Tips for winding up market linked pensions

We expect many of our clients will look to wind up their legacy pensions this year – thanks to the amnesty introduced in December 2024. But is there anything to watch out for?

I’m a huge fan of flexibility and simplicity and I expect many accountants, advisers and SMSF members are the same. That alone will prompt many to wind up market linked pensions this year.

There are, however, some traps to be aware of along the way. In this article I’ve focused on large market linked pensions. Most smaller market linked pensions (say $500,000 or less) were set up for their Centrelink benefits. Winding up a market linked pension now will certainly mean the generous concessions for the assets test (50% of the market linked pension being exempt from the test entirely) will be gone. But there can be even worse consequences (involving retrospective reassessment of pension entitlements for the last few years). We’re still waiting on a crucial instrument from the Minister to ensure those don’t happen. So I suspect anyone relying on the partial asset test exemption from their market linked pension isn’t winding it up just yet.

So what are the issues for larger market linked pensions?

(And actually before I get into the detail, I should flag we can help with all these – see our website here for more information and how we can help.)

Potentially less tax exempt income in the fund

I say potentially because this won’t impact everyone. It happens because the way in which market linked pensions work for the transfer balance account is complicated. There are formula calculations used here for both the amount originally checked against the cap in 2017 and for the commutation value used today.

In many examples we’ve reviewed already, members commuting (say) a $2m market linked pension haven’t been able to put the full $2m back into pension phase. In fact, nowhere near it. It’s easy to assume that if this is their only pension and it is fully commuted, surely they should at least be able to put $1.6m (their transfer balance cap) back into an account-based pension. But unfortunately that’s not the case. For those who’ve had to take large amounts out in pension payments since 2017, sometimes winding up their market linked pension means no pensions at all in future.

Of course, this doesn’t mean the money has to come out of super, it just means it would need to go back to accumulation phase. But it will certainly mean the fund no longer enjoys such generous treatment when it comes to tax exemptions on its income.

That’s definitely a downside of winding up a market linked pension.

But there is often a tax upside to weigh up as well. Larger market linked pensions (where the pension payments are over $118,750) are taxed. (Effectively, 50% of the excess over this threshold is added to the recipient’s assessable income. No offsets. No reduction for tax free components. Nothing).

So the recipient of a very large market linked pension might find themselves balancing a future that is:

• Wind up the market linked pension and pay more tax in the super fund, or
• Leave the market linked pension in place and continue paying more tax personally.

It’s not too hard to calculate the difference but it’s important to do the calculations. Different people will find they have different results.

And it’s also important to remember that every year is not the same. Market linked pensions are specifically designed to run out (they have to end at the end of their term). That means a fund enjoying a high tax break today might not be in the future (as the pension winds down). So calculating the tax break that will be given up “today” if the pension is wound up is only part of the story – we need to look to the future as well.

In a similar vein, personal income tax on the pension payments might initially be low if the pension payments required each year are only just about $118,750. But one thing that tends to happen with market linked pensions is that payments balloon towards the end of the term. (Again, this is because they are designed to reach $0 at the end of the term no matter how good the investment returns have been.)

So again, we need to consider the future as well as the here and now.

In cases we’ve seen so far, sometimes the answer has been to wind up immediately despite a large reduction in the fund’s tax exemption. But in others the best outcome has been to wait a few years. Remember – the amnesty lasts for 5 years so not everything has to happen in 2024/25.

Dealing with inherited pensions

Some of our clients have market linked pensions they’ve inherited from a spouse. Their issues are slightly different. Remember inherited super can’t be rolled back to accumulation phase. That means any part of the market linked pension balance that can’t be turned into a new account-based pension will have to come out of super entirely. Again, that requires some planning.

Documentation

Getting the documentation right is going to be critical here. Particularly when you consider a few sneaky traps with the amnesty. For a start, it’s only available where the pension is fully commuted. So in cases where the market linked pension balance is going to end up split between an account-based pension and an accumulation account, it will be important to make sure the documentation is watertight on exactly how that happens. The last thing anyone wants is for the transaction to look like a partial commutation followed by a full commutation.

And there are the inevitable bits and pieces along the way that are important in getting the wind up right. Things like correctly calculating the minimum pension before the commutation happens, understanding how to do the calculations for transfer balance cap purposes and more.

We have a number of options to help here – see our website for more details. Or if you’re a nerd like me and would really like to understand how market linked pensions work in order to get the wind up perfect, we have a new online learning module on exactly this called (unsurprisingly) “Market linked pensions”. It’s available any time as part of an Education Bites subscription or included in our Super Specialist – Benefits course.