Thanks to some new rules introduced late last year, many people with old-style super pensions (known as ‘legacy pensions’) will look to wind them up this year.
If you have one, you’ll know. You’ll have seen your accountant grimace slightly when talking about your pension and it will have a name like market-linked (also known as term allocated), complying lifetime or complying life expectancy pension. They’re very inflexible, with strict payment rules and can’t be switched off (known as being ‘commuted’) except under very specific circumstances. People who have them often dislike the fact that they can’t be turned into a more flexible account-based pension, the money can’t be taken out at will and some of them present unique estate planning challenges.
So there were many happy super pensioners when the Government legislated to take the shackles off these pensions from 7 December 2024. From that time, there is a temporary (5-year) amnesty allowing these pensions to be commuted (stopped) at any time, for any reason.
In this article, I’ve focussed on the most common legacy pension – a market-linked (or term-allocated) pension.
If you’re taking advantage of the amnesty, what should you know?
Is it actually law yet?
Laws often have two parts – an Act (resulting from a bill passed by Parliament and setting out the framework for the legislation) and Regulations (which provide more specific rules for some aspects of the law). Changes to acts have to be passed by Parliament but the Government can just make changes to regulations itself. This legacy pension amnesty only needed a change to the super regulations rather than the act. Technically, Parliament has 15 (sitting) days in which any member can put forward a disallowance motion to kill off changes to regulations. We’re still in that period because the Regulations came out just before Parliament rose last year and they’ve only just returned to work. So technically the change could be struck down but that’s unlikely – it’s a measure that has the support of both major parties. And even if it does get removed, it’s law until then.
So anyone who wants to wind up their market linked pension ‘right now’ can do so and won’t be impacted if the change is rolled back later.
What about social security?
Some people with market-linked pensions set them up (or transferred other old-style pensions into them) because they wanted special treatment for the age pension assets test. Specifically, they could ignore 50% of their market-linked pension balance when adding up their assets for this test. If those people take advantage of the amnesty, they will obviously lose their assets test exemption. 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.
That means anyone relying on the partial asset test exemption from their market-linked pension might choose not to wind up yet.
So, in this article, I’m focussed on larger market-linked pensions. What should we be careful of there?
Potentially less tax-exempt income in the fund
Funds that pay pensions to people in the retirement phase get a special tax break – they don’t pay tax on some of their investment income. If 100% of the fund is in pension accounts, 100% of the fund’s taxable investment income is exempt from tax (this includes things like rent, dividends, distributions as well as capital gains). If only 60% of the fund relates to pension accounts, only 60% of this income is exempt. So clearly – the bigger the pension the better.
But winding up a market-linked pension can potentially mean ending up with less in pension phase. I say potentially because this won’t impact everyone. It happens because of the way in which market-linked pensions work for the transfer balance cap.
To understand why, it’s important to remember two important things about this cap.
First, the transfer balance cap is a limit on the amount anyone can put into a retirement pension over their lifetime. It started at $1.6 million back in 2017 and those who didn’t use up all their cap have received increases since then. Someone starting their first pension now has a cap of $1.9 million. But someone with a large market-linked pension in 2017 probably used up all their cap at the time (either with their market-linked pension alone or other account-based pensions they had at the time). They don’t get any increases.
Second (and this is relevant for particularly large market-linked pensions), people who only had market-linked pensions but they exceeded the $1.6 million cap got special permission to go over the cap back in 2017. They didn’t get a higher cap, they were just allowed to exceed their $1.6 million cap.
So why does that mean they’ll have trouble winding up and converting their balance to an account-based pension?
Market-linked pensions are unusual in that 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 $2 million market-linked pension haven’t been able to put the full $2 million back into pension phase. In fact, nowhere near it. It’s easy to assume that if this is their only pension (and used up all their cap in 2017) and it is fully commuted, surely they should at least be able to put $1.6 million (their transfer balance cap) back into an account-based pension.
But unfortunately, members with market-linked pensions often can’t even put $1.6 million into an account-based pension. That’s because every pension payment they’ve taken since 2017 has used up some of their cap. For example, if they used their cap in full back in 2017 and have taken $600,000 in pension payments over that (nearly 10-year) period, they only have $1 million of their cap left. 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.
And that’s where the tax problem comes in. Now, the fund will have less in pension phase, more in accumulation phase. Its tax break on investment income will be reduced accordingly.
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 in 2024/25) 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.
This might really impact the decision.
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.
All in all, winding up a market linked pension is likely to be attractive for many people. But it will need to be done with care.
Meg Heffron is the Managing Director of Heffron SMSF Solutions, a sponsor of Firstlinks. This is general information only and it does not constitute any recommendation or advice. It does not consider any personal circumstances and is based on an understanding of relevant rules and legislation at the time of writing.
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