I said earlier, that’s not actually how it works.

Firstly, when John started his pension, he won’t have set aside exactly $1.3m to finance it. His actuary will have advised him that there are other solvency tests he needs to meet when he has one of these pensions and so he should put aside more money. In particular, an actuary is required to certify every year whether or not the fund has enough in his pension account to meet the “high degree of probability” test. This test is only met if the actuary can say there is a “70% chance” that the pension can be covered by the available assets. As you can imagine, this requires much more money to be set aside at the outset than if John was only worried about having enough for the actuary’s “best estimate” of the value of the pension (which is generally more like a “50/50 chance”).

In other words, the Government itself has forced people like John to set aside more money in these pensions. John’s pension account probably started at a level far higher than $1.3m – let’s say $1.5m. So, some of the “reserves” he has now actually came from his own capital to begin with. That capital has either already been taxed (ie, it will have come from taxable super contributions or earnings while he was in accumulation phase that were also taxed) or has come from sources that are explicitly not taxed (such as non-concessional contributions).

And what about the fact that John’s investments have performed well and some of the “reserves” have probably come from strong investment returns? It would appear that the Government feels these have already escaped income tax because they were earned in a pension account and normally pension account earnings are exempt from tax.

Well not quite.

A very confusing feature of these pensions is that most actuaries calculate the tax-exempt proportion of the fund’s investment returns using only the “best estimate” amount.

If I was John’s actuary, for example, and the only money in the SMSF was the $1.5m supporting his lifetime pension, I would certify that roughly 67% ($1m ÷ $1.5m) of this year’s investment earnings should be exempt from tax and his fund should pay the normal 15% tax on the remaining 33% of his fund’s earnings. He will have been doing that (albeit with different percentages) since the pension started. Unlike someone with an account-based or market linked pension, John’s fund has probably never enjoyed a 100% tax exemption on its investment income.

So even if a lot of John’s $500,000 in reserves comes from great investment returns, I’ll bet his fund has already paid tax on that too.

Which brings us right back to my concern. Exactly what “prior concessional tax treatment” is the Government trying to make up for in taxing these reserves? 

Maybe I should stop looking for logic in the maths about how reserves have appeared. Perhaps the Government’s worry is that recipients of these things have secured great social security benefits on the promise of locking up their super in this way and now we’re giving them a free pass to get out of the pension? I think that would be a bit overzealous. We’ve had these people’s super locked up for at least 15 years and often a lot longer. I think they have served their time – taxing their savings now seems almost vindictive.

I’m looking forward to the consultation process on this – like I said, I really want the Government to get this great change right.

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