Draft legislation for legacy pensions

Just before Christmas, there was another small step towards resolution for those with “legacy pensions” with some new draft legislation being released for comment.

While it’s only draft legislation, it’s worth bearing in mind that the changes are being made via additional regulations rather than amendments to the Income Tax Assessment Act 1997 itself. The distinction is important – regulations don’t require a vote in Parliament to become law. That means once Treasury is satisfied it has the words right, it’s feasible this change will be locked in quite quickly.

So what do the draft rules say?

Importantly, they don’t have anything to do with the 2 year amnesty announced by the Federal Government in the last budget (see our article here). Remember that amnesty was supposed to allow people with these legacy pensions to get rid of them entirely.

For this purpose – and for those with SMSFs – legacy pensions are complying lifetime and life expectancy pensions (these are both defined benefit pensions) and market linked pensions. A key feature of all three is that they can’t be commuted (stopped) and paid out as a lump sum, rolled back to accumulation phase or converted to a simpler and more flexible account-based pension except under really (really really) limited circumstances. Generally, these pensions can only be commuted if the balance is used to start a new legacy pension. And to most people that sounds very much like a “frying pan” and “fire” situation – leaving one complex and restrictive pension only to start another that’s also complex and restrictive.

So the beauty of the amnesty (should it ever see the light of day) is that it will potentially allow people to move their super out of their restrictive legacy pensions entirely.

But we’re not there yet.

Instead, these regulations address another big problem that is already being faced by people with legacy pensions.

I call this the “permanent excess” problem. 

It arises when one of these pensions is commuted and converted to a new legacy pension. While that doesn’t sound particularly attractive to begin with it does happen. For example, people with defined benefit pensions often move them to market linked pensions later in life to make sure all their super can be paid out to their beneficiaries when they die. It also happens when people change super funds. For example, someone with a market linked pension in an SMSF who winds up their fund and moves to a public super fund will also need to have a market linked pension in their new fund. They have commuted a legacy pension and started a new one.

The problem is that doing so can mean the member exceeds their transfer balance cap (TBC) even if they didn’t beforehand.

It happens because of some quirky rules around how these pensions are treated for TBC purposes. 

I’ll explain how using an example shortly but the key is that under current law, people who have their super in one of these pensions but have an excess over their TBC currently have no way of solving that problem. Remember, anyone else who goes over their TBC is simply told by the ATO to commute part of their pension back to accumulation phase or pay it out of the fund. But people with legacy pensions aren’t allowed to make that commutation. So what do they do? To date, it’s been a stalemate.

What these draft regulations propose to do is make a few changes that help solve the problem.

Most importantly, they would change the super rules around when these pensions can be commuted to include an extra opportunity; when the fund is told to do so by the ATO because the pensioner has exceeded their TBC.

Because this change has been a long time coming, it’s entirely possible that some people have actually had an excess for years and are only now in a position to do something about it. That’s a problem because the current law keeps adding interest to the excess. The interest is taxed and both the excess itself and the interest have to be rolled back to accumulation phase. In other words, the longer it takes to solve the problem, the bigger and more expensive it becomes. The draft regulations therefore also include some special rules about timing. In particular, interest will only start from the date these new rules come in for commutations that happened earlier.

An example might help explain how it would all work.

Anne started her market linked pension way back in 2006 and it was still running in 2017 when the new rules about transfer balance caps were first introduced. At the time, she had no other pensions.  Back in 2017, pensions like Anne’s were called “capped defined benefit pensions” and there was a formula used to work out how much should count towards her TBC – in Anne’s case the value was $2.4m. Even though this was way over her $1.6m TBC, there were also special rules that let her leave it that way because her only pensions were capped defined benefit pensions.

Now, in 2022, Anne wants to wind up her SMSF and move the market linked pension to a new fund.  If she does so, she will stop her current market linked pension and start a new one in the new fund.  An extra complication for Anne is that the special deal that allowed her to go over her $1.6m cap without having an excess back in 2017 only worked because her market linked pension was a capped defined benefit pension. Market linked pensions that start after 1 July 2017 (such as Anne’s pension in her new fund) aren’t capped defined benefit pensions. So Anne will definitely have an excess. Let’s say it’s $500,000.

Under current law, Anne would receive a notice from the ATO saying she had an excess (growing with interest) but she couldn’t do anything about it. The new law (if implemented) will allow her to take a partial commutation of $500,000 (plus interest – worked out by the ATO) from her new market linked pension. This $500,000 (plus interest) can be paid out to her as a lump sum benefit or transferred to an accumulation account in her name. Importantly she has a pathway to doing something about her excess.

A very important point here is that the new rules only allow Anne to commute the $500,000 (plus interest) when she gets her excess notice from the ATO. Until that happens, she has to leave the pension untouched. This means there’s nothing Anne can do to minimize the amount of interest building up – other than hope the ATO issues its determination quickly. This is quite different to the situation for people with account-based pensions who work out (belatedly) that they have exceeded their cap. They can commute some of their pension as soon as they work it out – even before the ATO tells them to do so. It means they can limit their interest bill to negligible amounts if they deal with it quickly enough.

That said the draft regulations will be extremely beneficial for some people.

There are even cases where people with very large balances could exit a market linked pension entirely (move the full balance back into an accumulation account). We’ll explore some of those in a future newsletter if the rules make it into law!

Note - if you have clients who have already commuted their market linked pension and started a new one post 1 July 2017 but have not yet lodged the relevant TBARs, the ATO expects trustees to commence reporting as soon as the regulations commence.

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