Paying pensions

SMSF technical expert and columnist for The Australian newspaper
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The purpose of paying a pension is to provide an income. In order for a super fund to pay that income it must earn an income. Without this income, the fund would have to sell assets.

Technically, there is nothing wrong with selling assets to pay an income except that you might find that having to sell assets at a certain time might force you to accept a lower price for the asset than you would prefer. The process of earning an income to make pension payments means that the asset allocation should probably be different than that used to accumulate money for retirement.

In retirement you should generally focus on investments that will pay the super fund sufficient income to cover fund expenses and pension payments. In an ideal world your assets would hopefully be generating some excess income above the cashflow requirements of the fund. This means you need to carefully prepare a budget for your super fund’s cash flow requirements each year before that year begins. While you need to focus carefully on cash flow, your pension’s asset allocation also needs to generate capital growth. Without this capital growth, your pension will not last long.

Types of super income streams

Since 20 September 2007, two forms of complying super income streams are allowed: account-based income streams, and non-account based income streams.

Account-based income streams (which are mainly pensions or allocated pensions) are covered in this section. The assets supporting the pension are directly attributable to the member, and the member’s account balance rises/falls as the market value of the assets change.

Non-account based income streams do not have an account balance attributable to the member. They include immediate annuities which are payable for a fixed term of for life (read All about annuities).

What pensions can be paid from an SMSF?

Generally, all new account-based income streams paid by SMSFs have to be account-based pensions (ABP). These were previously known as ‘allocated pensions’. It is possible to begin paying another type of pension called a Term Allocated Pension, however this will only apply in some rare cases where a person has an old defined benefit pension that has a financial status deemed unsatisfactory by an actuary requiring the defined benefit pension to be commuted and a new pension commenced. This is a complex area and seeking good advice is essential.

Features of an account-based pension

The major feature of ABPs is that each financial year a minimum income has to be paid based on the pensioner’s age.

Pensioner’s AgeMinimum income payment
Under 654%
65 – 745%
75 – 796%
80 – 847%
85 – 899%
90 – 9411%
95 –> +14%

This is the minimum that can be paid and is worked out each July 1. The percentage is the member’s account balance with assets valued at net market value. Note: the minimum payment usually differs in the first year that a pension commenced because it is adjusted to reflect the part of the year for which payments were made. For example, suppose a pension commenced on January 1, 2015 for a super fund member who was aged 65 at the time. This means that the pension period covered 181 days of the financial year and the minimum pension payment would therefore be:

(181 days ÷ 365 days)   x 5%  = 2.48%

So, in the first year, the pension payments have to be at least 2.48% of the member’s initial pension account balance. If they’re not made, the super fund is deemed to have breached an important super law. These pension payments must be made at least once a year, however they can also be paid more frequently, such as on a monthly or weekly basis.

Death benefit options

Depending on the wording of your super fund’s trust deed and the rules governing your pension, you may be eligible to nominate a reversionary pensioner. If you nominate a reversionary (who must be your spouse) then your pension will continue to be paid to them.  Often the nominated reversionary takes precedence over any binding nomination that you complete.

Another alternative is to complete a binding nomination which pays your survivors a new pension which begins to be paid out of your remaining pension assets.

Steps to starting a pension

  1. Deal with all members at arm’s length
  2. Check your fund’s trust deed – make sure you can pay a pension (don’t rely on your fund’s general compliance or catch-all clause)
  3. Why is the pension being paid?
  4. Prepare a Product Disclosure Statement
  5. The member must formally accept the pension’s terms and conditions
  6. The trustee confirms in writing the nature of the pension
  7. The trustee needs to fully document the pension for its own records including deciding to segregate assets (for record keeping and tax purposes)
  8. If necessary, the super fund applies to become a PAYG withholder – this will be relevant if the pensioner is under 60 at the date income is paid
  9. Pay all pension income payments on time

Tax exemption on pension assets

One of the main attractions in paying a pension is that the assets backing the pension are tax free (except for defined benefit and other special circumstances). However, any franking credits earned on pension assets are still paid.

Keeping pace with inflation

If you pay yourself the minimum income payments from an account based pension then your pension payments will nearly always not keep pace with inflation. You should factor this into your forward planning.

Capital can’t be added

Once a pension has been commenced, capital can’t be added to it. The only effective way to add capital to a pension is to stop it (called a commutation), bring it back to the accumulation part of a fund, combine it with other money and then commence a new pension. You’re often best to take advice on this option.

If possible hold some money back

Suppose you have $700,000 in super assets and want to take a pension with that money. In this case your fund would pay you a minimum pension of $35,000 (5.0% of $700,000) if you’re aged at least 65 but under 75. Let’s assume that you need at least this income amount on which to live.

One option to consider is to keep between 5% and 15% of your super assets aside for a “rainy day”.  That is between $35,000 and $105,000 still in the accumulation phase.  The purpose here is to invest these assets for the longer term thereby trying to ensure that your assets last a bit longer.

Suppose you put to one side $70,000 and left this in the accumulation phase. On this amount, the earnings and realised capital gains would be taxed at 15%. $630,000 would be the revised purchase price of the pension, and a withdrawal at a rate of 5.5% would give the same pension income of $35,000 per annum.

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